“What does this ‘Accounting: The Language of Business, Investing, Finance, and Taxes’ about?”, you may wonder. Okay, this is not about calculating (measuring), nor recording transaction (recognizing), neither about how to construct accounting/financial report (reporting) in easy way. Instead, it is about: realizing how accounting is relevant to you, grasping how all economic activity requires accounting, watching an accounting department in action, shaking hands with business financial statements, and answering a question “should I become an accountant?”
[Info_Box]Accounting is all about financial information — capturing it, recording it, configuring it, analyzing it, and reporting it to persons who use it.[/Info_Box]
I won’t say much about how accountants capture, record, and configure financial information in this post. But I am going to talk a lot about how accountants communicate information in financial statements, and I explain the valuation methods accountants use — ranging from measuring profit and loss to putting values on assets and liabilities of businesses.
As you go through life, you come face to face with accounting information more than you would ever imagine. Regretfully, much of this information is not self-explanatory or intuitive, and it does not come with a user’s manual. Accounting information is presented on the assumption that you have a basic familiarity with the vocabulary of accounting and the accounting methods used to generate the information. In short…
[Info_Box] …most of the accounting information you encounter is not transparent. The main reason for studying accounting is to learn its vocabulary and valuation methods, so you can make more intelligent use of the information.
People who use accounting information should know the basic rules of play and how the financial score is kept, much like spectators at a football or baseball game.[/Info_Box]
Let me point out another reason you should know accounting basics….
A lot of people out there in the cold, cruel financial world may take advantage of you, not necessarily by illegal means but by withholding key information and by diverting your attention from unfavorable aspects of certain financial decisions. These unscrupulous characters treat you as a lamb waiting to be fleeced. The best defense against such tactics is to know some accounting, which can help you ask the right questions and understand the financial points that con artists don’t want you to know.
Is Accounting Just for Accountants?
One main source of accounting information is in the form of financial statements that are packaged with other information in a financial report. Accountants keep the books and record the financial activities of an entity (such as a business). From these detailed records the accountant prepares financial statements that summarize the results of the activities.
Financial statements are sent to people who have a stake in the outcomes of the activities. If you own stock in General Electric, for example, or you have money in a mutual fund, you receive regular financial reports. If you invest your hard-earned money in a private business or a real estate venture, or you save money in a credit union, you receive regular financial reports. If you are a member of a nonprofit association or organization, you’re entitled to receive regular financial reports.
In summary, one important reason for studying accounting is to make sense of the financial statements in the financial reports you get. I guarantee that Warren Buffett knows accounting and how to read financial statements.
Accounting Affects both Insiders and Outsiders
People who need to know accounting fall into two broad groups: “insiders” and “outsiders“.
1. The insider (business managers) – they have the authority and responsibility to run a business. They need a good understanding of accounting terms and the methods used to measure profit and put values on assets and liabilities. Accounting information is indispensable for planning and controlling the financial performance and condition of the business. Likewise, administrators of nonprofit and governmental entities need to understand the accounting terminology and measurement methods in their financial statements.
2. The outsiders – They are not privy to the day-to-day details of a business or organization. They have to rely on financial reports from the entity to know what’s going on. Therefore, they need to have a good grip on the financial statements included in the financial reports. For all practical purposes, financial reports are the only source of financial information we get directly from a business or other organization.
By the way, the employees of a business — even though they obviously have a stake in the success of the business — do not necessarily receive its financial reports. Only the investors in the business and its lenders are entitled to receive the financial reports. Of course, a business could provide this information to those of its employees who are not shareowners, but generally speaking most businesses do not. The financial reports of public businesses are in the public domain, so their employees can easily secure a copy. However, financial reports are not automatically mailed to all employees of a public business.
[Info_Box]In our personal financial lives, a little accounting knowledge is a big help for understanding investing in general, how investment performance is measured, and many other important financial topics. With some basic accounting knowledge, you’ll sound much more sophisticated when speaking with your banker or broker.[/Info_Box]
I can’t promise you that learning accounting will save you big bucks on your income taxes, but it can’t hurt and will definitely help you understand what your tax preparer is talking about.
Overcoming the Stereotypes of Accountants
Maybe you’ve heard the joke that an accountant with a personality is one who looks at your shoes when he is talking to you, instead his own shoes.
Like most stereotypes, there’s an element of truth in the preconceived image of accountants. Even I am not an accounting professor, I have met and known a large number of accountants. Most accountants are not as gregarious as used-car sales people (though some are).
Accountants certainly are more detail-oriented than your average person. However, you don’t have to be good at mathematics to be a good accountant. Accountants use very little math (no calculus and only simple algebra).
Accountants are very good at one thing: They want to see both sides of financial transactions: the give and take. Accountants know better than anyone that, as economists are fond of saying, there’s no such thing as a free lunch.
If you walked down a busy street in metropolis city (Chicago, London, Tokyo, New York, or Los Angeles), I doubt that you could pick out the accountants. I have no idea whether accountants have higher or lower divorce rates than others, whether they go to church more frequently or if they generally sleep well at night. I do think that accountants are more honest in paying their income taxes than other people, although I have no proof of this.
Relating Accounting to Your Personal Financial Life
I’m sure you know the value of learning personal finance and investing fundamentals. Well, a great deal of the information you use in making personal finance and investing decisions is accounting information. One knock I have on oversee in these areas is that they often don’t make clear that you need a basic understanding of accounting terminology and valuation methods in order to make good use of the financial information.
You have a stake in the financial performance of the business you work for, the government entities you pay taxes to, the churches and charitable organizations you donate money to, the retirement plan you participate in, the businesses you buy from, and the healthcare providers you depend on. The financial performance and viability of these entities has a direct bearing on your personal financial life and well-being.
We’re all affected by the profit performance of businesses, even though we may not be fully aware of just how their profit performance affects our jobs, investments, and taxes. For example: as an employee your job security and your next raise depend on the business making a profit. If the business suffers a loss, you may be laid off or asked to take a reduction in pay or benefits.
Business managers get paid to make profit happen. If the business fails to meet its profit objectives or suffers a loss, its managers may be replaced (or at least not get their bonuses).
Your investments in businesses, whether direct or through retirement accounts and mutual funds, suffer if the businesses don’t turn a profit. I hope the stores I trade with make profit and continue in business. The government depend on businesses making profit to collect income taxes from them.
Accounting Focuses on Transactions
Accounting focuses on transactions. A good bookkeeping system captures and records every transaction that takes place without missing a beat. Transactions are economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals. Transactions are the lifeblood of every business, the heartbeat of activity that keeps it going. Understanding accounting, to a large extent, means understanding how accountants record the financial effects of transactions. The immediate and future financial effects of some transactions can be difficult to determine.
A business carries on economic exchanges with six basic types of persons or entities:
- Its customers, who buy the products and services that the business sells
- Its employees, who provide services to the business and are paid wages and salaries and provided with benefits, such as: a retirement plan, medical insurance, workers’ compensation, and unemployment insurance.
- Its suppliers and vendors, who sell a wide range of things to the business, such as legal advice, products for resale, electricity and gas, telephone service, computers, vehicles, tools and equipment, furniture, and even audits.
- Its debt sources of capital who loan money to the business, charge interest on the amount loaned, and are due to be repaid at definite dates in the future.
- Its equity sources of capital, the individuals and financial institutions that invest money in the business and expect the business to earn profit on the capital they invest.
- The government, or the federal, state, and local agencies that collect income taxes, sales taxes, payroll taxes, and property taxes from the business.
Even a relatively small business generates a surprisingly large number of transactions, and all transactions have to be recorded. Certain other events that have a financial impact on the business have to be recorded as well. These are called events because they’re not based on give-and-take bargaining—unlike the something-given-for-something-received nature of economic exchanges.
Events such as the following have an economic impact on a business and are recorded:
- A business may lose a lawsuit and be ordered to pay damages. The liability to pay the damages is recorded.
- A business may suffer a flood loss that is uninsured. The waterlogged assets may have to be written down, meaning that the recorded values of the assets are reduced to zero if they no longer have any value to the business. For example, products that were being held for sale to customers (until they floated down the river) must be removed from the inventory asset account.
- A business may decide to abandon a major product line and downsize its workforce, requiring that severance compensation be paid to the laid-off employees.
At the end of the year the accountant makes a special survey to make sure that all events and developments during the year that should be recorded have been recorded, so that the financial statements and tax returns for the year are complete and correct.
The talk is getting more seriously eh? But let’s take a break for some drinks. If you love this kind discussion, you may want to check out my next topic: Range Of Accounting: What Accounting Department Mainly Responsible For?
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