Chapter 1 Introduction to Accounting
1.1 What is Accounting?
Definition
Accounting is the process
of recording and summarizing financial information in a useful
way.
Introduction
Explanation
Even if you’re new to accounting, you may have noticed some use of
accounting in your daily life.
My mom for example is the chief accountant of our family. At the start of
each month, she prepares a budget that lists all expected payments and income
for the month. She then records all payments and receipts in her personal diary
such as groceries, utilities, taxes and so on. Tracking home expenses against
the monthly budget helps her avoid overspending and also gives her peace of
mind knowing where the money was spent in case she forgets. She keeps all the
invoices and bank statements in a shoe box. Once every year my Mom files her
taxes and this is where all her hard work in maintaining the financial record
pays off as she has all the required information on her finger tips (and a shoe
box). Even though my mom doesn't know, she is performing basic functions of an
accountant to manage the home finances.
Accounting is just a more formal and efficient version of such processes in
the context of a business. Businesses use accounting to keep their financial
information organized which helps them in making sense of their financial data
and also keeps them compliant of financial regulations.
1.2 Components of
Accounting/ Accounting Careers
Accounting consists of 2 parts:
1. Book-keeping
2. Analysis
- Book-keeping, which is also known as financial accounting, is the process of recording and summarizing financial information. Book-keeping involves the recording of transactions (e.g. sales, purchases, and expenses) which are then summarized and presented in the form of financial statements which show the overall health of the business.Book-keeping helps to organize the financial data which facilitates the effective management of the business by providing key information such as:
- How much they owe to suppliers, tax authorities, banks, employees and
others?
- How much each customer owes the business?
- How much capital is invested by the owners in the business?
- How profitable is the business?
Bookkeeping is
the backbone of an accounting system and forms the basis of analysis in
management accounting.
- Management accounting, also known as managerial accounting, provides
information to management for analysis, decision making, planning and
control of the business. For example, information relating to investment
decisions, budgeting and performance measurement.
Importance of
Accounting
Record
Organizations need to have a reliable and systematic way of recording
financial information. Accounting is necessary to ensure that those running the
business have a reliable record of financial transactions.
Legal
Accounting helps organizations to determine their financial rights and
obligations. Without proper accounting, it would be very difficult for a
business to calculate, for example, the exact amount a supplier needs to be
paid taking into account cost of purchase, discounts, sales tax, withholding
tax, duties, refunds, etc.. Accounting is therefore necessary for a business to
fulfill its legal obligations and asserting its own legal rights.
Maintaining accounting records and preparing financial statements is also
often a legal responsibility for businesses above a certain size.
Performance
Accounting information is summarized to produce financial statements. Financial
Statementsprovide an overview of the financial activities of a
business during a period (e.g. cash flow, income and expenses during
the year) as well as information about its financial
position on a specific date (e.g. amount of cash and inventory at
the end of the year).
Financial Statements help owners in assessing the performance and position
of their business which can guide their investment decisions (e.g.
whether they should invest more in the business, diversify or dispose their investment).
Planning and Control
Accounting helps organizations to plan their finances by developing budgets
and forecasts. Variance
analysis provides a mechanism for the monitoring of expenses incurred by
organizations by comparison with the budgeted expenditure. This process helps
organizations in planning their finances ahead and controlling any deviations
from the budget.
Decisions
Accounting provides a basis for managerial decisions. Examples of such
decisions include:
- Investment Appraisal
- Make or Buy decisions
- Pricing Decisions
- Limiting factors analysis
Summary
Accounting is a reliable process for recording, organizing and analyzing
financial information which helps in the effective management of the business.
1.2 Accounting careers
Although there are many other specialties, the four major areas of
accounting are:
- Public accounting
- Management accounting
- Governmental accounting
- Internal auditing
Public Accounting
Public accounting covers a wide range of services, including preparing and
issuing the public financial reports for a company, providing business
consulting services or personal financial planning services, and preparing tax
returns.
Public accounting includes several types of accounting:
- Financial accounting involves preparing a company's public financial statements.
- Forensic accounting involves examining financial records looking for fraud and other
illegal activities or reconstructing missing financial records.
- Tax accounting focuses
on individual and business taxes, typically with the intent of limiting
the tax obligation as much as possible.
- External auditing involves the review of financial statements to determine that they
were prepared correctly.
New accountants who go to work for a public accounting firm may serve as
staff auditors who analyze and verify activities in specific assigned client
accounts. This is sometimes considered the "grunt work" of auditing,
and it doesn’t usually involve any interaction with clients.
Similarly, tax staff accountants with accounting firms do most of the tax
return preparation and research without interacting with clients.
Experienced accountants can move into senior positions, taking on more responsibility,
and eventually move into management positions if a firm thinks the accountant
has partner potential.
Management positions include Audit Manager, Tax Manager, and Management
Services/Consulting Manager. Only about two percent of accountants in a public
accounting firm eventually become a partner, according to the American
Institute of CPAs.
With experience, public accountants may go on to work in areas like
personal financial planning, sometimes starting their own practice. Some
accountants take on roles in forensic accounting, specializing in detecting and
preventing fraud.
Management Accounting
Management accounting is also called managerial, cost, corporate,
industrial, or private accounting. Management accountants have an internal
business role that supports business managers in making business decisions.
Management accountants prepare detailed reports and forecasts for managers
inside the company. These reports are not intended for public review.
Management accountants track and analyze internal financial information by
designing, implementing, and managing internal financial management systems
that assist with performance management, strategic management, and risk
management.
Within management accounting are different approaches. For example, project
accounting (or job cost accounting) tracks finances by project and prepares
financial reports specific to these projects. Resource consumption accounting
is a new approach to management accounting developed in Germany in 2000. This
approach is principle-based and not tied to a specific method, according to the
Resource Consumption Accounting Institute.
New accountants who take jobs in corporations often begin as junior
internal auditors or as staff accountants in areas such as financial accounting
and reporting, management accounting, or tax accounting.
Junior internal auditors make sure the company has accurate records and
adequate controls to protect against fraud and waste by examining and
evaluating financial and information systems, internal controls, and management
procedures.
Financial accounting and reporting staff accountants typically have
responsibilities in an assigned area, such as payroll, receivables, payables,
general ledger, treasury management, asset management, or financial statements.
Management staff accountants collect detailed cost data and may prepare
preliminary cost analyses and reports that are then presented to management and
executive leadership.
Junior tax accounting staff members prepare tax returns or related schedules
for review, keeping information current and tax deductions maximized throughout
the tax year.
As accountants gain experience, they can move into senior positions in any
of the areas, taking on more responsibility and more complicated tasks.
Accountants may eventually move into management positions as Financial
Accounting & Reporting Managers, Management Accounting Managers, Tax
Managers, or Internal Audit Managers.
Other types of accounting jobs within corporations include the Assistant
Controller, who assists in supervising the day-to-day collection and
interpretation of accounting data, and the Controller, who is the chief
accounting executive.
An accountant could also become the Chief Financial Officer (CFO) who
advises the President or CEO in matters related to financial strategy and
financial reporting.
Government Accounting
The umbrella term governmental accounting refers to any type of accounting
use to keep and examine the financial records of government agencies and to
audit private businesses and individuals who engage in activities subject to
government regulations or taxation. Thus, governmental accounting may include
the methods of financial accounting, tax accounting, or other types of
accounting.
Government agencies sometimes use fund accounting, which is a way to
separate resources into categories in order to track the source and use of
these funds. Fund accounting is used as a way for a government agency or
division to be transparent and responsible in their management of the tax
dollars used to fund the agency or division. Fund accounting is also often used
by non-profit organizations.
Entry-level jobs are also available with the federal government, as well as
for state and municipal government agencies. New accounting hires may serve as
junior auditors or staff accountants, tax examiners who review filed tax
returns for accuracy and adherence to law, or revenue agents who review complex
business income, sales, and excise tax returns. Experienced accountants can
move into senior and management positions in similar roles.
Internal Auditing
Internal auditors provide an independent, objective examination of an
organization's finances. Internal auditors mainly identify financial
mismanagement or fraud or identify ways to improve financial management and
reduce waste.
The Securities and Exchange Commission (SEC) requires all publicly traded
companies to regularly conduct internal audits. Audits are used to provide
investors with an accurate financial picture of publicly traded companies.
Corporate and retail investors use the information revealed through internal
audits to decide which securities are worth purchasing.
Other Types of Accounting Jobs
Accountants can become educators at the post-secondary level for community
colleges, schools of business, and universities. Earning a PhD is usually
required for college-level professorships in accounting.
Professionals with backgrounds in accounting can also serve as consultants
in any accounting/financial capacity for which they are qualified, or work in non-profit
organizations in jobs that are similar to those found in the corporate world.
Tax accounting involves keeping records for paying taxes and making
decisions that comply with tax laws. Large multinationals, small business,
non-profits and individuals alike, all may have occasion to use tax accounting.
Regardless of tax status or obligation, all persons and organizations that
generate revenue, receive pay, or accept funding may benefit from the services
of tax accounting professionals.
1.3 General Principles
What are Generally Accepted Accounting
Principles - GAAP
Generally accepted accounting
principles (GAAP) refer to a common set of accepted accounting principles,
standards, and procedures that companies and their accountants must follow when
they compile their financial statements. GAAP is a combination of authoritative
standards (set by policy boards) and the commonly accepted ways of recording
and reporting accounting information. GAAP improves the clarity of the
communication of financial information.
GAAP
BREAKING DOWN Generally Accepted Accounting
Principles - GAAP
GAAP is meant to ensure a minimum
level of consistency in a company's financial
statements, which makes it easier for investors to analyze and extract
useful information. GAAP also facilitates the cross comparison of financial
information across different companies.
These 10 general principles can
help you remember the main mission and direction of the GAAP system.
1.) Principle of Regularity
The accountant has adhered to GAAP
rules and regulations as a standard.
2.) Principle of Consistency
Professionals commit to applying
the same standards throughout the reporting process to prevent errors or
discrepancies. Accountants are expected to fully disclose and explain the
reasons behind any changed or updated standards.
3.) Principle of Sincerity
The accountant strives to provide
an accurate depiction of a company’s financial situation.
4.) Principle of Permanence of
Methods
The procedures used in financial
reporting should be consistent.
5.) Principle of Non-Compensation
Both negatives and positives
should be fully reported with transparency and without the expectation of debt
compensation.
6.) Principle of Prudence
Emphasizing fact-based financial
data representation that is not clouded by speculation.
7.) Principle of Continuity
While valuing assets, it should be
assumed the business will continue to operate.
8.) Principle of Periodicity
Entries should be distributed
across the appropriate periods of time. For example, revenue should be divided
by its relevant periods.
9.) Principle of Materiality /
Good Faith
Accountants must strive for full
disclosure in financial reports.
10.) Principle of Utmost Good
Faith
Derived from the Latin phrase
“uberrimae fidei” used within the insurance industry. It presupposes that
parties remain honest in transactions.
Compliance
GAAP must be followed when a
company distributes its financial statements outside of the company. If a
corporation's stock is publicly
traded, the financial statements must also adhere to rules established
by the U.S. Securities
and Exchange Commission (SEC).
GAAP covers such things as revenue
recognition, balance
sheet item classification and outstanding share measurements. If a
financial statement is not prepared using GAAP,
investors should be cautious. Also, some companies may use both GAAP and
non-GAAP compliant measures when reporting financial results. GAAP regulations
require that non-GAAP measures are identified in financial statements and other
public disclosures, such as press releases.
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