Main Concepts
There are three main concepts at the heart of accounting in a for-profit entity:
- Financial value - every asset and liability is assigned a financial value that is expressed in terms of a currency such as dollars, Euros, etc. In an idealized setting, every financial value would have a direct meaning - it would be the amount of money at which it could be bought or sold.
- Wealth of an organization is the sum of the financial values of all its assets minus the sum of the financial value of all its liabilities. In an idealized setting, this would have a direct meaning -the amount of money at which the entire entity could be bought or sold.
- Economic income is the change in and entity’s wealth over an accounting period, excluding capital transactions with its owners. In an idealized setting, this would perfectly and completely capture the entity’s financial performance over the period.
The idealized setting referenced above is the utopia of a free-market economist - there would be a market for every item produced or consumed and there would be lots of suppliers and lots of sources of demand for each item. Each market would instantly bring supply and demand into equilibrium at a single price and would involve no transactions costs.
Needless to say, taking concepts from an idealized setting into the real world involves lots of simplifications, compromises, and subtleties. That is, actual accounting involves, in Warren Buffett’s words, a lot of nuances.
The Rules
So what rules govern how information is gathered, organized, and reported in accounting? In order to make accounting uniform in the United States, the Securities and Exchange Commission (SEC) requires the use of Generally Accepted Accounting Principles (GAAP), which are commonly understood and accepted conventions in the United States. Regulators in other countries often require the use of International Financial Reporting Standards (IFRS). US GAAP are set primarily by the Financial Accounting Standards Board (FASB), which is headquartered in Norwalk, CT. IFRS are set primarily by the International Accounting Standards Board (IASB), which is headquartered in London.
Financial accountants have a lot of leeway in applying US GAAP or IFRS. Although it is a bit long, the following YouTube video gives you a good idea about flexibility in application:
Cases
How does this apply to the real world?
These cases will get you started:
As you can see, accounting is complex and at times can be very subjective. To be an effective manager, you must understand how it works. To get this understanding, we start with simple transactions and events and then dig deeper and deeper. The best place to start is the Accounting Indentity and how it is used. The next section of this site begins the process.