The Purpose of Accounting
Accounting is the way a business “keeps score” from a financial perspective. In the accounting system, we document all of the financial events that have occurred and determine how the business is performing financially. We collect the data that we need to make effective business decisions. And we also meet various legal, regulatory, and tax requirements.
Key Generally Accepted Accounting Principles (GAAP)
While a lengthy book would be required to discuss all of GAAP, there are a few significant principles that provide the basis for much of GAAP.
- Fiscal year. While organizations typically prepare monthly, quarterly, and year-to-date financial statements, one year is normally the critical financial period. Although it is most common to use the calendar year, seasonal businesses usually select a year-end shortly after the end of their peak season.
- The “going concern” concept. Financial statements are normally prepared on the assumption that the company will continue its business indefinitely. This assumption allows us to spread the cost of the firm’s buildings and equipment over a number of years because we assume the firm will be able to stay in business and continue using the buildings and equipment.
- The historical cost concept. In both the U.S. and Canada, historical cost (i.e., what was paid) is the basis for valuing most of what the business owns. For example, if the company paid $500,000 for a piece of land 10 years ago, the land remains on the company’s books at $500,000, even though its market value today might be $1,000,000. One exception to this rule is a financial investment that might be sold—it is shown at market value instead of historical cost.
- Conservatism. Conservatism in accounting means that the company recognizes its losses as soon as it can quantify them. For example, if the company decides to close a plant, it should determine how much the closing will cost it and show that amount as a loss on its financial statements even though the actual costs of closing may be incurred over many months or even years. Conservatism also means that a company should not recognize any financial gains until it realizes them. For example, some land the company owns may have increased dramatically in value. However, the company would continue to show that land at the historical cost on its financial statements. Only when it sells the land would it record the profit from the sale.
- Quantifiable items. Accounting deals with items or events that we can assign a monetary value to. For example, a software company’s most valuable resource may be the people who develop its products. However, because the company does not own these people and cannot put a concrete dollar value on what their contributions are worth, the employees are not listed on the financial statements as part of the company’s belongings. This is one reason why companies are often sold for much more than the values listed on their financial statements.
- Materiality. Materiality recognizes that some financial information and events are more important than others. Items are material if knowledge of them would change your perception of the company. For example, a pharmaceutical company would list research and development as a separate expense because such companies spend a great deal on R & D, and people who evaluate them want to know how much they are spending. On the other hand, a construction company would probably not list R & D as a separate expense because the firm spends very little in that area—hence, the expense is not “material.”
- Consistency. Organizations often have choices in how they may account for different items and events. Consistency requires that once a company selects a particular accounting method (for example, decides to value its inventory in a certain way), it continues to follow that method. If the company changes the method, it must disclose that fact and the financial consequences of the change— full disclosure—in the footnotes to its financial statements.
The Five Types of Accounts
Although a business may have thousands of different accounts in its accounting system, they all fall into one of five categories:
- Assets: everything the business owns: cash, receivables, inventory, property buildings, equipment, and investments.
- Liabilities: the debts and financial obligations.
- Equity: what the shareholders paid for stock and the reinvested profits (i.e., retained earnings).
- Revenues: what the organization earned from selling its products or services. There may also be revenues from investments or the sale of assets.
- Expenses: costs incurred in running the business.
Business transactions are recorded in a double-entry accounting system that involves the use of debits and credits. This procedure requires that every transaction be recorded two ways: as one or more debit entries and as one or more credit entries. The debit entries must equal the credit entries.
Debit is probably the most misunderstood of all accounting terms. Most people think a debit is always a negative. In reality, a debit entry is merely a left-hand entry in a ledger account, while a credit is a right-hand entry. Debits can be positive or negative depending on the account type. For example, a debit entry increases an asset account while it decreases a liability or equity account. Likewise a credit entry can be either positive or negative. A credit decreases an asset account, but increases a revenue account.
At the end of an accounting period, various adjustments are made to account balances to reflect economic events that occurred but did not cause a transaction. Examples of such adjusting entries include recording depreciation expenses or accruing liabilities for expenses that were incurred during the period, such as salaries that have not been paid.
Closing the Books
At the end of each accounting period, revenue and expense accounts are consolidated to determine if the organization made or lost money, and are reset to zero. This process allows the organization to identify its revenues and expenses for that particular period. The profit or loss for the period is then transferred to the retained earnings account of the balance sheet. Then the financial statements are prepared. The closing process can be extremely involved for large organizations, as each subsidiary closes its books and then consolidates its data, often first by region, such as North American, Europe, and so on, and then for the entire organization.
The information in this article is intended only as a very basic introduction to some of the principles of accounting. Hopefully it will encourage you to learn more about the subject, increasing your general business knowledge and so, your value to your boss, your organization, and your future success.
© American Management Association. All rights reserved.
Adapted from AMA’s seminar Fundamentals of Finance and Accounting for Administrative Professionals.