Understanding Principles of Accounting

business essentials -- part 13 -- summary

Accounting is a comprehensive system for collecting, analyzing, and communicating financial information. It measures business performance and translates the results into information for management decisions. It also prepares performance reports for owners, the public, and regulatory agencies, thereby providing an accurate picture of the firm's financial health.

There are two main fields and accounting: (1) financial accounting deals with external information users (consumer groups, unions, stockholders, and government agencies). It prepares income statements, balance sheets, and other financial reports published for shareholders in the public. (2) managerial (or management) to accounting serves internal users, such as managers at all levels.

Certified public accountants (CPAs) are licensed professional to provide auditing, tax, and management advisory services for other firms and individuals. CPAs are always independent of the firms they audit. Many businesses hire their own salaried employees -- private accountants -- to perform internal accounting activities. Certified management accountants (CMAs) are certified professionals who provide services to support manager's in such areas as taxation, budgeting, internal auditing, and cost analysis.

CPA Vision Project

The Vision Project is a profession wide assessment to see what the future of the accounting profession will be like. It was initiated because of the declining number of students entering the accounting profession and because of rapid changes in the business world. Practicing CPAs and other industry leaders participated in identifying key forces that are affecting the profession. Then they developed recommendations for change, including a set of core services that the profession should offer clients and a set of core competencies that CPAs should possess. Overall, the new vision reflects changes in this CPAs culture and professional lifestyle.

Accounting Concepts

Accountants use the following equation to balance the data pertaining to financial transactions:

Assets = liabilities + owners equity

We can rewrite the accounting equation to show the value of the firm to the owners:

Assets - liabilities = owners equity

In the accounting equation, if assets exceed liabilities, owners equity is positive; if the firm goes out of business, owners will receive some cash (a gain) after selling assets and paying off liabilities. If liabilities outweigh assets, owners equity is negative; assets aren't enough to pay off debt. If the company goes under, owners will get a cash and some creditors won't get paid.

Because every transaction affects two accounts, accountants use a double entry accounting system to record the dual effects. Because the double entry system requires at least two bookkeeping entries for each transaction, it keeps the accounting equation in balance. These tools serve as double checks for counting errors.

Financial Statements

Accounting summarizes the results of the firm's transactions and issues reports to help managers make informed decisions. The class of reports known as financial statements is divided into three categories.
(1) balance sheets -- sometimes called statement of financial position, supply detailed information about the accounting equation factors such as assets, liabilities, and owners equity, ask a given point in time.
(2) the income statement -- sometimes called a profit-and-loss statement, describes revenues and expenses to show a firm's annual profit or loss.
(3) a statement of cash flows -- is a publicly traded statement which describes its yearly cash receipts and payments. It shows the effects on cash of three activities: (1) Cash flows from operations, (2) Cash flows from investing, and (3) Cash flows from financing.

Accountants follow standard reporting practices and principles when they prepare financial statements. Otherwise, users wouldn't be able to compare information from different companies, and they might misunderstand -- or be led to misconstrue -- a company's true financial status. The following are three of the most important standard reporting practices and principles:
(1) revenue recognition is the formal recording and reporting of revenues in the financial statements. All firms burned revenues continuously as they make sales, the earnings are not reported until the earnings cycle is completed. This cycle is complete under two conditions: (a) the sale is complete and the product delivered; (b) the sale price has been collected or is collectible. This practice assures interested parties that the statement gives a fair comparison of what was gained for the resources that were given up.
(2) the matching principal states that expenses will be matched with revenues to determine net income. It permits users to see how much net gain resulted from the assets that had to be given up in order to generate revenues.
(3) because they have inside knowledge, management prepares additional information that explain certain events or transactions, or discloses the circumstances behind certain results. Full disclosure means that financial statements include management interpretations and explanations to help external users understand information contained in statements.

Financial Ratios

Financial statements provide data that can be applied to ratios (comparative numbers). Ratios can then be used to analyze the financial health of one or more companies. Ratios can help creditors, investors, and managers assess the firm's finances. They can also be used to check a firm's progress by comparing current and past statements.

Solvency ratios, such as the current ratio, estimate risk by measuring the ability to meet current obligations out of current assets. Long-term solvency ratios, such as the debt to owners equity ratio (or debt-to-equity ratio), described the extent to which a firm is financed through borrowed money. High indebtedness can be risky because it requires payment of interest and repayment of borrowed funds. Profitability ratios -- return on equity and earnings per share -- measure potential earnings. Activity ratios reflect management's use of assets by measuring the efficiency in with which a firm uses its resources. The inventory turnover ratio, for example, measures the average number of times the inventory is sold in restocked annually -- that is, how quickly it is produced and sold. A high inventory turnover ratio means a efficient operations: because a smaller amount of investment is tied up in the inventory, the firm's funds can be put to work elsewhere to earn greater returns.

Accounting for foreign transactions involve special procedures, such as translating the values of different countries currencies and accounting for the effects of exchange rates. Moreover, currencies are subject to change: as they are traded each day around the world, their values are determined by market forces -- what buyers are willing to pay for them. The resulting values are foreign currency exchange rates, which can be fairly volatile.

International purchases, sales autocratic, and accounting for foreign subsidiaries all involve transactions affected by exchange rates. When a U.S. company imports a French product, it's accountant must be sure that its books reflect its true costs. The amount owed to the French seller changes daily along with the exchange rate between euros and dollars. The American accountant must therefore identified the actual rate on the day that payment in euros is made so that the correct U.S. dollar cost of the product is reported.