Understanding the Basic Elements of Accounting

Probably the first thing you think of is that accountants keep the books — they keep the records of the financial activities of the business. But accountants perform other very critical, but less well-known, functions in a business:

• Accountants carry out vital back-office operating functions that keep the business running smoothly and effectively — including payroll, cash inflows and cash payments, purchases and inventory, and property records.

• Accountants prepare tax returns, including the federal income tax return for the business, as well as payroll and property tax returns.

• Accountants determine how to measure and record the costs of products and how to allocate common costs among different departments and other organizational units of the business.

• Accountants are the professional profit scorekeepers of the business world. They prepare reports for the managers of a business, which keep managers informed about costs and expenses, how sales are going, whether the cash balance is adequate, what the inventory situation is, and, the most important thing — accountants help managers understand on the reasons for changes in the bottom-line performance of a business.

• Accountants prepare financial statements that help the owners and stockholders of a business understand where the business stands financially. Stockholders wouldn't invest in a business without a clear understanding of the financial health business, which regular financial reports (sometimes called the financials) provide.

Accountants provide the critical numbers to help business managers make good decisions, which keep a business on course toward its financial objectives. Accounting also involves bookkeeping, which refers to the painstaking and detailed recording of economic activity and business transactions. However, accounting is a much broader term that refers to the design of the bookkeeping system. It addresses the many problems in measuring the financial effects of economic activity and events and then communicating these economic measures of value and performance to non-accountants in a clear and concise manner — a diverse range of people need this accounting information to make good economic decisions.

Accountants design the internals controls in an accounting system, which serve to minimize errors in the large number of entries that a business records over the period. The internal controls that accountants design can detect and deter theft, embezzlement, fraud, and dishonest behavior of all kinds. In accounting, internal controls are the ounce of prevention that is worth a pound of cure.

Seldom does an accountant prepare a complete listing of all activities that took place during a period. Instead, he or she prepares a summary financial statement, which shows totals, not a complete listing of all the individual activities making up the total. Managers may occasionally need to search through a detailed list of all the specific transactions that make up the total, but this is not common. Most managers just want summary financial statements for the period — if they want to drill down into the details making up a total amount for the period, they can ask the accountant for this more detailed backup information. Also, outside investors usually only see these summary-level financial statements.

Financial statements are prepared at the end of each accounting period. A period may be one month, or one quarter (three calendar months), or one year. One basic type of accounting report prepared at the end of the period is a "Where do we stand at the end of the period?" type of report. This is called the Statement of Financial Condition or, more commonly, the balance sheet. A balance sheet shows two sides of the business. On the one side are listed in order the assets of the business, which are its economic resources being used in the business, and on the other side is a breakdown of where the assets came from, or the sources of the assets.

Assets are not like manna from the heavens. They come from borrowing money on the basis of loans that have to be paid back at a later date, and from owners' investment of capital (usually money) in the business. Also, making profit increases the assets of the business; profit retained in the business is the third basic source of assets. If a business has, say, $2.5 million in total assets (without knowing which particular assets the business holds), then the total of its liabilities, plus capital invested by its owners, plus its retained profit, adds up to $2.5 million.

This basic equality between total assets and total sources of assets is the foundation of double-entry bookkeeping and is the reason that the statement of financial condition is called the balance sheet. If students remember one thing from their introductory accounting course, it's that

Assets = Liabilities + Owners' Equity

The other financial statements are different than the balance sheet in one important respect: they summarize the significant flows of activities and operations over the period.

For a business, accountants prepare two types of summary flow reports:

• The income statement summarizes the inflows of assets from the sale of products and services during the period. The income statement also summarizes the outflow of assets for expenses during the period — leading down to the well-known bottom line, or final profit or loss for the period.

• The cash flow statement summarizes the business's cash inflows and outflows during the period, starting with the net cash increase or decrease from the profit reported in the Income Statement. The cash flow statement also shows other sources of cash and uses of cash during the period.

Business entities need accounting reports for three essential purposes:

• Tax returns are prepared to determine the amount of tax owed for the period as required by income tax, payroll, and property tax laws.

• Accounting reports keep managers informed about what's going on and the financial position of the business. These accounting reports are essential to help managers control the performance of a business, identify problems as they come up, and plan the future course of a business.

• External financial statements go to those persons outside a business who need to stay informed about the business's financial affairs. These individuals may have invested capital in the business, or the business may owe them money, for example; therefore, they have a financial interest in how well the business is doing.