What is accounting? Recall from previous scenarios in this chapter that Cindy Li was asked to make a decision about her company’s ability to finance a large project, Ginny McIntyre was trying to raise money to buy new equipment and hire another employee, and Joseph Cortez needed financing to expand the manufacturing of his cars. To make an informed decision, all these business owners and managers relied on financial data that either they or their accountants prepared. Similarly, Arnold Sawyer must decide how his niece’s catering business will acquire the extra funds it needs to keep the business moving. Arnold will need to review the company’s financial information and possibly enlist outside consultants before making a decision. All these situations illustrate how accounting helps business managers make well-informed decisions about the financial needs of a company. Accounting is the process of tracking a business’s income and expenses by recording its financial transactions. The transactions are then summarized into key financial reports that are further used to evaluate a business’s current and expected financial status. Accounting is not just for large organizations. In fact, as Arnold Sawyer can attest, it is vital for businesses of all sizes. Accounting defines the heart and soul of even the smallest business because it helps to “account for” what the business has done, what it is currently doing, and what it has the potential to do. Although accounting involves a great deal of precision, there are also some degrees of interpretation related to it. This makes accounting both an art and a science.

Are there different types of accounting? Accounting is a general term, to say the least. Because different forms of business have varying needs, a multitude of specialty areas reside under the accounting umbrella. Figure 15.7 outlines the main types of accounting:

Figure 15.7

Primary Accounting Disciplines

• Corporate accounting (including managerial and financial accounting)

• Auditing, government, and not-for-profit accounting

• Tax accounting

What is corporate accounting? Among the decisions financial managers must make is determining whether a company’s financial assets are working efficiently, evaluating what kind of financing strategy is best, or choosing a way to obtain needed funds. The answers to these and many other decisions they must make are found in the reports and analyses performed by corporate accountants. Corporate accounting is the part of an organization’s finance department responsible for gathering and assembling data required for key financial statements. Corporate accounting has two separate functions: managerial accounting and financial accounting.

What is managerial accounting? Managerial accounting provides information and analyses to managers within an organization so they can make informed business decisions. For example, a managerial accounting budget can help a company’s managers determine whether to increase the firm’s staff or initiate layoffs. Managerial accountants also prepare short-term reports that help managers with the day-to-day operations of the business, such as weekly sales reports they can use to direct and motivate their sales force. Moreover, managerial accountants analyze which business activities are most profitable and least profitable. Based on their analyses, managers are better equipped to make decisions about whether to continue with, expand, or eliminate certain business activities. In addition, managerial accountants monitor the actual performance of the firm and compare it to the budgeted expectations set for it.

What is financial accounting? Financial accounting is an area of accounting that produces financial documents to aid investors and creditors. Managerial accounting is used by managers inside a company to make decisions, whereas interested parties outside a company depend on financial accounting. Figure 15.8 compares the two corporate accounting disciplines.

Figure 15.8

A Comparison of Managerial and Financial Accounting

Prospective and current investors and creditors rely on financial accounting information to help them evaluate a company’s performance and profitability. Such information is generally found in key documents, such as an annual report—a document produced once a year that presents the current financial state of a company and its future prospects. The financial statements in an annual report help investors determine whether it is wise to invest in the company.

Banks and other creditors analyze financial accounting statements to get a sense of a business’s financial health and creditworthiness. Some companies employ private accountants to perform financial accounting tasks in-house, whereas other companies hire public accountants external to the firm to do these tasks. Public and private accountants who have passed a rigorous series of examinations given by the American Institute of Certified Public Accountants and who have also met state requirements are given the designation of certified public accountant.

What is auditing? Auditing is the area of accounting responsible for reviewing and evaluating the accuracy of financial reports. Large corporations may have internal auditors on staff who work independently of the accounting department to determine whether a company’s financial information is recorded correctly and has been prepared using proper procedures. Generally, however, most companies hire independent auditors from outside the organization to ensure that their financial statements have been prepared accurately and are not biased or manipulated in any way. Companies can avoid devastating budget problems, such as the one experienced by the assessor’s office in Carver County, Minnesota (described in the Off the Mark box), by performing audits.

What type of accounting do governments and not-for-profit corporations use? Accounting is not only for organizations that strive to make money; government institutions and not-for-profit organizations use accounting as well. Government and not-for-profit accounting refers to the accounting required for organizations such as legislative bodies and charities that are not focused on generating profits. Nonetheless, to have the funds necessary to continue to serve the public, not-for-profit organizations such as the American Red Cross, as well as some hospitals, and educational institutions must distribute and manage funds, maintain a budget, and plan for future projects, just like for-profit companies. Government and not-for-profit organizations must also report their financial activities so taxpayers and donors can see how funds are spent and used.

Are there accountants who focus just on taxes? State and local governments require individuals and organizations to file tax returns annually. Tax accounting involves preparing taxes and giving people advice on tax strategies. Preparing a firm’s taxes can be complicated and is ever changing. Consequently, companies often have tax accountants on staff or hire self-employed tax accountants or outside tax-accounting firms, to prepare their taxes.

Accounting is so important to a business that accountants of all kinds are in high demand. Table 15.2 outlines the many different types of accountants and what each does.

Table 15.2

Accountants in High Demand

Are there specific standards accountants must adhere to? For any financial information to be useful, it is critical that the information is accurate, fair and objective, and consistent over time. Therefore, accountants in the United States follow a set of generally acceptable accounting principles (GAAP), which are standard accounting rules defined by the Financial Accounting Standard Board, an independent organization.

Although GAAP consists of general rules, they are often subject to different interpretations, which can lead to problems. In 2002, Congress passed the Sarbanes-Oxley Act (SOX), which was created to protect investors from corporate accounting fraud. The act was passed after a number of publicly traded companies, including WorldCom, Enron, and Tyco, collapsed as a result of aggressive and fraudulent accounting practices. The act established the Public Company Accounting Oversight Board (PCAOB), which is responsible for overseeing the financial audits of public companies. Congress also passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. One provision of the Dodd-Frank Act gives the PCAOB the power to oversee auditors of brokers and dealers in securities markets. The Dodd-Frank Act requires broker-dealers to have their financial statements certified by a PCAOB-registered public accounting firm. Read the BizChat to find out more about SOX.

Do all countries have the same accounting standards? Outside the United States, other countries have their own accounting standards, which may differ from U.S. GAAP. For example, U.S. GAAP is different from Canadian GAAP. This can pose a problem for companies who do business in other countries. A movement is in place toward international convergence of accounting standards to remedy these global differences. Most other countries are beginning to accept a common set of country-neutral accounting standards, which are known as International Financial Reporting Standards. By doing so, multinational companies with operations in the United States and other countries, such as Honda, LG, and Samsung, can avoid the need to convert the financial reports prepared to meet their own country’s accounting standards into U.S. GAAP specifications. Nearly 100 countries require or accept financial statements that are presented in accordance with IFRS.8

What is the accounting process? When people think of accounting, most think of the systematic recording of a company’s every financial transaction. This precise process is a small but important part of accounting called bookkeeping. The process of bookkeeping centers on the fundamental concept that what a company owns (its assets) must equal what it owes to its creditors (its liabilities) plus what it owes to its owners (owners’ equity). This balance is illustrated in Figure 15.9 and is better described as the fundamental accounting equation:

Figure 15.9

The Fundamental Accounting Equation

Does the accounting equation always stay in balance? To maintain the balance of assets and liabilities plus owners’ equity, accountants use a recording system called double entry bookkeeping. Double entry bookkeeping recognizes that for every transaction that affects an asset, an equal transaction must also affect either a liability or owners’ equity. For example, suppose you start a business mowing lawns, and your initial assets are a lawn mower worth $500 and $1,500 in cash that you have saved and are willing to use to start the business. Your business’s assets therefore total $2,000. Because the cash and lawn mower were yours to begin with, you do not owe anyone any money, so you have zero liabilities. If you were to close the business tomorrow, the cash and the lawn mower would belong to you. Therefore, they are considered owners’ equity. The accounting statement for your lawn mowing business would look like the one in Figure 15.10.

Figure 15.10

Business with No Liability

Now suppose the business is growing rapidly. You realize you need to buy a bigger lawn mower. You also want to buy a snow blower so you can expand your business to include snow removal. Together these items cost $2,500. You do not have enough cash to buy either outright, so you have to borrow the money. Although you are increasing your assets with a new lawn mower and a new snow blower, you are also adding a liability—the debt you have incurred to buy the new equipment. If the business closed tomorrow, your owners’ equity would not change because you could sell the lawn mower and the snow blower to pay off the debt in full (assuming you could sell the equipment for what you paid for it). The accounting statement for your lawn mower business would look like the one in Figure 15.11. What would the accounting statement look like if you were to purchase office equipment with cash to help run the business, such as a computer for $900?

Figure 15.11

Business with Liability