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By Leita Hart-Fanta
The McGraw-Hill Companies, Inc.Copyright © 2011The McGraw-Hill Companies, Inc.
All rights reserved.
Where Did All This Lingo Come From?
Business is very simple. Money flows into an organization, and money flows out. But we in the finance and accounting profession sometimes get a little out of hand giving fancy names to very simple concepts. This fancy lingo can cause more than a little bit of confusion. So it is helpful to envision accounting as a foreign language. Most of the rules and concepts are perfectly intuitive and simple; you just have to know what to call them.
The title of this book, Accounting Demystified, is very appropriate. It is definitely attributing too much romance and intrigue to the profession to call it a mystery, but it does probably sell a few more books than the title, Clarifying Accounting Lingo. (This is why I am writing and someone else is marketing this book!)
Describe the origin and general purpose of accounting
Introduce the three key financial statements
I want to give you the ability to have an intelligent conversation with an accountant or finance person. I want you to be able to justify your actions in terms that the folks holding the purse strings can understand and appreciate. I want you to be able to go to meetings with your management team and understand what the heck they are talking about. I don't want you to have to nod your head like you understand when you don't, so I am going to give you the knowledge to ask intelligent questions regarding finance.
What I am not going to do is bore you or muddy the waters with a load of unnecessary detail. You know, I was out of college and already had my certified public accountant (CPA) certificate before all the detail the accounting professors had me memorize gelled together in my head to form a big picture. I am going to take the opposite approach with you. We are going to start with the big picture and then go into a bit of detail. We are not going to go into super detail. I think it is best to keep it at a high level.
I am not going to tell you how to handle an advance repurchase agreement on stock or how to calculate a bond discount. This is too much detail for 99.99 percent of the population—and probably you. However, if you do need this kind of detail, this book will give you the basis to start asking those questions and understanding what the finance person says in response.
As Glinda the Good Witch says in The Wizard of Oz, "It is always best to start at the beginning." So let's take a minute to get a sense of how this system we have in place began a long time ago. It actually started in a very romantic and sometimes mysterious and dramatic place—Italy.
The Birth of the Accountant
The system we use today to track money in business was invented in Italy during the Renaissance. An Italian merchant invented it so that he could easily summarize his results at the end of the day. The system had a simple method of checks and balances to make sure that everything he had recorded was done correctly.
The Italian merchant called his system the double-entry accounting system, and it was very simple to understand. Each and every transaction must balance. The "ins" had to equal the "outs." This is the root of debits and credits that we will talk about in more detail in Chapter 6.
For instance, let's say this merchant sold jewelry. When he sold a piece of jewelry, the jewelry went out of his business. In return something came in— some cash. Through a series of entries in his books, the ins would equal the outs.
With this system, the merchant could make sure that every transaction was recorded completely because the books had to balance. If the books didn't balance, the merchant knew that he had missed something.
This system also was useful in that it posted the information to discrete accounts or categories that could be summarized at the end of the day. The merchant could look at his cash account category and see how much cash he had brought in that day; he could look at his jewelry inventory category to see how much jewelry he had left to sell. All very convenient.
This system was so convenient and useful that the merchant decided to share it with his friends. His friends liked it, and because Italy was a trade center, soon businesses all over the world were using the system. (Don't ask me what they were doing previous to this; I imagine just keeping a list of cash on long sheets of parchment.)
But the folks who were the most excited about this new system were the lenders—the banks and financiers who gave merchants money to expand their businesses. Before this system, the banks and financiers had to rely on subjective information to decide who to loan money to. They made decisions based on family reputation, where they lived, or what kind of carriage they drove. Now they could decide based on some real hard data.
The only problem is that everyone's data looked a little different because they all used different rules. They chose how to treat a transaction according to how good it made their books look.
For example, let's say that you are a sales representative for the famous artist Michelangelo. Your job is to find him commissions so that he can concentrate on his art, not on selling. The head of the Medici family, a very influential and wealthy Italian family, has commissioned Michelangelo—through you—to sculpt a replica of David for the foyer of the family villa.
When do you record a sale in your books? When you shake hands with the head of the Medici clan and say, "We'll have it to you in three years"? Or when Michelangelo puts chisel to marble? Or when the statue is installed in the villa? Do you record a sale when you bill for the statue or when the Medicis pay in cash?
All these viewpoints have validity. The lenders didn't like this at all. They desired consistency. They wanted everyone to use the same rules so that their financial statements would be comparable. They wanted to know, when choosing to invest in one of three businesses, which business actually was doing better.
The lenders demanded rules so that everyone would be consistent. It was then that accountants were born. Accountants are just the folks who know the rules on how to keep the records consistent. A dark day in the annals of history, I know, but....
Gaps in GAAP?
Nowadays accounting rules are voluminous. The standards that accountants use to create financial statements are called generally accepted accounting principles (GAAP). There is a set of GAAP that applies to most everyone, and then there is GAAP for specific industries. The oil and gas business has different transactions than a software developer, so we have to have different rules for each group.
GAAP is created by a rule-making body called the Financial Accounting Standards Board (FASB, pronounced "faz-bee"). Governmental entities such as cities and counties have their own rule-setting body called the Governmental Accounting Standards Board (GASB, pronounced "gaz-bee").
Unfortunately, GAAP is full of gaps or loopholes. GAAP is designed to make financial statements comparable and consistent. And generally, most transactions are treated conservatively, meaning that transactions are not recorded until we are absolutely sure that the transaction will occur or actually has occurred.
But some organizations take advantage of the gaps in GAAP just to make their financial statements look a little bit better than those of their competitors. Wealthy folks hire savvy tax accountants to find shelte
Excerpted from Accounting DeMYSTiFieD by Leita Hart-Fanta. Copyright © 2011 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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