In order to function, the people who operate such a system ... must be reprogrammed to stop thinking as humans and to start thinking like accountants. As everyone from ancient times till today knows, clerks and accountants think in a non-human fashion. This is not their fault."
Harari, Y.N., Sapiens: A Brief History of Humankind, 2015, P129-130 in discussing the importance of accounting in ancient Mesopotamia. Emphasis added.
Uses
No one does accounting for fun. Accounting is done because it is useful. The first thing it is useful for is simply keeping track of things. Who owes money and how much, who is owed money and how much, what goods are available to sell, what supplies are available to be used, etc. We won't dwell on this but it should not be overlooked.
These factual records also for the basis for creating accounting statements and reports that are useful in less direct ways. These are:
- Informing decision making;
- Influencing behavior;
- Guiding regulatory and legal judgments.
Decision-making
In both profit and not-for-profit organizations, accounting reports are key sources of information for making strategic decisions. For example, accounting information will be utilized to help determine:
- What to produce and what services to offer;
- What combination of inputs should be used to produce those products and services;
- Whether to enter a new market;
- How much cash should be raised and when;
- Whether to invest in a joint venture.
Essentially, any time an organization faces a decision that requires weighing benefits and costs, at least some of which are financial in nature, it is natural to look to an accounting system to inform that decision. Accounting systems provide information about similar situations in the past and the state of current resources. Accounting systems also can be used to project future resources and revenue flows.
Behavior-influencing
Accounting reports influence behavior. When people are aware that their performance will be assessed using accounting-based information, they alter their conduct to conform to how their work is measured. For example, executives often have bonus plans tied to net income, return on assets, return on equity, and other numbers drawn from an organization's accounting system.
Note
Thorough understanding of what accounting numbers mean is necessary to design such performance evaluation systems properly. Boards and senior managers hope tying compensation to summary measures drawn from the accounting system will provide incentives for managers to pay attention to key organizational goals. However, performance evaluation schemes that do not make appropriate use of accounting information can actually lead to damaging behavior, as managers "game" the system to improve their rewards, but not improve organizational performance.
Inputs to the Regulatory and Justice Systems
Though often-overlooked, regulators, courts and the legal system often make extensive use of accounting information. For example, when one company has harmed another by using intellectual property without paying royalties, the damages are often assessed using accounting reports and systems. How much extra profit was earned through the misuse of a given piece of intellectual property? How much profit was foregone by the failure to collect royalties and fees? Assessments of these amounts usually begins by studying accounting reports.
Different Specifics, Common Structure
As an important source of information for everyone from investors to the government, accounting reports are governed by a lot of different rules and conventions, some of which are chosen with particular uses in mind. For example, the tax code in the United States guides how accounting reports for federal taxation purposes must be done. That code is established by the U.S. Congress, administered by the Internal Revenue Service, and interpreted by federal courts. Accounting reports that claim to be compiled under Generally Accepted Accounting Principles (GAAP) must follow the rules governed by the U.S. Securities & Exchange Commission, which delegates the specifics to the Financial Accounting Standards Board and related bodies. There is also an international accounting rule-making apparatus that determines the rules for reporting under International Financial Reporting Standards.
Regardless of the specific rules, all financial accounting systems share a common underlying structure. They use double entry accounting techniques to compile financial reports about a situation at a point in time and about flows over periods of time. While we use U.S. GAAP as our primary example, a major goal of this site is to expose the underlying common structure that all financial accounting systems share. Understanding the common structure will allow you to adapt to financial statements prepared under different rules, as well as to understand how new rules and conventions will change existing reports. The important thing is to understand the common structure of all accounting systems, not specific rules.
Entity and Transactions
To begin accounting, you must first identify the entity you will be considering. The entity, for example, could be an individual, a partnership, a limited liability company, a corporation, a non-profit or a government.
Whatever the entity, it must interact with outside parties to accomplish its goals. We think of these interactions as transactions in which the parties involved trade things of value.
Here's a short video that discusses the entity concept and transactions:
Framework
An accounting system and the reports reflect three elements:
- Aspirations
- Conventions
- Context
A framework for understanding accounting and its products, financial reports, requires knowing what the accounting is trying to achieve (aspirations), the practical ways it goes about it (conventions) and the context in which the accounting is being done.
Aspirations
Accounting systems do not "measure" the "truth." The world of economic activity is too complex for that. At best, accounting systems aspire to give useful insights as to an entity's operations from a particular point of view. Understanding what the creators of an accounting system were looking to capture is a key step in interpreting the results from the system
Conventions
One of the problems in assessing value is that it is very hard to define precisely what we mean by “value”, much less measure it. For example, how much is a key piece of machinery worth? Worth to whom and for what purpose? Should one value it at its purchase price depreciated by its age? Should it be valued by how much someone else might be willing to pay for it? Should it be valued at the market price of purchasing a new replacement? You can make an argument for any one of these methods (and people have).
Instead of getting bogged down in a misguided attempt to “measure” the “truth”, accountants adopt conventions to deal with such thorny issues. If applied properly, the conventions may not capture the full reality of a situation. But if you understand the convention, you can diagnose an accounting report's limitations (and strengths).
Context
Accounting does not take place in a vacuum. It is done by human beings who are naturally influenced by their personal goals, the society in which they live, the prevalent economic conditions, and the political winds that are flowing. The influence of the context is sometimes difficult to parse, but time and time again, we have seen how it sways accounting reports.
Here's a video that discusses these three parts of the Framework:
Importance of Tracking Wealth Creation
One of the key aspirations of for-profit accounting is to examine whether an entity is actually creating wealth. This is more difficult to determine than you might imagine. Money flows into an entity from a variety of sources – for example there are early investors, bond-holders, later investors, customer deposits, and supplier credits. The central goal of a for-profit entity is to add value to inputs and generate a profit. However, sometimes entities just move money from one outside party to another, giving the appearance of being successful, but actually not generating wealth.
(NOTE: This video refers to T-bills, which is short for Treasury Bills. T-bills are one way the U.S. Federal Government borrows money. It also refers to the S&P 500, which is short for Standard & Poors 500. The S&P 500 is an index of the stock prices of 500 large U.S. companies picked to be representative of the U.S. economy.)
Financial Statements 101
Accounting statements present two types of financial information:
- Financial information pertaining to a point in time.
- Financial information pertaining to flows over a period of time.
An accounting statement focused on a point in time is like a snapshot to present financial "position." The balance sheet, or statement of financial position, is this type of accounting report.
An accounting statement focused on flows over a period of time is like a movie that shows financial "motion." For a for-profit entity, the income statement, cash flow statement, and statement of changes in shareholders' equity are these kinds of statements. For a not-for-profit entity, the statement of activities and statement of cash flows show similar information.
An important feature of accounting is that the snapshots and the movies must all fit together - i.e., they must articulate. Here is a video to help you visualize this structure.
You can tell from the video how important the Fundamental Accounting Identity is in guiding accountants' thinking about balance sheets. It is so important that we should take more time to go into it more deeply.