Chapter Two: Information Processing

Chapter Two: Information Processing

Your goals for this “information processing” chapter are to learn about:

• Accounts, debits and credits.
• The journal.
• The general ledger.
• The trial balance.
• Computerized processing systems.
• T-Accounts.

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Accounts, Debits And Credits

The previous chapter showed how transactions caused financial statement amounts to change. "Before" and "after" examples were used to develop the illustrations. Imagine if a real business tried to keep up with its affairs this way! Perhaps a giant chalkboard could be set up in the accounting department. As transactions occurred, they would be communicated to the department and the chalkboard would be updated. Chaos would quickly rule. Even if the business could manage to figure out what its financial statements were supposed to contain, it probably could not systematically describe the transactions that produced those results. Obviously, a system is needed.

It is imperative that a business develop a reliable accounting system to capture and summarize its voluminous transaction data. The system must be sufficient to fuel the preparation of the financial statements, and be capable of maintaining retrievable documentation for each and every transaction. In other words, some transaction logging process must be in place. In general terms, an accounting system is a system where transactions and events are reliably processed and summarized into useful financial statements and reports. Whether this system is manual or automated, the heart of the system will contain the basic processing tools: accounts, debits and credits, journals, and the general ledger. This chapter will provide insight into these tools and the general structure of a typical accounting system.

ACCOUNTS

The records that are kept for the individual asset, liability, equity, revenue, expense, and dividend components are known as accounts. In other words, a business would maintain an account for cash, another account for inventory, and so forth for every other financial statement element. All accounts, collectively, are said to comprise a firm's general ledger. In a manual processing system, imagine the general ledger as nothing more than a notebook, with a separate page for every account. Thus, one could thumb through the notebook to see the "ins" and "outs" of every account, as well as existing balances. An account could be as simple as the following:

This account reveals that cash has a balance of $63,000 as of January 12. By examining the account, one can see the various transactions that caused increases and decreases to the $50,000 beginning- of-month cash balance. In many respects, this Cash account resembles the "register" one might keep for a wallet-style checkbook. A balance sheet on January 12 would include cash for the indicated amount (and, so forth for each of the other accounts comprising the entire financial statements). Notice that column headings for this illustrative Cash account included "increase" and "decrease" labels. In actuality, these labels would instead be "debit" and "credit." The reason for this distinction will become apparent in the following discussion.

DEBITS AND CREDITS

References to debits and credits are quite common. It is common for a business to indicate they are “crediting” an account. “Debit” cards may be used to buy goods. Debits (abbreviated “dr”) and credits (abbreviated “cr”) are unique accounting tools to describe the change in a particular account that it is said necessitated by a transaction. In other words, instead of saying that cash is "increased" or "decreased," it is said that cash is "debited" or "credited." This method is again traced to Pacioli, the Franciscan monk who is given credit for the development of our enduring accounting model. Why add this complexity -- why not just use plus and minus like in the previous chapter? There is an ingenious answer to this question that will soon be discovered!

Understanding the answer to this question begins by taking note of two very important observations:

(1) every transaction can be described in debit/credit form

and

(2) for every transaction, debits = credits

THE FALLACY OF A “+/-” SYSTEM

The second observation above would not be true for an increase/decrease system. For example, if services are provided to customers for cash, both cash and revenues would increase (a “+/+” outcome). On the other hand, paying an account payable causes a decrease in cash and a decrease in accounts payable (a “-/-” outcome). Finally, some transactions are a mixture of increase/decrease effects; using cash to buy land causes cash to decrease and land to increase (a “-/+” outcome). In the previous chapter, the “+/-” nomenclature was used for the various illustrations. Take time to review the comprehensive illustration that was provided in Chapter 1, and notice that various combinations of pluses and minuses were needed.

As one can tell by reviewing the illustration, the "+/-" system lacks internal consistency. Therefore, it is easy to get something wrong and be completely unaware that something has gone amiss. On the other hand, the debit/credit system has internal consistency. If one attempts to describe the effects of a transaction in debit/credit form, it will be readily apparent that something is wrong when debits do not equal credits. Even modern computerized systems will challenge or preclude any attempt to enter an "unbalanced" transaction that does not satisfy the condition of debits = credits.

The debit/credit rules are built upon an inherently logical structure. Nevertheless, many students will initially find them confusing, and somewhat frustrating. This is a bit similar to learning a new language. As such, memorization usually precedes comprehension. Take time now to memorize the "debit/credit" rules that are reflected in the following diagrams. going forward, one needs to have instant recall of these rules, and memorization will allow the study of accounting to continue on a much smoother pathway. Full comprehension will follow in short order.

ASSETS/EXPENSES/DIVIDENDS

As shown at left, asset, expense and dividend accounts each follow the same set of debit/credit rules. Debits increase these accounts and credits decrease these accounts. These accounts normally carry a debit balance. To aid recall, rely on this mnemonic: D-E-A-D = debits increase expenses, assets, and dividends.

LIABILITIES/REVENUES/EQUITY

Liability, revenue and equity accounts each follow rules that are the opposite of those just described. Credits increase liabilities, revenues, and equity, while debits result in decreases. These accounts normally carry a credit balance.

TRANSACTION ANALYSIS

It is now apparent that transactions and events can be expressed in "debit/credit" terminology. In essence, accountants have their own unique shorthand to portray the financial statement consequence for every recordable event. This means that as transactions occur, it is necessary to perform an analysis to determine (a) what accounts are impacted and (b) how they are impacted (increased or decreased). Then, debits and credits are applied to the accounts, utilizing the rules set forth in the preceding paragraphs.

SOURCE DOCUMENTS

Usually, a recordable transaction will be evidenced by a source document. A disbursement will be supported by the issuance of a check. A sale might be supported by an invoice issued to a customer. A time report may support payroll costs. A tax statement may document the amount paid for taxes. A cash register tape may show cash sales. A bank deposit slip may show collections of customer receivables. Suffice it to say, there are many potential source documents, and this is just a small sample. Source documents usually serve as the trigger for initiating the recording of a transaction. The source documents are analyzed to determine the nature of a transaction and what accounts are impacted. source documents should be retained (perhaps in electronic form) as an important part of the records supporting the various debits and credits that are entered into the accounting records.

To illustrate, assume that Jill Aoki is an architect. Concurrent with delivering completed blueprints to one of her clients, she also prepared and presented an invoice for $2,500. The invoice is the source document evidencing the completed work for which payment is now due. Therefore, Accounts Receivable is to be increased (debited) and Revenues must be increased (credited). When her client pays, the resulting bank deposit receipt will provide evidence for an entry to debit Cash (increased) and credit Accounts Receivable (decreased).

A properly designed accounting system will have controls to make sure that all transactions are fully captured. It would not do for transactions to slip through the cracks and go unrecorded. There are many such safeguards that can be put in place, including use of prenumbered documents and regular reconciliations. For example, an individual might maintain a checkbook for recording cash disbursements. A monthly reconciliation should be performed to make sure that the checkbook accounting system has correctly reflected all disbursements. A business must engage in similar activities to make sure that all transactions and events are recorded correctly. Good controls are essential to business success. Much of the work performed by a professional accountant relates to the design, implementation, and evaluation of properly functioning control systems.

AN ACCOUNT'S BALANCE

The balance of a specific account can be determined by considering its beginning (of period) balance, and then netting or offsetting all of the additional debits and credits to that account during the period. Earlier, an illustration for a Cash account was presented. That illustration was developed before the introduction of debits and credits. However, accounts are maintained by using the debit/ credit system. The Cash account is repeated below, except that the increase/decrease columns have been replaced with the more traditional debit/credit column headings. A typical Cash account would look similar to this illustration:

Bear in mind that each of the debits and credits to Cash shown in the preceding illustration will have some offsetting effect on another account. For instance, the $10,000 debit on January 2 would be offset by a $10,000 credit to Accounts Receivable. The process by which this occurs will become clear in the following sections of this chapter.

A COMMON MISUNDERSTANDING ABOUT CREDITS

Many people wrongly assume that credits always reduce an account balance. However, a quick review of the debit/credit rules reveals that this is not true. Where does this notion come from? Probably because of the common phrase "we will credit your account." This wording is often used when one returns goods purchased on credit. Carefully consider that the account (with the store) is on the store's books as an asset account (specifically, an account receivable). Thus, the store is reducing its accounts receivable asset account (with a credit) when it agrees to credit the account. On the customer's books one would debit (decrease) a payable account (liability).

On the other hand, some may assume that a credit always increases an account. This incorrect notion may originate with common banking terminology. Assume that Matthew made a deposit to his account at Monalo Bank. Monalo's balance sheet would include an obligation ("liability" ) to Matthew for the amount of money on deposit. This liability would be credited each time Matthew adds to his account. Thus, Matthew is told that his account is being "credited" when he makes a deposit.

The Journal

Most everyone is intimidated by new concepts and terminology (like debits, credits, journals, etc.). But, learning can be made quite simple by relating new concepts to preexisting notions that are already well understood. So, think: what is already known about a journal (not an accounting journal, just any journal)? It's just a log book, right? A place where one can record a history of transactions and events, usually in date (chronological) order. Perhaps one maintains a personal journal of important events in life, or record notes when they travel.

Likewise, an accounting journal is just a log book that contains a chronological listing of a company's transactions and events. The accounting journal serves to document business activity as it occurs. However, rather than including a detailed narrative description of a company's transactions and events, the journal lists the items by a form of shorthand notation. Specifically, the notation indicates the accounts involved, and whether each is debited or credited. Remember what was said at the beginning of the chapter:

The system must be sufficient to fuel the preparation of the financial statements, and be capable of maintaining retrievable documentation for each and every transaction. In other words, some transaction logging process must be in place.

The journal satisfies the need for this logging process!

The general journal is sometimes called the book of original entry. This means that source documents are reviewed and interpreted as to the accounts involved. Then, they are documented in the journal via their debit/credit format. As such the general journal becomes a log book of the recordable transactions and events. The journal is not sufficient, by itself, to prepare financial statements. That objective is fulfilled by subsequent steps. But, maintaining the journal is the point of beginning toward that end objective.

JOURNAL EXAMPLE

The following illustration draws upon the facts for the Xao Corporation. Specifically it shows the journalizing process for Xao’s transactions. Review it carefully, specifically noting that it is in chronological order with each transaction of the business being reduced to the short-hand description of its debit/credit effects.

For instance, the first transaction increases both cash and equity. Cash, an asset account, is increased via a debit. Capital stock, an equity account, is increased via a credit. The next transaction increases Advertising Expense "with a debit" and decreases Cash "with a credit."

Note that each transaction is followed by a brief narrative description; this is a good practice to provide further documentation. For each transaction, it is customary to list "debits" first (flush left), then the credits (indented right). Finally, notice that a transaction may involve more than two accounts (as in the January 28 transaction); the corresponding journal entry for these complex transactions is called a "compound" entry.

In reviewing the general journal for Xao, note that it is only two pages long. An actual journal for a business might consume hundreds and thousands of pages to document its many transactions. As a result, some businesses may maintain the journal in electronic form only.

Having reviewed the journal entries for January, consider a few more points.

SPECIAL JOURNALS

First, the illustrated journal was referred to as a "general" journal. Most businesses will maintain a general journal. Any and all transactions can be recorded in the general journal. However, a business may sometimes find it beneficial to employ optional "special journals." Special journals are deployed for highly redundant transactions.

For example, a business may have huge volumes of redundant transactions that involve cash receipts. Thus, the company might have a special cash receipts journal. Any transaction entailing a cash receipt would be recorded therein. Indeed, the summary total of all transactions in this journal could correspond to the debits to the Cash account, further simplifying the accounting process. Other special journals might be used for cash payments, sales, purchases, payroll, and so forth.

The special journals do not replace the general journal. Instead, they just strip out recurring type transactions and place them in their own separate journal. The transaction descriptions associated with each transaction found in the general journal are not normally needed in a special journal, given that each transaction is redundant in nature. Without special journals, a general journal can become quite voluminous.

PAGE NUMBERING

Second, notice that the illustrated journal consisted of two pages (labeled Page 1 and Page 2). Although the journal is chronological, it is helpful to have the page number indexing for transaction cross-referencing and working backward from financial statement amounts to individual transactions. The benefits of this type of indexing will become apparent in the general ledger exhibits within the following section of the chapter. As an alternative, some companies will assign a unique index number to each transaction, further facilitating the ability to trace transactions throughout the entire accounting system.

RECAP

The general journal is a great tool to capture transaction and event details, but it certainly does nothing to tell a company about the balance in each specific account. For instance, how much cash does Xao Corporation have at the end of January? One could go through the journal and net the debits and credits to Cash ($25,000 - $2,000 + $4,000 - $500 + $4,800 - $5,000 = $26,300). But, this is tedious and highly susceptible to error. It would become virtually impossible if the journal were hundreds of pages long. A better way is needed. This is where the general ledger comes into play.

The General Ledger

As illustrated, the general journal is, in essence, a notebook that contains page after page of detailed accounting transactions. In contrast, the general ledger is, in essence, another notebook that contains a page for each and every account in use by a company. As examples, the ledger accounts for Xao would include the Cash and Accounts Receivable pages illustrated below:

Xao’s transactions utilized all of the following accounts:

• Cash
• Accounts Payable
• Service Revenue
• Accounts Receivable
• Notes Payable
• Advertising Expense
• Land
• Capital Stock
• Utilities Expense

Therefore, Xao’s general ledger will include a separate page for each of these nine accounts.

POSTING

Next, consider how the details of each specific account can be determined through a process known as posting. To "post" means to copy the entries listed in the journal into their respective ledger accounts. In other words, the debits and credits in the journal will be accumulated ("transferred"/"sorted") into the appropriate debit and credit columns of each ledger page. The following illustration shows the posting process. Arrows are drawn for the first journal entry posting. A similar process would occur for each of the other transactions to produce the resulting ledger pages.

In reviewing the ledger accounts at right, notice that the "description" column includes a cross-reference back to the journal page in which the transaction was initially recorded. This reduces the amount of detailed information that must be recorded in the ledger, and provides an audit trail back to the original transaction in the journal. The check marks in the journal indicate that a particular transaction has been posted to the ledger. Without these marks (in a manual system), it would be very easy to fail to post a transaction, or even post the same transaction twice.

TO REVIEW

Thus far the following accounting “steps” should have been grasped:

• STEP 1: Each transaction is analyzed to determine the accounts involved

• STEP 2: A journal entry is entered into the general journal for each transaction

• STEP 3: Periodically, the journal entries are posted to the appropriate general ledger pages

The Trial Balance

After all transactions have been posted from the journal to the ledger, it is a good practice to prepare a trial balance. A trial balance is simply a listing of the ledger accounts along with their respective debit or credit balances. The trial balance is not a formal financial statement, but rather a self-check to determine that debits equal credits. Following is the trial balance prepared from the general ledger of Xao Corporation.

DEBITS EQUAL CREDITS

Since each transaction was journalized in a way that insured that debits equaled credits, one would expect that this equality would be maintained throughout the ledger and trial balance. If the trial balance fails to balance, an error has occurred and must be located. It is much better to be careful as one proceeds, rather than having to go back and locate an error after the fact. Be aware that a "balanced" trial balance is no guarantee of correctness. For example, failing to record a transaction, recording the same transaction twice, or posting an amount to the wrong account would produce a balanced (but incorrect) trial balance.

FINANCIAL STATEMENTS FROM THE TRIAL BALANCE

The next chapter reveals additional adjustments that may be needed to prepare a truly correct and up-to-date set of financial statements. But, for now, a tentative set of financial statements could be prepared based on the trial balance. The basic process is to transfer amounts from the general ledger to the trial balance, then into the financial statements:

In reviewing the following financial statements for Xao, notice that italics are used to draw attention to the items taken directly from the previously shown trial balance. The other line items and amounts simply relate to totals and derived amounts within the statements.

CHART OF ACCOUNTS

A listing of all accounts in use by a particular company is called the chart of accounts. Individual accounts are often given a specific reference number. The numbering scheme helps keep up with the accounts in use and the classification of accounts. For example, all assets may begin with "1" (e.g., 101 for Cash, 102 for Accounts Receivable, etc.), liabilities with "2," and so forth. The assignment of a numerical value to each account assists in data management, in much the same way as zip codes help move mail more efficiently. many computerized systems allow rapid entry of accounts by reference number rather than by entering a full account description. A simple chart of accounts for Xao Corporation might appear as follows:

• No. 101: Cash
• No. 102: Accounts Receivable
• No. 103: Land
• No. 201: Accounts Payable
• No. 202: Notes Payable
• No. 301: Capital Stock
• No. 401: Service Revenue
• No. 501: Advertising Expense
• No. 502: Utilities Expense

Another benefit is that each account can be further subdivided in subsets. For instance, if Accounts Receivable bears the account number 102, one would expect to find that individual customers might be numbered as 102.001, 102.002, 102.003, etc. This facilitates the maintenance of "subsidiary" account records which are the subject of the next section of this chapter.

CONTROL AND SUBSIDIARY ACCOUNTS

Some general ledger accounts are made of many sub-components. For instance, a company may have total accounts receivable of $19,000, consisting of amounts due from Compton, Fisher, and Moore. The accounting system must be sufficient to reveal the total receivables, as well as amounts due from each customer. Therefore, sub-accounts are used. For instance, in addition to the regular general ledger account, separate auxiliary receivable accounts would be maintained for each customer, as shown in the following illustration:

The total receivables are the sum of all the individual receivable amounts. Thus, the Accounts Receivable general ledger account total is said to be the control account or control ledger, as it represents the total of all individual subsidiary account balances. It is simply imperative that a company be able to reconcile subsidiary accounts to the broader control account that is found in the general ledger. Here, computers can be particularly helpful in maintaining the detailed and aggregated data in perfect harmony.

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Chapter One: Welcome to the World of Accounting

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  Chapter 1 introduces the study of accounting. Accounting is defined as a set of concepts and techniques that are used to measure and report financial information about an economic entity. Accounting consists of both external reporting issues known as “financial accounting,” and internal reporting issues related to “managerial accounting.” There are numerous accounting career choices, and these options are discussed in the chapter. There is a long-standing fundamental accounting equation that is core to the overall reporting model: Assets = Liabilities + Equity. This chapter shows that the equality is preserved as transactions are processed through an accounting system. The system customarily results in the production of certain core financial statements: The Income Statement, Statement of Retained Earnings, Balance Sheet, and Statement of Cash Flows. Each of these statements, and their interrelationships, are illustrated. This chapter is foundational for beginning to understand how business activity is reflected in key financial reports.

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Chapter One: Welcome to the World of Accounting

Your goals for this “welcoming” chapter are to learn about:

• The nature of financial and managerial accounting information.
• The accounting profession and accounting careers.
• The accounting equation: Assets = Liabilities + Owners’ Equity.
• How transactions impact the accounting equation.
• The four core financial statements.

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Accounting Information

You likely have a general concept of accounting. Information about the transactions and events of a business is captured and summarized into reports that are used by persons interested in the entity. But, you likely do not realize the complexity of accomplishing this task. It involves a talented blending of technical knowledge and measurement artistry that can only be fully appreciated via extensive study of the subject. The best analogy is to say that you probably know what a surgeon does, but you no doubt appreciate that considerable knowledge and skill is needed to successfully treat a patient. If you were studying to be a surgeon, you would likely begin with some basic anatomy class. In this chapter, you will begin your study of accounting by looking at the overall structure of accounting and the basic anatomy of reporting.

Be advised that a true understanding of accounting does not come easily. It only comes with determination and hard work. If you persevere, you will be surprised at how much you discover about accounting. This knowledge is very valuable to business success.

DEFINITIONS

It seems fitting to begin with a more formal definition of accounting: Accounting is a set of concepts and techniques that are used to measure and report financial information about an economic unit. The economic unit is generally considered to be a separate enterprise. The information is reported to a variety of different types of interested parties. These include business managers, owners, creditors, governmental units, financial analysts, and even employees. In one way or another, these users of accounting information tend to be concerned about their own interests in the entity.

Business managers need accounting information to make sound leadership decisions. Investors hope for profits that may eventually lead to distributions from the business (e.g., “dividends”). Creditors are always concerned about the entity’s ability to repay its obligations. Governmental units need information to tax and regulate. Analysts use accounting data to form opinions on which they base investment recommendations. Employees want to work for successful companies to further their individual careers, and they often have bonuses or options tied to enterprise performance. Accounting information about specific entities helps satisfy the needs of all these interested parties.

The diversity of interested parties leads to a logical division in the discipline of accounting: financial accounting and managerial accounting. Financial accounting is concerned with external reporting to parties outside the firm. In contrast, managerial accounting is primarily concerned with providing information for internal management. One may have trouble seeing the distinction; after all, aren’t financial facts being reported? The following paragraphs provide a closer look at the distinctions.

FINANCIAL ACCOUNTING

Consider that financial accounting is targeted toward a broad base of external users, none of whom control the actual preparation of reports or have access to underlying details. Their ability to understand and have confidence in reports is directly dependent upon standardization of the principles and practices that are used to prepare the reports. Without such standardization, reports of different companies could be hard to understand and even harder to compare.

Standardization derives from certain well-organized processes and organizations. In the United States, a private sector group called the Financial Accounting Standards Board (FASB) is primarily responsible for developing the rules that form the foundation of financial reporting. The FASB’s global counterpart is the International Accounting Standards Board (IASB). The IASB and FASB are working toward convergence, such that there may soon be a single harmonious set of international financial reporting standards (IFRS). This effort to establish consistency in global financial reporting is driven by the increase in global trade and finance. Just as standardization is needed to enable comparisons between individual companies operating within a single economy, so too is standardization needed to facilitate global business evaluations.

Financial reports prepared under the generally accepted accounting principles (GAAP) promulgated by such standard-setting bodies are intended to be general purpose in orientation. This means they are not prepared especially for owners, or creditors, or any other particular user group. Instead, they are intended to be equally useful for all user groups. As such, attempts are made to keep them free from bias (neutral). Standard-setting bodies are guided by concepts that are aimed at production of relevant and representationally faithful reports that are useful in investment and credit decisions.

MANAGERIAL ACCOUNTING

Managerial accounting information is intended to serve the specific needs of management. Business managers are charged with business planning, controlling, and decision making. As such, they may desire specialized reports, budgets, product costing data, and other details that are generally not reported on an external basis. Further, management may dictate the parameters under which such information is to be accumulated and presented. For instance, GAAP may require that certain product development costs be deducted in computing income; on the other hand, management may see these costs as a long-term investment and stipulate that internal decision making be based upon income numbers that exclude such costs. This is their prerogative. Hopefully, internal reporting is being done logically and rationally, but it need not follow any particular set of mandatory guidelines.

A QUALITY SYSTEM

Both financial accounting and managerial accounting depend upon a strong information system to reliably capture and summarize business transaction data. Information technology has radically reshaped this mundane part of the practice of accounting over the past 50 years. The era of the “green eye-shaded” accountant has been relegated to the annals of history. Now, accounting is more of a dynamic, decision-making discipline, rather than a bookkeeping task.

INHERENT LIMITATIONS

Accounting data are not absolute or concrete. Considerable amounts of judgment and estimation are necessary to develop the specific accounting measurements that are reported during a particular month, quarter, or year. For example, how much profit is actually earned when a car is sold with a 3-year warranty? It will be three years before the final costs of this warranty agreement are all known. One approach would be to wait three years before reporting on the profit or loss for this transaction. However, by the time the information could be reported with certainty, it would be so stale as to lose its usefulness. Thus, in order to timely present information, reasonable estimations are routinely embraced in the normal preparation of periodic financial reports.

In addition, accounting has not advanced to a state of being able to value a business. As such, many transactions and events are reported based on the historical cost principle (in contrast to fair value). For example, land is typically recorded and carried in the accounting records at the price at which it was purchased. The historical cost principle is based on the concept that it is best to report certain financial statement elements at amounts that are tied to objective and verifiable past transactions.

The alternative is to value (and periodically revalue) accounts based upon subjective assessments of current worth. Such adjustments are problematic and the subject of much debate. Nevertheless, the current trend in global standard setting is toward an increased acceptance of the circumstances under which fair value accounting is deemed acceptable for selected financial statement elements.

The ongoing debate about fair value versus historical cost is often cast in the context of a tradeoff between the “relevance” of fair value information and the “reliability” of historical cost information. This debate is apt to continue, and the related accounting standards will likely be in an evolutionary state for many years to come. Nevertheless, it is reasonable to expect that the accountant of the future will be increasingly skilled in valuation issues.

The Accounting Profession And Careers

To decide to be an accountant is no more descriptive than deciding to be a doctor. There are many specialty areas. Many accountants engage in the practice of public accounting, which involves providing audit, tax, and consulting services to the general public. To engage in the practice of public accounting usually requires one to be licensed. In the United States, individual states issue a license called a CPA (Certified Public Accountant). Other countries offer similar designations such as the “Chartered Accountant.” Auditing involves the examination of transactions and systems that underlie an organization’s financial reports, with the ultimate goal of providing an independent report on the appropriateness of financial statements. Tax services relate to the providing of help in the preparation and filing of tax returns and the rendering of advice on the tax consequences of alternative actions. Consulting services can vary dramatically, and include such diverse activities as information systems engineering to evaluating production methods.

Many accountants are privately employed by small and large businesses (i.e., “industry accounting”) and not-for-profit agencies (such as hospitals, universities, and charitable groups). They may work in areas of product costing and pricing, budgeting, and the examination of investment alternatives. They may serve as internal auditors, who look at controls and procedures in use by their employer. Objectives of these reviews are to safeguard company resources and assess the reliability and accuracy of accounting information and accounting systems. They may serve as in-house tax accountants, financial managers, or countless other occupations.

It probably goes without saying that many accountants also work in the governmental sector, whether it be local, state, or national levels. Many accountants are employed at the Internal Revenue Service, General Accounting Office, Securities and Exchange Commission, and even the Federal Bureau of Investigation.

ETHICS

Because investors and creditors place great reliance on financial statements in making their investment and credit decisions, it is imperative that the financial reporting process be truthful and dependable. Accountants are expected to behave in an entirely ethical fashion. To help insure integrity in the reporting process, the profession has adopted a code of ethics to which its licensed members must adhere. In addition, checks and balances via the audit process, government oversight, and the ever vigilant “plaintiff’s attorney” all serve a vital role in providing additional safeguards against the errant accountant. Those who are preparing to enter the accounting profession should do so with the intention of behaving with honor and integrity. Others will likely rely upon accountants in some aspect of their personal or professional lives. They have every right to expect those accountants to behave in a completely trustworthy and ethical fashion. After all, they will be entrusting them with financial resources and confidential information.

The Accounting Equation

The basic features of the accounting model in use today trace roots back over 500 years. Luca Pacioli, a Renaissance era monk, developed a method for tracking the success or failure of trading ventures. The foundation of that system continues to serve the modern business world well, and is the entrenched cornerstone of even the most elaborate computerized systems. The nucleus of that system is the notion that a business entity can be described as a collection of assets and the corresponding claims against those assets. The claims can be divided into the claims of creditors and owners (i.e., liabilities and owners’ equity). This gives rise to the fundamental accounting equation:

Assets = Liabilities + Owners’ Equity

ASSETS

Assets are the economic resources of the entity, and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangible assets like patents and other legal rights and claims. Assets are presumed to entail probable future economic benefits to the owner.

LIABILITIES

Liabilities are amounts owed to others relating to loans, extensions of credit, and other obligations arising in the course of business. Implicit to the notion of a liability is the idea of an “existing” obligation to pay or perform some duty.

OWNERS’ EQUITY

Owners’ equity is the owner “interest” in the business. It is sometimes called net assets, because it is equivalent to assets minus liabilities for a particular business. Who are the “owners?” The answer to this question depends on the legal form of the entity; examples of entity types include sole proprietorships, partnerships, and corporations. A sole proprietorship is a business owned by one person, and its equity would typically consist of a single owner’s capital account. Conversely, a partnership is a business owned by more than one person, with its equity consisting of separate capital accounts for each partner. Finally, a corporation is a very common entity form, with its ownership interest being represented by divisible units of ownership called shares of stock. These shares are easily transferable, with the current holder(s) of the stock being the owners. The total owners’ equity (i.e., “stockholders’ equity”) of a corporation usually consists of several amounts, generally corresponding to the owner investmentsin the capital stock (by shareholders) and additional amounts generated through earnings that have not been paid out to shareholders as dividends (dividends are distributions to shareholders as a return on their investment). Earnings give rise to increases in retained earnings, while dividends (and losses) cause decreases.

BALANCE SHEET

The accounting equation is the backbone of the accounting and reporting system. It is central to understanding a key financial statement known as the balance sheet (sometimes called the statement of financial position). The following illustration for Edelweiss Corporation shows a variety of assets that are reported at a total of $895,000. Creditors are owed $175,000, leaving $720,000 of stockholders’ equity. The stockholders’ equity section is divided into the $120,000 that was originally invested in Edelweiss Corporation by stockholders (i.e., capital stock), and the other $600,000 that was earned (and retained) by successful business performance over the life of the company.

Does the stockholders’ equity total mean the business is worth $720,000? No! Why not? Because many assets are not reported at current value. For example, although the land cost $125,000, Edelweiss Corporation's balance sheet does not report its current worth. Similarly, the business may have unrecorded resources, such as a trade secret or a brand name that allows it to earn extraordinary profits. Alternatively, Edelweiss may be facing business risks or pending litigation that could limit its value. If one is looking to buy stock in Edelweiss Corporation, they would surely give consideration to these important non-financial statement valuation considerations. This observation tells us that accounting statements are important in investment and credit decisions, but they are not the sole source of information for making investment and credit decisions.

Assets ($895,000) = Liabilities ($175,000) + Stockholders’ equity ($720,000)

How Transactions Impact The Accounting Equation

The preceding balance sheet for Edelweiss represented the financial condition at the noted date. But, each new transaction brings about a change in financial condition. Business activity will impact various asset, liability, and/or equity accounts without disturbing the equality of the accounting equation. How does this happen? To reveal the answer to this question, look at four specific cases for Edelweiss. See how each impacts the balance sheet without upsetting the basic equality.

CASE A: COLLECT AN ACCOUNT RECEIVABLE

If Edelweiss Corporation collected $10,000 from a customer on an existing account receivable (i.e., not a new sale, just the collection of an amount that is due from some previous transaction), then the balance sheet would be revised to show that cash (an asset) increased from $25,000 to $35,000, and accounts receivable (an asset) decreased from $50,000 to $40,000. As a result total assets did not change, and liabilities and equity accounts were unaffected, as shown in the following illustration.

CASE B: BUY EQUIPMENT VIA LOAN

If Edelweiss Corporation purchased $30,000 of equipment, agreeing to pay for it later (i.e. taking out a loan), then the balance sheet would be further revised. The Case B illustration shows that equipment (an asset) increased from $250,000 to $280,000, and loans payable (a liability) increased from $125,000 to $155,000. As a result, both total assets and total liabilities increased by $30,000.

CASE C: PROVIDE SERVICES ON ACCOUNT

What would happen if Edelweiss Corporation did some work for a customer in exchange for the customer’s promise to pay $5,000? This requires further explanation; try to follow this logic closely! Retained earnings is the income of the business that has not been distributed to the owners of the business. When Edelweiss Corporation provided a service to a customer, it can be said that it generated revenue of $5,000. Revenue is the enhancement resulting from providing goods or services to customers. Revenue will contribute to income, and income is added to retained earnings. Examine the resulting balance sheet for Case C and notice that accounts receivable and retained earnings went up by $5,000 each, indicating that the business has more assets and more retained earnings. Note that assets still equal liabilities plus equity.

CASE D: PAY EXPENSES

It would be nice if a business could be run without incurring any expenses. However, such is not the case. Expenses are the outflows and obligations that arise from producing goods and services. Imagine that Edelweiss paid $3,000 for expenses. This transaction reduces cash and income (i.e., retained earnings), as shown in the Case D illustration.

IN GENERAL

There are countless transactions, and each can be described by its impact on assets, liabilities, and equity. Importantly, no transaction will upset the balance of the accounting equation.

TERMS

In day-to-day conversation, some terms are used casually and without precision. Words may incorrectly be regarded as synonymous. Such is the case for the words “income” and “revenue.” However, each term has a very precise meaning. Revenues are enhancements resulting from providing goods and services to customers. Conversely, expenses can generally be regarded as costs of doing business. This gives rise to another accounting equation:

Revenues - Expenses = Income

Revenue is the “top line” amount corresponding to the total benefits generated from business activity. Income is the “bottom line” amount that results after deducting expenses from revenue. In some countries, revenue is also referred to as “turnover.”

The Four Core Financial Statements

One’s future will undoubtedly be marked by numerous decisions about investing money in the capital stock of some corporation. Another option that will present itself is to lend money to a company, either directly, or by buying that company’s debt instruments known as “bonds.” Stocks and bonds are two of the most prevalent financial instruments of the modern global economy. The financial press and television devote seemingly endless coverage to headline events pertaining to large public corporations. Public companies are those with securities that are readily available for purchase/sale through organized stock markets. Many more companies are private, meaning their stock and debt is in the hands of a narrow group of investors and banks.

If one is contemplating an investment in a public or private entity, there is certain information that will logically be sought to guide the decision process. What types of information is desired? What does one want to know about the companies in which one is considering an investment? If one were to prepare a list of questions for the company’s management, what subjects would be included? Whether this challenge is posed to a sophisticated investor or to a new business student, the listing almost always includes the same basic components.

What are the corporate assets? Where does the company operate? What are the key products? How much income is being generated? Does the company pay dividends? What is the corporate policy on ethics and environmental responsibility? Many such topics are noted within the illustrated “thought cloud.” Some of these topics are financial in nature (noted in blue). Other topics are of more general interest and cannot be communicated in strict mathematical terms (noted in red).

FINANCIAL STATEMENTS

Financial accounting seeks to directly report information for the topics noted in blue. Additional supplemental disclosures frequently provide insight about subjects such as those noted in red. One would also need to gain additional information by reviewing corporate websites (many have separate sections devoted to their investors), filings with securities regulators, financial journals and magazines, and other such sources. Most companies will have annual meetings for shareholders and host webcasts every three months (quarterly). These events are very valuable in allowing investors and creditors to make informed decisions about the company, as well as providing a forum for direct questioning of management. One might even call a company and seek “special insight” about emerging trends and developments. Be aware, however, that the company will likely not be able to respond in a meaningful way. Securities laws have very strict rules and penalties that are meant to limit selective or unique disclosures to any one investor or group. It is amusing, but rarely helpful, to review “message boards” where people anonymously post their opinions about a company.

Financial accounting information is conveyed through a standardized set of reports. The balance sheet has already been introduced. The otherfinancial statements are the income statement, statement of retained earnings, and statement of cash flows. There are many rules that govern the form and content of each financial statement. At the same time, those rules are not so rigid as to preclude variations in the exact structure or layout. For instance, the earlier illustration for Edelweiss was first presented as a “horizontal” layout of the balance sheet. The subsequent Edelweiss examples were representative of “vertical” balance sheet arrangements. Each approach, and others, is equally acceptable.

INCOME STATEMENT

A summary of an entity’s results of operation for a specified period of time is revealed in the income statement, as it provides information about revenues generated and expenses incurred. The difference between the revenues and expenses is identified as the net income or net loss.

The income statement can be prepared using a single-step or a multiple-step approach, and might be further modified to include a number of special disclosures relating to unique items. These topics will be amplified in a number of subsequent chapters. For now, take careful note that the income statement relates to activities of a specified time period (e.g., year, quarter, month), as is clearly noted in its title:

STATEMENT OF RETAINED EARNINGS

Previous illustrations showed how retained earnings increases and decreases in response to events that impact income. Retained earnings is also reduced by shareholder dividends.

The statement of retained earnings provides a succinct reporting of these changes in retained earnings from one period to the next. In essence, the statement is nothing more than a reconciliation or “bird’s-eye view” of the bridge between the retained earnings amounts appearing on two successive balance sheets.

If one examines very many sets of financial statements, one will soon discover that many companies provide a statement of stockholders’ equity in lieu of the statement of retained earnings. The statement of stockholders’ equity portrays not only the changes in retained earnings, but also changes in other equity accounts. An expanded statement of stockholders’ equity is presented in a future chapter.

BALANCE SHEET

The balance sheet focuses on the accounting equation by revealing the economic resources owned by an entity and the claims against those resources (liabilities and owners’ equity). The balance sheet is prepared as of a specific date, whereas the income statement and statement of retained earnings cover a period of time. Accordingly, it is sometimes said that balance sheets portray financial position (or condition) while other statements reflect results of operations. Quartz’s balance sheet is as follows:

STATEMENT OF CASH FLOWS

The statement of cash flows details the enterprise’s cash flows. This operating statement reveals how cash is generated and expended during a specific period of time. It consists of three unique sections that isolate the cash inflows and outflows attributable to (a) operating activities, (b) investing activities, and (c) financing activities.

Notice that the cash provided by operations is not the same thing as net income found in the income statement. This result occurs because some items hit income and cash flows in different periods. For instance, remember how Edelweiss (from the earlier illustration) generated income from a service provided on account. That transaction increased income without a similar effect on cash. These differences tend to even out over time. Other cash flow items may never impact operations. For instance, dividends paid are an important financing cash outflow for a corporation, but they are not an expense. They are a distribution of income. The proceeds of a loan would be an example of a nonoperating cash inflow. It would be shown as a financing cash flow item.

The statement cash flows require a fairly complete knowledge of basic accounting. Do not be concerned by a lack of complete comprehension at this juncture. Comprehension develops as studies progress, and a future chapter is devoted to the statement of cash flows.

SELF-BALANCING

It is important to note that the income statement, statement of retained earnings, and balance sheet articulate. This means they mesh together in a self-balancing fashion. The income for the period ties into the statement of retained earnings, and the ending retained earnings ties into the balance sheet. This final tie-in causes the balance sheet to balance. These relationships are illustrated in the following diagram.

It seems almost magical that the final tie-in of retained earnings will exactly cause the balance sheet to balance. This is reflective of the brilliance of Pacioli’s model, and is indicative of why it has survived for centuries. The companion website includes a series of web pages that comprehensively illustrate how transactions impact the income statement, statement of retained earnings, and balance sheet. Click through those pages and study the impact of each transaction on the financial statements.