You are about to embark on an exciting journey into the world of financial accounting. If you are taking this course or reading this textbook then it probably means you are curious about financial accounting or similar subjects in the business world. As we progress through this course, you will be learning about all aspects of financial accounting from a theoretical and applied point of view. Mastering the concepts in this course is essential to becoming a true business professional. If you decide to progress to more advanced accounting courses then the fundamental theories taught in this course will be essential to your success.
Financial accounting is not simply a theoretical subject; it is a skill that must be applied to master the subject. The only way to learn these skills is by applying the skills to solve complex problems. We have a variety of practice problems, questions, and tools that will help you apply the concepts taught in this course. We also have simulation problems that will simulate how financial accounting is applied to real-world situations. To fully benefit from this course, you must do all of the practice problems and understand them completely.
We begin this chapter by giving you an introduction to the world of business and then show you how accounting information is essential to making important business decisions. Our goal is to begin with the “big picture” of accounting and then slowly progress to more detailed aspects of accounting. In this introductory chapter you will be introduced to the purpose and the history of accounting. You will learn why accounting is important and why it is such a valuable skill in today’s modern business world. We will learn why ethics is the cornerstone of high-quality accounting information and you will be introduced to the profession of being an accountant. We will conclude the chapter by giving you a high-level overview of financial accounting.
A business is a formal economic entity or organization that provides goods or services for money. The business will use the factors of production: land, labor, and capital to provide goods and services to customers. The goal of a business is to satisfy the wants and needs of their customers. Businesses can range from tiny “mom and pop” businesses to multinational corporations which operate in multiple countries. Of critical importance to these businesses is the ability to make efficient and effective resource allocation decisions.
The modern business environment is very competitive as all businesses are competing with each other to obtain customers and provide the best products or services in the marketplace. In order to effectively compete, the businesses must be able to understand the world around them and be able to make effective decisions. One way of accomplishing this goal is by having relevant and reliable accounting information. Without relevant and reliable accounting information, it would be impossible to make effective business decisions.
If we take a step back to analyze how businesses operate in a generalized form we will be able to better understand why accounting is important. In general terms, all businesses must perform the following critical tasks in order to successfully operate their business:
Let’s explore each of these goals in more detail.
All companies must create strategic goals in order to achieve success. Companies have different strategic goals, but most have similar goals. Some of the more common goals are: maximizing profit potential, customer satisfaction, expanding to new markets, and achieving sustainable business operations. Some companies do not have profit oriented strategic goals. These companies are called not-for-profit companies or non-profits. A not-for-profit company’s strategic goals will be focused on improving the overall wellbeing of society or a specific philanthropic goal. For non-profit companies, they are not working towards maximizing profits; rather they work towards achieving their stated mission, such as, reducing poverty, helping the disabled, protecting animals, restoring the environment and so on. The strategic goals are created by the top levels of management. The board of directors of corporations or the majority owners of the business are usually the individuals who are responsible for creating strategic goals. For major businesses, strategic goals will often require specialized consultants such as lawyers, accountants or financial analysts to analyze the various dynamics associated with the strategic goal. The most common dynamics would be:
Most businesses develop strategic goals that require the use of capital, or money, to achieve the goal. In order to implement the strategy, financing must be obtained. Financing can come from a variety of sources. The most common form of financing comes in the form of loans from lenders (creditors). Lenders can offer either short-term (less than 12 months) or long-term (greater than 12 months) loans. The borrower agrees to repay the loaned funds with interest over the stated terms of the loan. If the borrower was to miss a payment or default (unable to repay) then the lender would use the court system in an attempt to obtain assets or repayment of the loan.
A company could also issue bonds to investors. A bond is a financial instrument where the company agrees to repay the bondholder the amount of the bond plus a stated interest rate. For large bond issues, the bonds are often traded among owners in a market that is similar to a stock market. Another way of obtaining financing is to sell ownership in the company in exchange for a cash investment. For large corporations, the additional ownership stake is issued through the use of offering stock in the company. Stock is a partial ownership in the business and entitles the owner to receive dividends from the corporation. The shareholder can also vote for the board of directors and other special matters in an annual vote as well as other legal rights. The overall goal of obtaining financial resources is to obtain the financing at a rate that is beneficial to the company. Managers must determine the financing strategy that is the most beneficial to the company over the long-term.
When sufficient financing has been achieved. The company will use the capital to purchase assets or make investments. The investments can involve using the funds for a variety of purposes. Some examples of investments might be the following:
When the company has created its primary operations, the company will need to manage day-to-day operations. Primary operations include: purchasing, production, marketing, administration, and research and development.
The business environment is filled with competitive forces from other companies as well as other requirements that require the company to refine and improve its operations. These forces will require the company to stay competitive and the only way to achieve that goal is by continuously refining operations. Refining operations could mean investing in improved technology, performing more research and developing marketing strategies.
Now that we have a general understanding of business, we can begin to study topics directly related to accounting and what role it plays in the business environment. As you can see from the above explanations, accounting information will be essential to carrying out all the tasks above.
Accounting at its most basic level is an information science that measures, records and communicates relevant business information to users of accounting information. With this definition in mind, accounting is often referred to as the language of business due to its ability to communicate important business information. Without a basic understanding of accounting, many important financial documents will be mysterious and incomprehensible to fully understand. For any individual who wants to use financial documents or have a career in the business world, a basic understanding of accounting is essential.
As was stated above, accounting measures, records and communicates relevant business information. Since these three functions are the basis of accounting, we should explain each one in complete detail:
The ultimate goal of accounting information is to allow users of that information to make effective business decisions.
The earliest known form of accounting dates to the Mesopotamian era (3100 BC – 539 BC) when writing, money, and counting were developed. During this era, temples became the center of commerce and taxation. The advancement of record keeping quickly gained need. Similar record keeping systems were also noted during the time in different parts of the world. As civilizations advanced, accounting became more organized and the practice of auditing (verifying accuracy of the books) became common in Ancient Egypt. By the time of the Roman Empire (27 BC – 395 AD), detailed financial records were being created to record detailed information about the financial state of the Roman government. The field of accounting gradually gained widespread use, but remained mostly of simple methods.
Modern methods of accounting weren’t widely known until an Italian mathematician named Luca Pacioli published a book entitled Summa de arithmetica, geometria, proportioni et proportionalita (Summary of arithmetic, geometry, proportions and proportionality). This book contained a summary of mathematical methods as well as the first recorded description of an accounting method called the double-entry system. It is important to note that Pacioli did not create the methods of double-entry accounting; he simply described the methods that were currently in use by Venetian merchants of the time. After the publication of summa de arithmetica, the book became the only textbook that covered accounting topics for the next 150 years and became the premier book for accounting apprentices to learn the profession. Many of the earliest known accounting vocabulary, such as debit, credit, account and journal, originated from Pacioli’s writings. The summa was originally written in Italian, however, an English translation is available from the Pacioli Society.
Pacioli eloquently described the reasoning behind writing the summa’s section on accounting:
“I have decided to compile an accounting manual. Such a manual is much needed by businessmen. I have put it together in such a way that, whenever necessary, everything essential to understand accounts and bookkeeping may readily be found. My wish is to provide the minimum number of accounting rules for businessmen to keep all their accounts and books in good order.”
So why did it take so long for double-entry methods to be created in the first place? The answer has to do with the complexity of business transactions of the time. During the Venetian era, businesses began to become much more sophisticated in their structure and operation. Of notable significance during the time was the development of interest-based bank loans. Businesses began to create business operations that were largely financed by bank loans. Companies also became more sophisticated with the development of the joint-stock company which had become widespread. A common theme seen throughout the development of accounting is that accounting methods are developed after complex business operations were created. As a result, many accounting research courses focus on understanding complex business transactions first and then devising methods to properly record and report those transactions.
The double-entry system of accounting described in the book allowed for recording advanced accounting transactions and became the basis for modern day accounting information systems. Based on this work, Luca Pacioli is often referred to as “the father of accounting” due to his contribution of recording the accounting methods used in a double-entry accounting system.
In the late 1880s, accounting professionals began to organize into trade organizations to advocate for the profession and create standardized sets of rules and methods. Many aspects seen in modern professional accounting began to originate during the end of the 18th century, such as, a commonly accepted set of uniform accounting principles. The profession has continued on that path to the present day.
A user of accounting information is an individual or organization that relies upon accounting information to make decisions. Prior to creating accounting information, the end user’s informational needs are factored in. For example, external users need their financial information to be standardized to a set of rules while managers of the company will need accounting information that is very specific to internal operations. Ultimately, the end user of financial information creates the different types of accounting. Once we have identified the information user, we determine what type of information they will need to make their decisions. We then develop an accounting system to record specific information and create relevant reports based on the informational needs of the user. Here is a brief list of the different types of accounting and the type of information that is created:
As you can see from the above, financial accounting focuses on external information users while managerial accounting focuses on internal users. Realizing that financial accounting information is focused towards external users will explain why financial accounting focuses on specific attributes such as standardization of accounting principles.
The types of users of accounting information can be separated into two categories: external users and internal users.
1. External users are individuals or organizations that are outside of the company. The most common forms of external users are lenders (organizations that issue credit), investors (individuals or organizations that own or want to own part of the company), tax authorities, customers, suppliers, and government regulatory agencies. For external users, a primary focus on the accounting information is the need for standardization to allow for comparability. Just imagine if you are an investor and want to determine which company to invest your money in. You will need accounting information to compare each company. If that accounting information is not prepared based on the same set of standards, then it will be impossible to make a reliable investment decision. In other words, external users are going to need reliable accounting information in order to make effective resource allocation decisions (Should we invest in this company or sell our investment? Should we lend money to this company? etc.). Due to this need, financial accounting information is heavily standardized. Financial accounting communicates accounting information through the use of financial statements. Likewise, financial accounting focuses on the needs of external users as a priority.
2. Internal users are individuals, such as managers within the business entity, that need accounting information to make operational decisions. Compared to external users, internal users have very different needs compared to external users. External users need timely information and specific information. An engineering manager will need cost accounting information to determine if his prototype is going to be able to generate a profit based on the estimated selling price. Unlike financial accounting, managerial accounting information is not restricted to a standardized set of rules. The information will be specifically created to help make the correct decisions for the internal managers. Financial accounting can be utilized by internal users but it is generally more limited compared to information that is created specifically for their needs. Managerial accounting and cost accounting are accounting information systems that create accounting information for internal users.
The following is a brief summary of how each external user will use accounting information:
Financial accounting simply cannot be fully taught in one course. In order to provide for high academic standards and complete coverage of the topic, a series of courses is developed to learn the various aspects of financial accounting. This course serves as the basic or introductory course for a series of financial accounting courses. The general course track for financial accounting is as follows:
Other courses in accounting are generally beneficial as well, such as the following:
Since accounting is an information system, the quality of information is only reliable if the information is created according to a specific set of high-quality standards. Professionals who are delegated accounting or bookkeeping duties must maintain a high level of ethical decision making. In terms of accounting, ethical decision making should always focus on ensuring that accounting information is not deceptive to users. If the professional does not maintain their ethical standards, then the accounting statements might become susceptible to accounting fraud. An accounting fraud occurs when business management or the internal accounting staff purposefully decides to create misleading financial statements with the intent of deceiving internal or external users.
When an accounting fraud occurs, it can be devastating on users who have relied on those statements to make an investment, credit or other decisions. As a result, governments, businesses and professional organizations have all mandated a high level of ethical decision making for accounting and business professionals.
Accounting professionals must be properly trained to detect situations that would create an unethical decision. For example, an accounting professional should never modify the accounting records such that it reports information that is known to be misleading. Professionals should also place extra emphasis on how their actions would look to individuals who do not work for the firm. If an accountant employed for the company is seen taking large sums of cash in front of the office building, then that situation would appear to be highly unethical even if the transaction is ethical in reality.
Most companies have an ethical guidelines policy that requires all employees to abide by. Higher levels of management should set the “tone at the top” by always emphasizing ethical decision making as a top priority. Management should enforce the policies and make sure that ethical violations are properly investigated. Corrective actions should be performed immediately when ethical violations have occurred. On a fundamental level, all employees should strongly believe that ethical decision-making is a priority. All employees should know the difference between “right and wrong” and how to detect unethical decisions when they are occurring or might occur.
For certain situations, ethical decision making becomes incredibly complex as situations become complicated. An employee might believe that he or she is making an ethical decision while in reality; they are unknowing making an unethical decision. In such situations, seeking outside advice and proper training will allow for these situations to be detected by employees early on.
Many prominent accounting professional organizations have established ethical guidelines that all accounting professionals should follow. The American Institute of Certified Public Accountants (AICPA) code of professional conduct is a well regarded example of ethical guidelines.
At a fundamental level, an accountant must understand how businesses conduct their daily operations. Understanding how the daily operations or other key events are conducted is important for being able to recognize what to record in the accounting records. We will review a high-level overview of how most businesses operate. Variations exist for other businesses based on what type of business they are operating. Those variations will be covered in later chapters.
When a business idea is established the business founders will need to raise money to setup the business. To raise capital for the business they can either issue shares of common stock if they are a corporation or sell bonds. Common stock is a certificate that legally recognizes an ownership interest in a corporation by whoever owns the share. Bonds are a financial instrument that will pay a fixed amount of money plus interest to the owner. When the bond is issued the purchaser pays a certain amount of money which goes directly to the company issuing the bonds. The owner will receive periodic interest payments and at the end of the bond’s life, the owner will receive the fixed amount of principle as stated on the bond. The proceeds from issuing common stock and bonds are used by the business to either begin operations or expand operations.
The company will use the bond or common stock proceeds to purchase equipment, hire employees or purchase other materials needed to begin the primary operations of the business. Primary operations are business activities which are designed to generate revenue for the business. Revenue is the money received by the business from their customers for providing goods or services. In the process of conducting primary operations, the business will have expenses that need to be paid. Expenses are bills that are due to suppliers, employees, or other service providers that are needed to conduct the business operations. If you subtract expenses from revenue you will get profit or income. Profit is the amount of money that remains after all bills related to the primary operations have been paid. For most businesses, they must generate profit to stay in business for the long-term.
The profit of the business can be used to reward owners through distributions of either cash or property. Corporations reward their shareholders through dividends. A dividend is a payment to the shareholder in either cash or property. The profit of the business can also be used to expand the business by acquiring other businesses, expanding operations or developing different products or services.
Before we can review each type of business entity, we need to cover a few characteristics that may differentiate each business structure:
Liability: Liability refers to how much financial responsibility will be held by a business or individual in the event of business losses. In business terms, this often means who will be held financially responsible in the event that debts cannot be repaid or the business suffers losses from an action by a court of law. This issue brings about two distinct concepts called unlimited liability or limited liability. Unlimited liability means that the owners of the business will be held financially liable for losses incurred by the business. What this ultimately means is that creditors or a court of law can seize an individual’s personal assets (their personal home, personal car, personal bank accounts etc.) in order to pay debts that were incurred by the business. Limited liability, on the other hand, means that the owners or investors will only be held liable up to the extent of their investment. However, courts can still seize personal assets of investors if fraud has occurred that lead to the failure of the business.
Double Taxation: For certain business structures, primarily C-Corporations, the profits of the entity will be taxed a minimum of two times. When a corporation earns profit, the corporation will be levied a corporate income tax on those profits. If the corporation decides to declare dividends (a cash payment sent directly to shareholders based on how many shares they own and the type of shares they own) then that shareholder will pay personal income taxes on those dividend payments. In essence the profit from the corporation is being taxed twice. Double taxation is considered a negative in terms of selecting a business structure. Based on our discussion of business entities, only the C-corporation suffers from double taxation. Note that the concept of double taxation can vary from country to country based on their tax policies. One country might double tax a specific entity structure while others will not.
Flow-Through Entity: A flow-through entity is an important tax concept which means that income and expenses of the business “flow-through” the entity and on to the investors of the entity. The entity generally pays no taxes on the profit generated by the business. Instead, the profits are reported to each shareholder who then claims the income/expenses on their personal tax return. A flow-through entity is considered a superior business structure since it bypasses double taxation often associated with C-corporations.
As you can see from the above, many business structures have important tax characteristics. As a result, proper tax planning should be used when selecting a business structure. Now that we have some basic concepts down, we can discuss each business structure in detail.
It is important to note that the name of each business structure tends to vary from country to country, however, the following business structures are common to all countries. The naming conventions we use are specific to the United States.
Examples of economic entities could be the following business structures:
|Sole Proprietorship||General Partnership||Limited Partnership||C-Corporation||S-Corporation||Limited Liability Company (LLC)|
|Owners||1 Maximum||2+ Minimum||Minimum 1 general partner and 1+ limited partner||Unlimited||Maximum 100 Shareholders||Unlimited|
|Governance||Sole Owner Operates||General Partners Manage by Agreement||Only General Partners Manage||Board of Directors Elected by Shareholders||Board of Directors Elected by Shareholders||Operated by Members based on Agreement|
|Managing Documents||None||General Partnership Agreement||Limited Partnership Agreement||Articles of Incorporation||Articles of Incorporation||Articles of Organization|
|Liability||Unlimited Liability||Unlimited Liability||General Partners have Unlimited Liability while Limited Partners have Limited Liability||Shareholders have Limited Liability||Shareholders have Limited Liability||Members have Limited Liability|
Individuals who learn accounting can be employed by businesses as bookkeepers or accountants. Bookkeepers generally require less formal education compared to an accountant. A bookkeeper will primarily perform accounting activities related to measuring and recording transactions while an accountant will perform more difficult accounting functions that often require several years of study.
Within the accounting profession, there are several broad types of work that most accountants enter:
Within the accounting profession, high levels of education will be required as well as professional certifications. The most common professional certification is the certified public accountant (CPA) or chartered accountant. As the profession becomes more specialized, many professionals are obtaining a variety of certifications. Some of which include the following:
These certifications are generally specific to the United States. Other countries might have similar certifications to the above. If you plan on obtaining certification. You should research your local job market to determine which certifications are most beneficial to your career or future goals.
Within university level education, accountants often obtain bachelor’s, master’s or doctorate degrees in accounting or taxation.
Professional experience is also important to a professional’s development. As the industry becomes more competitive, many accountants leverage their unique and diverse work experiences to stay competitive. Most accountants have come to realize that to stay competitive in the marketplace, one must continuously improve their technical skills as well as qualitative skills (communication, business etiquette, critical thinking ability etc.). Many professional certifications as well as organizations have adopted this philosophy as well by requiring their employees to complete continuing professional education courses.
Overall, financial accounting is a subtopic of financial reporting. Financial reporting is the formal process by which a company reports their financial information. The creation of general purpose financial statements is a part of this process, but it also involves other steps. For companies that are publicly traded on stock exchanges, they must be audited annually by an independent accounting firm to ensure that the financial reports are not misleading. Most publicly traded companies are required to issue an annual report that explains in detail the financial results and the nature of the company’s operations. The annual report in the United States is called a 10-k because this is the name of the form that is used by companies to file their annual report with the Securities and Exchange Commission (SEC).
The SEC is a United States federal government regulatory agency charged with the mission of making sure that financial security issuers, such as corporations, do not take advantage of the financial system or investors. The SEC is in charge of enforcing the United State’s securities laws. The US securities laws are applicable to US SEC registered companies and non-US registered companies. A US SEC registered company is a united states company that trades stock or debt on national stock exchanges, such as, the New York Stock Exchange (NYSE). A non-US SEC registered company is any foreign company that utilizes united states’ stock or debt markets for trading of their securities. Companies must also abide by a variety of other rules that are created by government agencies to ensure companies are not abusing the overall financial system.
We will wrap this chapter up by covering a high-level overview of what Financial accounting is all about to give you a “big picture” view of financial accounting. Some topics mentioned in this overview might not be covered in this course as they are far too advanced for the scope of this course. This course is primarily focused on teaching the fundamental theories of accounting to provide you with a solid foundation for more advanced courses in accounting.
To begin our overview, we will start with the end goal of financial accounting. The end goal of financial accounting is to create financial information for investors, lenders and other individuals who are external to the entity. These financial statements must follow a standardized set of rules to allow for comparability of the information. They are often referred to as general purpose financial statements due to the financial statements being used by a variety of external users (all with different informational needs). In the United States, we use Generally Accepted Accounting Principles (GAAP) while in non-US countries use International Financial Reporting Standards (IFRS). The general consensus in the accounting profession is focused towards making a uniform set of accounting standards that will be applied to every set of financial statements in the world. This process is called convergence. Overall, there are 4 primary financial statements that are commonly used to communicate financial information, which are:
In addition to these financial statements, companies must also report information that is not able to be easily recorded or measurable. For example, let’s think about a pending lawsuit against a company. It would be difficult to be able to accurately figure out the results of this lawsuit as it is still pending in the courts. However, this information would be extremely important for external users. To communicate this information, companies would include this information as a disclosure that are included with the financial statements.
Financial accounting is primarily focused on how to report business transactions and information in the financial statements. While most transactions are easily recorded in the financial statements, not all of them are. Some transactions involve uncertainty about a variety of aspects. The example of the lawsuit above is a good example. In the case of uncertainty, the profession had developed a set of guidelines that must be followed to record these transactions.
Other aspects of financial accounting simply involve extremely complex methods or steps to record the transaction. Let’s think about a situation where one company decides to buy another company. The records for both companies must be combined and it generally involves a complex set of actions to properly record this transaction. The topic of consolidations is taught in advanced accounting courses.
Emerging topics in financial accounting focus on complex financial instruments called derivatives. These transactions are very complex and the amount of ways they can be structured is virtually unlimited since it depends on how the transaction is agreed to be performed. This area of financial accounting is not yet fully developed and the profession is working towards creating a set of standardized rules on how to report these transactions or events that will impact the business.
Most of the fundamental theories behind these topics will be covered in later chapters.
In the next chapter we will be covering the fundamental theories behind financial accounting.