Basics of Accounting

Sometimes marketing is described as THE primary function in a business.  Designing a product, manufacturing, spending on advertising, and making sales are the engine of the business.   But there has to be some way of knowing how fast to run the engine and how much gas to put in it. Accounting is an information system that exists to let managers and investors know how things are going.  In simplest terms, if marketing is the engine, then accounting is the speedometer and the gas gauge.  We have to be able to measure what we’re doing along the way so we can make it to the end of the journey – which is profitability.

Information is the Key

The purpose of accounting is to communicate useful information that tells specific things about a company.  What is important is that the language used is consistent among all participants. When the language involved in the communication is understood and trusted, decisions vital to the performance of the business can be made. 

By the end of the tutorial lessons 7, 8, and 9 you should be able to understand most of the terms and concepts involved, and will be ready to understand more about how a business operates.  You will also see that you use accounting every day.

Types of Accounting
There are two major categories of accounting, which are based on for whom the information is being prepared.  If the information is being used primarily to inform managers within the company itself, Managerial Accounting methods are used.  If the information will be used to report financial activity to external partners such as bankers, investors, shareholders, suppliers, etc., then Financial Accounting methods are used.

• Managerial Accounting methods are used to prepare financial reports that will be used by managers to help plan and control activities within the organization.  The most well known are budgets, which are generally projections for what resources are needed to accomplish a forecast level of sales.  In other words, if we want to do $1.0 million in sales, how much inventory of raw materials will be needed? How many workers will be needed? Will we need to expand production capability by buying a new manufacturing plant? Will we need to hire more salespeople, etc.?

Budgets are checked along the way by comparing the original projections to the actual results of the activities. NEW projections can be made to adjust for under or over-budget situations, i.e.: we are under budget for sales, so perhaps we need to re-forecast our requirements for raw materials and labor, or we need to develop a new promotional campaign to boost sales.  By comparing budgeted numbers to actual results, the budget becomes a tool to help keep the company on track to profitable operations.

In this course we will spend very little time on Managerial Accounting.  If you continue with a Business program in school, you will be taking more Managerial Accounting courses in future quarters.

• Financial Accounting is information used by internal managers, but is also utilized by external partners to measure the performance of the company.  In this way not only owners, employees, and managers are apprised of financial details, but lenders, investors, shareholders, and suppliers are informed of the financial performance and overall condition of the company.  This information is then used by these external groups in making decisions about whether to lend or invest in the company.

There are a number of specific reports that are developed under Financial Accounting, but we will focus on the two main reports in this course:  the Balance Sheet, and the Income Statement, which is also called the Profit and Loss Statement.  We will go into detail about these two financial reports in the next sections of lesson 8.

Who, or what, are Accountants?
Two types:

Internal Accountants (work within the organization)
·         Controller is at the head of the company’s accounting system, which is an organized set of
          procedures for identifying, measuring, recording, and retaining information.

·         Internal Auditor confirms the accuracy of the internal reporting systems. (“Auditor” is another way of saying “fact checker”.)

·         Accounts Payable Manager is responsible for verifying the validity of, and then paying, bills from vendors.

·         Financial Analyst helps make decisions about what resources are needed to accomplish the budget, and also prepares information for upper management about possible plant and equipment purchases so final decisions can be made.

·         Payroll Manager makes sure all personnel are paid properly.  Payroll is generally one of the major expenditures of a company, so it is vital that it be done correctly, without incurring legal or tax liabilities.

·         Tax Accountant has the important job of minimizing another major expense category – taxes.

External Accountants (are brought into the company as consultants, but are independent)
·         Certified Public Accountants are trained professionals licensed by the state to perform the
          major functions of a CPA – audits, tax preparation, and management consulting. 

Audits are an examination of a company’s accounting practices and records to verify their accuracy.  This is important to external users, who must be able to trust that the information is up-to-date and accurate.

Tax Preparation is performed by independent CPAs to either verify the work done by internal tax preparers, or when the company is too small for an internal tax preparer.

Management Consulting is performed by CPAs to help companies create or improve their accounting practices and procedures.

How is the “language of accounting determined?
I have gone into great detail about how important it is that all preparers and users of financial reports be speaking the same language so that all information is consistent and easily understood. The language of accounting has been developed through many years, and is incorporated into a body of rules called Generally Accepted Accounting Principles, or “GAAP”.  Almost all of the activities of both internal and external accountants are governed by this published body of rules.

History
Generally Accepted Accounting Principles (though not called that for several hundred years) got a start hundreds of years ago as the exchange of money for goods and services began to be more important than the prevailing system of bartering.  A way of keeping accounts was needed, and a system was devised that helped both minimize arithmetical errors and that improved consistency of financial reporting.  This system utilized a technique of making two entries for each transaction so that two separate columns of numbers had to agree to verify accuracy.  This system, of debits and credits, became known as “double-entry” bookkeeping, and is still used today.

How accounting methods get updated
From time-to-time there are developments in the world that affect accounting.  Many years ago an alternative to buying equipment was developed, called “leasing”.  There were no GAAP rules governing this new type of transaction, since, in a strict sense it is neither a “purchase” nor a “rental”, both of which are discussed in the GAAP.  The Financial Accounting Standards Board takes these new developments under advisement, and then prepares rules that become part of the published GAAP.  The Financial Accounting Standards Board is comprised of a rotating group of leaders in the accounting profession, and these new rules are published as “FASB (number)” and become appendices to the GAAP.  Certified Public Accountants are kept apprised of these new rules and modifications to existing rules, through a newsletter from the FASB, and thorough periodic updates to the GAAP.  The last great wave of new accounting practices emerged with the rise of internet businesses.

More Background Reading
Please review the following web pages for more background information about accounting:

Overview of Accounting
http://www.businesstown.com/accounting/basic-language.asp

Basic Terms and Concepts
http://www.businesstown.com/accounting/basic-terms.asp

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