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Accounting For Dummies

Accounting For Dummies

3.7 14
by John A. Tracy

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Praise for 1st Edition of Accounting For Dummies® "Essential reading for all of us who want to manage our business finances effectively." —Mary Metcalfe, Partner, Envirocomm Communications "[Tracy] has an uncanny knack for explaining complicated accounting and financial material." —G. Dale Meyer, Professor, College


Praise for 1st Edition of Accounting For Dummies® "Essential reading for all of us who want to manage our business finances effectively." —Mary Metcalfe, Partner, Envirocomm Communications "[Tracy] has an uncanny knack for explaining complicated accounting and financial material." —G. Dale Meyer, Professor, College of Business, University of Colorado "A wealth of practical information on understanding how to manage budgets." — Jack Rudolph, Retired President, Colorado Community First National Bank

Find out how to improve your profits and control costs

Get a better grip on stock options and earnings per share Whether you're a small business owner, a manager with budget responsibilities, or just want to understand your 401(k) statements, this friendly guide helps you get a handle on all those columns of numbers — and shows how you can use accounting and financial reports to control business costs, minimize taxes, and maximize profits.

Discover how to: Make sense of bookkeeping basics Read a financial statement Manage budgets for a better bottom line Analyze business strengths and weaknesses Evaluate accounting methods and business structures

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Author Biography: John A. Tracy, CPA, a former staff accountant at Ernst & Young, taught accounting at the University of Colorado for many years. His other books include the 250,000 copy bestseller, How to Read a Financial Report.

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“…insightful and well-reasoned…” (Money Matters, October 2004)

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For Dummies Series
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Read an Excerpt

Accounting For Dummies

By John A. Tracy

John Wiley & Sons

ISBN: 0-7645-5314-3

Chapter One

Introducing Accounting to Non-Accountants

In This Chapter

* Understanding the different needs for accounting

* Making and enforcing accounting rules

* Peering into the back office: The accounting department in action

* Transactions: The heartbeat of a business

* Taking a closer look at financial statements

* Mama, should you let your baby grow up to be an accountant?

Most medium to large businesses employ one or more accountants. Even a very small business needs at least a part-time accountant. Have you ever wondered why? What do these bean counters with the green eye-shades do, anyway? Probably what you think of first is that accountants keep the books - they keep the records of the financial activities of the business. This is true, of course. 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 shared costs among different departmentsand other organizational units of the business.

  •   Accountants are the professional profit scorekeepers of the business world, meaning that they are the ones who determine exactly how much profit was earned, or just how much loss the business suffered, during the period. Accountants 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 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 of the business, which regular financial reports (which are sometimes just called the financials) provide.

    In short, accountants are much more than bookkeepers - they provide the numbers that are so critical in helping business managers make the informed decisions that keep a business on course toward its financial objectives.

    Business managers, investors, and others who depend on financial statements should be willing to meet accountants halfway. People who use accounting information, like spectators at a football game, should know the basic rules of play and how the score is kept. The purpose of this book is to make you a knowledgeable spectator of the accounting game.

    Accounting Everywhere You Look

    Accounting extends into virtually every walk of life. You're doing accounting when you make entries in your checkbook and fill out your federal income tax return. When you sign a mortgage on your home, you should understand the accounting method the lender uses to calculate the interest amount charged on your loan each period. Individual investors need to understand some accounting in order to figure the return on capital invested. And every organization, profit-motivated or not, needs to know how it stands financially. Accounting supplies all that information.

    Many different kinds of accounting are done by many different kinds of persons or entities for many different purposes:

  •   Accounting for organizations and accounting for individuals

  •   Accounting for profit-motivated businesses and accounting for nonprofit organizations (such as hospitals, homeowners' associations, churches, credit unions, and colleges)

  •   Income tax accounting while you're living and estate tax accounting after you die

  •   Accounting for farmers who grow their products, accounting for miners who extract their products from the earth, accounting for producers who manufacture products, and accounting for retailers who sell products that others make

  •   Accounting for businesses and professional firms that sell services rather than products, such as the entertainment, transportation, and healthcare industries

  •   Past-historical-based accounting and future-forecast-oriented accounting (that is, budgeting and financial planning)

  •   Accounting where periodic financial statements are mandatory (businesses are the primary example) and accounting where such formal accounting reports are not required

  •   Accounting that adheres to cost (most businesses) and accounting that records changes in market value (mutual funds, for example)

  •   Accounting in the private sector of the economy and accounting in the public (government) sector

  •   Accounting for going-concern businesses that will be around for some time and accounting for businesses in bankruptcy that may not be around tomorrow

    Accounting is necessary in any free-market, capitalist economic system. It's equally necessary in a centrally controlled, socialist economic system. All economic activity requires information. The more developed the economic system, the more the system depends on information. Much of the information comes from the accounting systems used by the businesses, individuals, and other institutions in the economic system.

    Some of the earliest records of history are the accounts of wealth and trading activity, and the need for accounting information was a main incentive in the development of the numbering system we use today. Professor William A. Paton, a well-known accounting professor at the University of Michigan for many years (and who lived to be over 100), expressed the purpose of accounting very well in his classic book, Essentials of Accounting (Macmillan):

    In a broad sense accounting has one primary function: facilitating the administration of economic activity. This function has two closely related phases: (1) measuring and arraying economic data; [and] (2) communicating the results of this process to interested parties.

    The Basic Elements of Accounting

    I like Professor Paton's short definition because it articulates the basic purpose of accounting. However, the definition does sidestep one aspect of accounting - bookkeeping (which you can find more about in Chapter 2). Accounting involves bookkeeping, which refers to the painstaking and detailed recording of economic activity and business transactions. But accounting is a much broader term than bookkeeping because accounting refers to the design of the bookkeeping system. It addresses the many problems in measuring the financial effects of economic activity. Furthermore, accounting includes the financial reporting of these values and performance measures to non-accountants in a clear and concise manner. Business managers and investors, as well as many other people, depend on financial reports for vital information they need to make good economic decisions.

    Accountants design the internal controls in an accounting system, which serve to minimize errors in recording the large number of activities that a business engages in 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.

    An accountant seldom prepares a complete listing of all the details of the 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 ask the accountant for this more detailed backup information. Also, outside investors usually only see summary-level financial statements. For example, they see the total amount of sales revenue for the period but not how much was sold to each and every customer.

    Financial statements are prepared at the end of each accounting period. A period may be one month, 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. The date of preparation is given in the header, or title above this financial statement. A balance sheet shows two sides of the business.

    On the one side are listed the assets of the business, which are its economic resources being used in the business. On the other side of the balance sheet is a breakdown of where the assets came from, or the sources of the assets. The asset values reported in the balance sheet are the amounts recorded when the assets were originally acquired. For many assets these values are recent - only a few weeks or a few months old. For some assets their values as reported in the balance sheet are the costs of the assets when they were acquired many years ago.

    Assets are not like manna from the heavens. They come from borrowing money in the form 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), I know that the total of its liabilities, plus the capital invested by its owners, plus its retained profit, adds up to $2.5 million.

    In this example suppose that the total amount of the liabilities of the business is $1.0 million. This means that the total amount of owners' equity in the business is $1.5 million, which equals total assets less total liabilities. Without more information we don't know how much of total owners' equity is traceable to capital invested by the owners in the business and how much is the result of profit retained in the business. But we do know that the total of these two sources of owners' equity is $1.5 million.

    The financial condition of the business in this example is summarized in the following accounting equation (in millions):

    $2.5 Assets = $1.0 Liabilities + $1.5 Owners' Equity

    Looking at the accounting equation you can see why the statement of financial condition is also called the balance sheet; the equal sign means the two sides have to balance.

    Double-entry bookkeeping is based on the accounting equation - or the fact that the total of assets on the one side are counter-balanced by the total of liabilities, invested capital, and retained profit on the other side. Double-entry bookkeeping is discussed in Chapter 2.

    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. Accountants prepare two types of summary flow reports for businesses:

  •   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. The first part of this financial statement calculates the net increase or decrease in cash during the period from the profit-making activities reported in the income statement.

    The balance sheet, income statement, and cash flow statement constitute the hard core of a financial report to those persons outside a business who need to stay informed about the business's financial affairs. These individuals have invested capital in the business, or the business owes them money; therefore they have a financial interest in how well the business is doing. These three key financial statements are also used by the managers of a business to keep informed about what's going on and the financial position of the business. They are absolutely essential to helping managers control the performance of a business, identify problems as they come up, and plan the future course of a business. Managers also need other information that is not reported in the three basic financial statements. (Part III of this book explains these additional reports.)

    Accounting and Financial Reporting Standards

    Imagine if every business could invent its own accounting methods and terminology for measuring profit and for presenting financial statements. As an example from the academic world, what if I give a student an A for a course and a professor at another university gives a student a K? Keeping track of academic performance would be pretty tough without some recognized and accepted standards.

    Experience and common sense have taught business and financial professionals that uniform financial reporting standards and methods are critical in a free-enterprise, private, capital-based economic system. A common vocabulary, uniform accounting methods, and full disclosure in financial reports are the goals. How well the accounting profession performs in achieving these goals is an open question, but few disagree that they are worthy goals to strive for.

    The supremacy of GAAP (generally accepted accounting principles)

    The most important financial statement and financial reporting standards and rules are called generally accepted accounting principles (GAAP), which describe the basic methods to measure profit and to value assets and liabilities, as well as what information should be disclosed in those financial statements released outside a business. Suppose you're reading the financial statements of a business.


    Excerpted from Accounting For Dummies by John A. Tracy Excerpted by permission.
    All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
    Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

  • Meet the Author

    John A. Tracy, CPA, a former staff accountant at Ernst & Young, taught accounting at the University of Colorado for many years. Tracy authored the first five editions of Accounting For Dummies. His other books include How to Read a Financial Report and Accounting Workbook For Dummies.

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