Introduction to Accounting


Accounting: the language of business

Accounting is the language of business. The purpose of accounting is to help people make informed financial decisions.

Every organization uses accounting information, including businesses, governments, and nonprofit organizations.


Accounting uses financial information to:

  • Interpret business transactions.
  • Record the transactions in the accounting system.
  • Classify the information into accounts.
  • Summarize by preparing financial statements.
  • Communicate the results to stakeholders.

One of the accounting organizations defines the accounting profession as:

Broadly defined, the accounting profession produces, analyzes, interprets and prepares reports about financial and operational information… Stakeholders throughout the economy base critical decisions on information provided by the accounting profession. (AICPA, 2010).

Financial accounting

Financial accounting, or financial reporting, is the process of preparing and issuing financial statements to the public. The financial statements are designed for external users.

These financial statements are issued quarterly and annually to provide information about a company’s financial position and performance.

The goal of financial accounting is to produce financial statements. For a private company, financial statements are confidential. However, for a public company, these financial statements must be issued to the public.

These financial statements are formal reports that every public company must issue each year and are called annual reports. Interim financial statements are published every three months and are called quarterly reports.

Who are users of company financial statements? There are several groups that need a company’s financial health and results:

  • Owners of the company
  • Investors that are potential investors in the company
  • Creditors that lend the company funds
  • Employees that work for the company
  • Managers of the company
  • Government entities such as tax agencies
  • Customers of the business
  • General public

Managerial accounting

Managerial accounting is usually the second college course in accounting. It includes accounting information used by management to make decisions. Knowledge of financial accounting is important for students studying managerial accounting.

Some managerial accounting information is confidential and is not available to the public. This would include budgets, forecasts, product costs, and salary information. This information must be kept private by the company and is used by the managers to make decisions.


Accounting careers

There are many career opportunities in the accounting profession. Accountants may be employed in the following areas:

Public Accounting

Accounting firms hire many accountants and offer their services to the public. The main services provided by these accounting firms are:

Auditing

Accountants examine financial statements and records of a company, which is called an independent audit.

Taxation

Accountants provide tax planning and preparation for individuals and businesses. Almost every financial transaction has a tax impact.

Advisory Services

Accountants also provide consulting services to companies and individuals.

Internal Auditing

Accountants can work as internal auditors for corporations, governments and other organizations. Internal auditors audit their organizations’ records and resources and help to ensure good internal controls and improve risk management.

Corporate Accounting

Accountants that work for a corporation in the accounting and finance areas are management accountants. Corporate accounting is also called managerial accounting. They provide financial expertise to help the company achieve its objectives.

Governmental Accounting

National, state, and local governments hire accountants to provide information for decision-making and accountability.

Nonprofit Accounting

Nonprofit organizations need accountants to help achieve their mission and to use their resources effectively.


Big Four Accounting Firms

The largest public accounting firms are global firms collectively known as the Big Four. These are firms with offices in over 100 countries and each has annual revenues of more than $25 billion. The Big Four includes the following firms ranked by 2019 revenue in billions of USD:

RankAccounting Firm2019 Revenue
1Deloitte $ 46.2 B
2PwC $ 42.5 B
3EY $ 36.4 B
4KPMG $ 29.8 B
Big Four Accounting Firms Ranked by Revenue

Financial Certifications

Accounting is a challenging and dynamic profession. Accounting careers require a university degree and sometimes additional hours of education. It is the international language of business, with an accounting profession worldwide.

There are several certifications that are available in the area of accounting and finance. Some of the most important accounting and financial certifications are:

Certified Public Accountant

Certified Public Accountant (CPA) is the largest accounting certification in the United States. To be a CPA, the accountant must have the required accounting education, have work experience, and pass the Uniform CPA Exam. Most states require a university degree and a total of at least 150 total semester hours to be able to take the CPA exam.

Chartered Accountant

Chartered Accountant (CA) is the equivalent to the CPA designation and is the professional certification in countries such as the UK, Canada, Ireland, and Australia.

Certified Management Accountant

Certified Management Accountant (CMA) is a professional certification for managerial accounting. Management accountants typically work in a corporation rather than an accounting firm.

Certified Internal Auditor

Certified Internal Auditor (CIA) is the certification for internal auditors that work for a company and audit the company’s financial records and operations.

Chartered Financial Analyst

Chartered Financial Analyst (CFA) is designed for financial analysts and portfolio managers. This is an important credential for money managers.

Certified Fraud Examiner

Certified Fraud Examiner (CFE) is the designation for professionals that investigate financial fraud and perform forensic work.

Certified Financial Planner

Certified Financial Planner (CFP) is a credential for financial planners that work with personal finance issues with individuals. This involves insurance, budgeting, taxes, and investing.


Professional Associations

There are several important professional organizations that affect accounting and finance practice and regulations in the United States.

American Institute of Certified Public Accountants

American Institute of Certified Public Accountants (AICPA) is the oldest and largest accounting organization in the United States. The AICPA administers the Uniform CPA exam.

Institute of Management Accountants

Institute of Management Accountants (IMA) is a professional association for managerial accounting. It sponsors the CMA certification.

Institute of Internal Auditors

Institute of Internal Auditors (IIA) is the organization for internal auditing that sponsors the CIA exam and certification.

CFA Institute

CFA Institute is the leading organization for investment professionals and sponsors the CFA charter.

Association of Certified Fraud Examiners

Association of Certified Fraud Examiners is the organization that provides education for financial fraud and sponsors the CFE designation.


Accounting Standards

There are several accounting organizations that set the requirements for financial reporting. These organizations and the rules they issue are below:

Securities and Exchange Commission

Securities and Exchange Commission (SEC) is the United States agency charged with regulating the financial services industry and the financial markets. It has statutory authority to set accounting standards in the United States.

Financial Accounting Standards Board

Financial Accounting Standards Board (FASB) is a private nonprofit organization that is charged with setting financial accounting standards in the U.S. It is composed of accounting and finance experts that set these financial reporting standards known as GAAP.

Generally Accepted Accounting Principles

Generally Accepted Accounting Principles (GAAP) is the combined set of accounting rules in the United States. U.S. GAAP is primarily set by the FASB with the oversight of the Securities and Exchange Commission.

International Accounting Standards Board

International Accounting Standards Board (IASB) is the independent organization that sets international accounting standards, called International Financial Reporting Standards or IFRS.

International Financial Reporting Standards

International Financial Reporting Standards (IFRS) is the set of accounting rules for 120 countries around the world. It is comparable to GAAP for the United States.


Legal Forms of Businesses

In the United States, a business may have four different legal forms.

  1. Proprietorship
  2. Partnership
  3. Corporation
  4. Limited Liability Company

Propietorship

A proprietorship, or sole proprietorship, is the simplest form of business. It has only one owner and most proprietorships are small. There are no legal requirements necessary to start the business. The owner receives any profits from the business and individually pays income tax owed. The owner also has unlimited responsibility for all losses and debts of the business, called unlimited liability.

Partnership

A partnership is an association of two or more owners in a business. It is a simple legal form like a proprietorship, except with additional owners. Each partner pays tax on partnership profits at the individual level and each partner also has unlimited liability for losses and debts.

Corporation

A corporation is a separate legal entity chartered under the law. In the U.S., each state has a corporate law, so a corporation is chartered by a state. Corporations typically have more than one owner.

The advantages of a corporation include access to more capital, professional management, and limited liability on company debts. A disadvantage is the corporate income tax. Corporate income is taxed at the business level and any dividends the corporation pays to its owners are taxed at the individual level. This tax on dividends represents double taxation on corporate profits.

The owners of a corporation receive shares of stock to represent their ownership and are called stockholders or shareholders. The stockholders elect a board of directors to govern the corporation. The board of directors hires the chief executive officer (CEO) and the top corporate officers.

A special type of corporation is a nonprofit corporation. A nonprofit company may be organized to provide educational, charitable, social, or scientific benefits. Charities, universities, churches, and hospitals may all be nonprofit corporations. Nonprofit corporations are corporations that do not have owners and are governed by a board of trustees.

Limited Liability Company

The limited liability company (LLC) is a hybrid that has characteristics of both corporations and partnerships. These hybrid business forms are created under state law similar to corporations. The goal of an LLC is to create an entity that is taxed like a partnership (at the individual level) with the limited liability of a corporation.

The hybrid form avoids both double taxation and unlimited liability. The owners of an LLC are typically called members or partners rather than stockholders.


Types of Business Activities

Businesses can be classified by the type of activity performed. There are three types of businesses based on their activities:

Service companies sell services for a fee. This includes accounting firms, law firms, and consultants.

Retailing companies buy goods and resell them for a profit. Retailers include bakeries, clothing stores, department stores, and grocery stores.

Manufacturing companies buy raw materials, convert them to products and sell the products for a profit. Manufacturers include computer manufacturers, car companies, and pharmaceutical companies.


Types of Accounts

In accounting, there are five types of accounts. Every organization has these accounts and these are the basic building blocks of the accounting system. The five categories of accounts are:

  1. AssetsAssets are economic resources that the company owns.
  2. LiabilitiesLiabilities are company debts or what the company owes. These are claims on the assets by the creditors.
  3. EquityEquity is the net worth of the company or the claims on the assets by the owners. It is calculated as assets – liabilities = equity. Equity is also called stockholders’ equity. Equity is the net worth of the company.
  4. RevenuesRevenues occur when the company receives assets from selling a product or service.
  5. Expenses – Expenses occur when the business consumes or uses up assets.

Accounting Equation

The accounting equation is Assets = Liabilities + Equity.

This means that all assets are paid for by either debt or equity. The more debt a company has, the less the owners’ equity.

Accounting Equation
Accounting Equation

Equity has several components that are used in the expanded accounting equation. Equity includes common stock, revenues, expenses, and dividends. Note that expenses and dividends subtract from the equity.

Expanded Accounting Equation
Expanded Accounting Equation

Financial Statements

There are four basic financial statements that each company prepares.

  1. Income Statement
  2. Balance Sheet
  3. Cash Flow Statement
  4. Retained Earnings Statement

Income Statement

The Income Statement shows the profitability of the company. The format of the Income Statement is Revenues – Expenses = Net Income (or Net Loss). The Income Statement is also called the Profit & Loss Statement, P&L Statement, or the Earnings Statement.

Sample income statement

Revenues and Expenses are called income statement accounts or temporary accounts because these accounts are only for each year.

Balance Sheet

The balance sheet shows the company’s financial position. The format of the balance sheet is Assets = Liabilities + Equity. This formula is also called the accounting equation. The balance sheet is also called the statement of financial position.

sample balance sheet

Assets, liabilities, and equity are called balance sheet accounts or real accounts because they go on the Balance Sheet and because the accounts continue longer than one year.

Cash Flow Statement

The cash flow statement gives the summary of all the company cash inflows and cash outflows for a period. This helps managers understand why the cash account increased or decreased.

Retained Earnings Statement

There is an additional financial statement. The retained earnings statement illustrates the retained earnings of a company and its change over the period. Retained earnings is an equity account for corporations. This statement could include all the equity of a company and be called the Statement of Stockholders’ Equity.

If the company is a proprietorship or a partnership, then this statement would be called a Capital Statement or an Owners’ Equity Statement.

Two Goals of Every Business

There are two basic goals for every business:

  1. Solvency
  2. Profitability

Solvency is the ability to pay debts when they are due. If the company cannot pay its debts, it will not survive to have the ability to generate profits and fulfill its mission. Solvency is always an important goal for every business.

Every company must be solvent with the ability to pay its debts on time. This is always an immediate goal of every company. The company will fail quickly if it cannot pay its employees, suppliers, and creditors.

Profitability is the ability to generate a profit. Profitability is long-term sustainability.

Each company needs to be profitable to continue in business in the future. Profitability is a long-term goal. A new business will close quickly if the company is insolvent, but may survive several years before the company makes a profit.

Three Goals of Financial Reporting

There are three goals of financial reporting. Financial reporting provides information about a company’s:

  1. Financial position—the company’s assets, liabilities, and equity.
  2. Cash inflows and outflows—the company’s cash receipts and payments.
  3. Operating Results—the company revenues and expenses and profitability.

The goals of financial reporting relate directly to three of the company’s financial statements. See the table below.

Accounting Concepts and Assumptions

In accounting, there are several underlying assumptions and concepts. These are understood by preparers and users of financial statements.

Business Entity

Business entity is the concept that a business is separate from its owner(s). The business records are separated from personal records.

Going Concern

Going concern is the assumption that the business will continue to exist unless there is evidence to the contrary. Without this assumption, the value of future benefits and liabilities would be useless.

Monetary Unit

Monetary unit is the concept that all activities of a company can be recorded in a single monetary unit, such as the dollar, euro, or yen. Multinational companies may have transactions in many different currencies, but they use a single currency for financial reporting. The monetary unit concept also assumes a stable monetary currency.

Measurement Concept

Measurement concept usually requires assets to be recorded at their original cost. This means that assets, like land, are shown at the original cost and not the current fair market value. Fair value is introduced later in the course.

Periodicity

Periodicity assumption, or the time period assumption, is the concept that a company’s life may be meaningfully evaluated in time periods of months, quarters, and years for financial reporting purposes.

Matching

The matching principle is the concept that requires matching, within an accounting period, revenues with the expenses that generated the revenues. The revenues must be matched with the related expenses even if the expenses are paid in the following period.

Objectivity

Objectivity is the concept that accounting information and financial reporting should be independent, verifiable, and free from bias.

Full Disclosure

Full disclosure is the principle that all relevant information must be provided in the accounting information and financial statements.

Consistency

Consistency is the concept that accounting methods and principles must be consistently used from year to year. This is a basic idea for comparison from company to company and from year to year.

Conservatism

Conservatism is the policy of estimating potential losses and expenses but not potential revenues or gains. This concept attempts to avoid overstating assets and net income.


Financial Accounting Lessons

We have many resources for Financial Accounting. This works for students learning principles of accounting or financial accounting.

For all the lessons see The Ultimate Guide to Learn Financial Accounting

Here are the lessons:

  1. Introduction to Accounting
  2. Recording Business Transactions
  3. Adjusting Entries and the Accounting Cycle
  4. Accounting for Merchandising Activities
  5. Time Value of Money
  6. Inventory
  7. Cash
  8. Receivables
  9. Long-term Assets
  10. Investments
  11. Current Liabilities
  12. Long-term Liabilities
  13. Stockholders’ Equity

Jeff Mankin

Jeff Mankin teaches financial literacy. His website is FinallyLearn.com.

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