Accounting and Bookkeeping

I

INTRODUCTION

Accounting and Bookkeeping, the process of identifying, measuring, recording, and communicating economic information about an organization or other entity, in order to permit informed judgments by users of the information. Bookkeeping encompasses the record-keeping aspect of accounting and therefore provides much of the data to which accounting principles are applied in the preparation of financial statements and other financial information.

Personal record keeping often uses a simple single-entry system, in which amounts are usually recorded in column form. Such entries include the date of the transaction, its nature, and the amount of money involved. Record keeping of organizations, however, is based on a double-entry system, whereby each transaction is recorded on the basis of its dual impact on the organization’s financial position or operating results or both. Information relating to the financial position of an enterprise is presented on a balance sheet, while disclosures about operating results are displayed on an income statement. Information relating to an organization’s liquidity—namely, how it obtains and spends cash—is shown on a statement of cash flows. These three financial statements provide information about past performance, which in turn becomes a basis for readers to try to project what might happen in the future.

II

HISTORY

Bookkeeping and record-keeping methods, created in response to the development of trade and commerce, are preserved from ancient and medieval sources. Double-entry bookkeeping began in the commercial city-states of medieval Italy and was well developed by the time of the earliest preserved double-entry books, from 1340 in Genoa.

The first published accounting work was written in 1494 by the Venetian monk Luca Pacioli. Although it disseminated rather than created knowledge about double-entry bookkeeping, Pacioli's work summarized principles that have remained essentially unchanged. Additional accounting works were published during the 16th century in Italian, German, Dutch, French, and English, and these works included early formulations of the concepts of assets, liabilities, and income.

The Industrial Revolution of the mid-1700s created a need for accounting techniques that would be adequate to handle mechanization, factory-manufacturing operations, and the mass production of goods and services. With the emergence in the mid-19th century of large, publicly owned business corporations, owned by absentee stockholders and administered by professional managers, the role of accounting was further redefined.

Starting in the mid-20th century, machines—particularly computers—performed many of the bookkeeping functions that are vital to accounting systems. The widespread use of computers broadened the scope of bookkeeping, and the term data processing now frequently encompasses bookkeeping.

III

ACCOUNTING INFORMATION

Accounting information can be classified into two categories: financial accounting, consisting of public information, and managerial accounting, consisting of private information. Financial accounting includes information disseminated to parties that are not part of the enterprise proper, such as stockholders, creditors, customers, suppliers, regulatory commissions, financial analysts, and trade associations. Such information relates to the financial position, the liquidity, and the profitability of an enterprise.

Managerial accounting deals with information that is not generally disseminated outside a company, such as salary costs, profit targets, and cost of materials per unit produced. Whereas the general-purpose financial statements of financial accounting are assumed to meet the basic information needs of most external users, managerial accounting provides a wide variety of specialized reports for division managers, department heads, project directors, section supervisors, and other managers within a company.

A

Specialized Accounting

Of the various specialized areas of accounting that exist, the three most important are auditing, income taxation, and nonbusiness organizations. Auditing is the examination, by an independent accountant, of the financial data, accounting records, business documents, and other pertinent documents of an organization in order to attest to the reasonableness of its financial statements. Businesses and not-for-profit organizations in the United States engage certified public accountants (CPAs) to perform audit examinations. Large private and public enterprises sometimes also maintain an internal audit staff to conduct auditlike examinations, which often are as much concerned with operating efficiency and managerial effectiveness as with the accuracy of the accounting data.

The second specialized area of accounting is income taxation. Preparing an income-tax return by filling out one or more forms entails collecting information and presenting data in a coherent manner; therefore, both individuals and businesses frequently hire accountants to determine their taxes. Tax rules, however, are not identical with accounting practices. Tax regulations are based on laws that are enacted by legislative bodies, interpreted by the courts, and enforced by designated administrative bodies. Much of the information required in calculating taxable income and the amount of tax due, however, is also needed in accounting, and many techniques of computing are common to both areas.

Not all accounting involves for-profit organizations. A third area of specialization is accounting for nonbusiness organizations, such as universities, hospitals, churches, trade and professional associations, and government bodies. These organizations differ from business enterprises in that they receive resources on some nonreciprocating basis—that is, without paying for such resources. They do not have a profit orientation, and they have no defined ownership interests as such. As a result, these organizations call for differences in record keeping, in accounting measurements, and in the format of their financial statements.

B

Financial Reporting

The traditional function of financial reporting was to provide business owners with information about the companies that they owned and operated. Once the delegation of managerial responsibilities to hired personnel became a common practice, financial reporting began to focus on stewardship—that is, on the managers’ accountability to the owners. Its purpose then was to document how effectively the owners’ assets were managed, in terms of both capital preservation and profit generation.

Once businesses were commonly organized as corporations, the appearance of large multinational corporations and the widespread employment of professional managers by absentee owners brought about a change in the focus of financial reporting. Although the stewardship orientation did not become obsolete, financial reporting beginning in the mid-20th century became somewhat more geared toward the needs of investors. Because both individual and institutional investors view ownership of corporate stock as only one of various investment alternatives, they seek much more future-oriented information than was supplied under the traditional stewardship model. As investors relied more on financial statements to predict the results of investment and disinvestment decisions, accounting became more sensitive to their needs. One important result was an expansion of the information supplied in financial statements.

The proliferation of mandated notes that accompany financial statements is a particularly visible example. Such notes disclose information that is not already included in the body of the financial statement. One of the very first notes identifies the accounting methods adopted when acceptable alternative methods also exist, or when the unique nature of the company's business justifies an otherwise unconventional approach.

The notes also disclose information about lease commitments, contingent liabilities, pension plans, stock options, and the effects of translating foreign currency amounts, as well as details about long-term debt, such as interest rates and maturity dates. A public company having a widely distributed ownership includes among its notes the income amounts that it earned in each three-month fiscal period known as a quarter. It also includes quarterly stock market prices of its outstanding shares of common stock and information about the relative sales and profit contributions of the different operating components that make up a diversified company.

IV

ACCOUNTING PRINCIPLES

Accounting as it exists today may be viewed as a system of assumptions, doctrines, tenets, and conventions, all encompassed by the phrase “generally accepted accounting principles.” Many of these principles developed gradually, as did much of common law. In recent decades, however, an authoritative body, such as the Financial Accounting Standards Board, has determined standards or rules for accounting principles. Following are several fundamental accounting concepts.

The entity concept states that the item or activity (entity) that is to receive an accounting must be clearly defined, and that the relationship assumed to exist between the entity and external parties must be clearly delineated.

The going-concern assumption states that it is expected that the entity will continue to operate indefinitely.

The historical-cost principle states that economic resources be recorded in terms of the amounts of money exchanged; when a transaction occurs, the exchange price is by its nature a measure of the value of the economic resources that are exchanged.

The realization concept states that accounting takes place only for those economic events to which the entity is a party. This principle therefore rules out recognizing a gain based on the appreciated market value of a still-owned asset.

The matching principle states that income is calculated by matching a period's revenues, such as the amount of merchandise sold, with the expenses (monetary costs) incurred in order to bring about that revenue.

The accrual principle defines revenues and expenses as the inflow and outflow of all assets—as distinct from the flow only of the cash asset—in the course of operating the enterprise.

The consistency criterion states that the accounting procedures used at a given time should conform with the procedures previously used for that activity. Such consistency allows data of different periods to be compared.

The disclosure principle requires that financial statements present the most useful amount of relevant information—namely, all information that is necessary in order not to be misleading.

The substance-over-form standard emphasizes the economic substance of an event even though its legal form may suggest a different result. An example is the practice of consolidating the financial statements of one company with those of another in which it has more than a 50 percent ownership interest.

The doctrine of accounting conservatism applies to a situation in which a company appears to be headed for a financial loss. The accountant confers with management to determine whether this loss is probable or only possible. In cases where the loss is deemed probable, the accountant and management then seek to estimate the likely amount of the loss. If the loss can be estimated, then the negative effect of the loss will be reflected in the company’s financial statement even though the loss has not yet actually occurred.

A

The Balance Sheet

Of the two traditional types of financial statements, the balance sheet relates to an entity's financial position at a point in time, and the income statement relates to its activity over an interval of time. The balance sheet provides information about an organization's assets, liabilities, and owners' equity as of a particular date—namely, the last day of the accounting or fiscal period. The format of the balance sheet reflects the basic accounting equation: Assets equal equities. Assets are economic resources that are expected to provide future service to the organization. Equities consist of the organization's liabilities, which are its obligations together with the equity interest of its owners. For example, assume that a business owns a building worth $7 million and that the amount left to pay on the mortgage loan is $5 million. On the business’s balance sheet, the building would be considered an asset worth $7 million, the unpaid mortgage loan balance would be considered a liability of $5 million, and the $2-million difference between the value of the building and the outstanding loan would be the business’s equity.

Assets are categorized as current or long-lived. Current assets are usually those that management could reasonably be expected to convert into cash within one year; they include cash, receivables (money due from customers, clients, or borrowers), merchandise inventory, and short-term investments in stocks and bonds. Long-lived assets include the land, buildings, machinery, motor vehicles, computers, furniture, and fixtures belonging to the company. Long-lived assets also include real estate being held for speculation, patents, and trademarks.

Liabilities are obligations that the organization must remit to other parties, such as vendors, creditors, and employees. Current liabilities generally are amounts that are expected to be paid within one year, including salaries and wages, taxes, short-term loans, and money owed to suppliers of goods and services. Noncurrent liabilities include debts that will come due beyond one year, such as bonds, mortgages, and other long-term loans. Whereas liabilities are the claims of outside parties on the assets of the organization, the owners' equity is the investment interest of the owners in the organization's assets. When an enterprise is operated as a sole proprietorship or as a partnership, the balance sheet may disclose the amount of each owner's equity. When the organization is a corporation, the balance sheet shows the equity of the owners (the stockholders) as consisting of two elements. These two elements are the amount originally invested by the stockholders and the corporation's cumulative reinvested income, or retained earnings—that is, income not distributed to stockholders as dividends.

B

The Income Statement

The traditional activity-oriented financial statement issued by business enterprises is the income statement. Prepared for a well-defined time interval, such as three months or one year, this statement summarizes the enterprise's revenues, expenses, gains, and losses. Revenues are transactions that represent the inflow of assets as a result of operations—that is, assets received from selling goods and rendering services. Expenses are transactions involving the outflow of assets in order to generate revenue, such as wages, rent, interest, and taxes.

A revenue transaction is recorded during the fiscal period in which it occurs. An expense appears on the income statement of the period in which revenues presumably resulted from the particular expense. To illustrate, wages paid by a merchandising or service company are recognized as an immediate expense because they are presumed to generate revenue during the same period in which they occurred. If, however, the wages are paid to process merchandise that will not be sold until a later fiscal period, they would not be considered an immediate expense. Instead, the cost of these wages will be treated as part of the cost of the resulting inventory asset; the effect of this cost on income is thus deferred until the asset is sold and revenue is realized.

In addition to disclosing revenues and expenses (the principal components of income), the income statement also identifies gains and losses from other kinds of transactions, such as the sale of plant assets (for example, a factory building) or the early repayment of long-term debt. Gains or losses that are deemed to be extraordinary—that is, both unusual and infrequent—are so labeled.

C

Other Financial Statements

A third important activity-oriented financial statement is the statement of cash flows. This statement provides information not otherwise available in either an income statement or a balance sheet. The statement of cash flows presents the sources and the uses of the enterprise's cash by classifying each type of cash inflow and cash outflow according to the nature of the type of activity, such as operating activities, investing activities, and financing activities. The statement’s operating activities section identifies the cash generated or used by operations. Investing activities include the cash exchanged to buy and sell long-lived assets such as plant and equipment. Financing activities consist of the cash proceeds from stock issuances and loans and the cash used to pay dividends, to purchase the company's outstanding shares of its own stock, and to pay off debts.

D

Bookkeeping and Accounting Cycle

Modern accounting entails a seven-step accounting cycle. The first three steps fall under the bookkeeping function—that is, the systematic compiling and recording of financial transactions. Business documents provide the bookkeeping input; such documents include invoices, payroll time cards, paid bank checks, and receiving reports. Special journals (daily logs) are used to record recurring transactions. These include a sales journal, a purchases journal, a cash-receipts journal, and a cash-disbursements journal. Transactions that cannot be accommodated by a special journal are recorded in the general journal.

D1

Step One

Recording a transaction in a journal marks the starting point for the double-entry bookkeeping system. In this system the financial structure of an organization is analyzed as consisting of many interrelated aspects, each of which is called an account (for example, the “wages payable” account). Every transaction is identified by its two or more aspects or dimensions, referred to as its debit (or left side) and credit (or right side) aspects, and each of these aspects has its own effect on the financial structure.

Depending on their nature, certain accounts are increased with debits and decreased with credits; other accounts are increased with credits and decreased with debits. For example, the purchase of merchandise for cash increases the merchandise account (a debit) and decreases the cash account (a credit). If merchandise is purchased on the basis of a promise to make a future payment, a liability would be created, and the journal entry would record an increase in the merchandise asset account (a debit) and an increase in a liability account (a credit). Recognition of wages earned by employees entails recording an increase in the wage-expense account (a debit) and an increase in a liability account (a credit). The subsequent payment of the wages would be a decrease in the cash asset account (a credit) and a decrease in the liability account (a debit).

D2

Step Two

In the next step in the accounting cycle, the amounts that appear in the various journals are transferred to the organization's general ledger—a procedure called posting. A ledger is a book having one page for each account in the organization's financial structure. The page for each account shows its debits on the left side and its credits on the right side, so that each account’s balance—that is, the net credit or net debit amount—can be determined.

In addition to the general ledger, a subsidiary ledger is used to provide information in greater detail about the accounts in the general ledger. For example, the general ledger contains one account showing the entire amount owed to the enterprise by all its customers; the subsidiary ledger breaks this amount down on a customer-by-customer basis, with a separate subsidiary account for each customer. Subsidiary accounts may also be kept for the wages paid to each employee, for each building or machine owned by the company, and for amounts owed to each of the enterprise's creditors.

D3

Step Three

Posting data to the ledgers is followed by listing the balances of all the accounts and calculating whether the sum of all the debit balances agrees with the sum of all the credit balances (because every transaction has been listed once as a debit and once as a credit). This determination is called a trial balance. This procedure and those that follow it take place at the end of the fiscal period. Once the trial balance has been prepared successfully, the bookkeeping portion of the accounting cycle has ended.

D4

Step Four

Once bookkeeping procedures have been completed, the accountant prepares adjustments to recognize events that, although they did not occur in conventional form, are in substance already completed transactions. The following are the most common circumstances that require adjustments: accrued revenue (for example, interest earned but not yet received); accrued expense (wage cost incurred but not yet paid); unearned revenue (earning subscription revenue that had been collected in advance); prepaid expense (expiration of a prepaid insurance premium); depreciation (recognizing the cost of a machine as expense spread over its useful economic life); inventory (recording the cost of goods sold on the basis of a period's purchases and the change between beginning and ending inventory balances); and receivables (recognizing bad-debt expenses on the basis of expected uncollected amounts).

D5

Steps Five and Six

Once the adjustments are calculated and entered in the ledger, the accountant prepares an adjusted trial balance—one that combines the original trial balance with the effects of the adjustments (step five). With the balances in all the accounts thus updated, financial statements are then prepared (step six). The balances in the accounts are the data that make up the organization's financial statements.

D6

Step Seven

The final step is to close noncumulative accounts. This procedure involves a series of bookkeeping debits and credits to transfer sums from income-statement accounts into owners' equity accounts. Such transfers reduce to zero the balances of noncumulative accounts so that these accounts can receive new debit and credit amounts that relate to the activity of the next business period.

V

REGULATIONS AND STANDARDS

Until 1973 a committee of certified public accountants (CPAs) established accounting principles in the United States. CPAs are accountants licensed by their state government on the basis of educational background, a rigorous certification examination, and in most jurisdictions, relevant practical work experience. In 1973 the seven-member Financial Accounting Standards Board was created as an independent standard-setting organization. Regulations for auditors are promulgated by the American Institute of Certified Public Accountants. United States companies whose stocks or bonds are traded publicly must conform to rules set by the Securities and Exchange Commission (SEC), a federal government agency. Tax laws and regulations are administered at the federal level by the Internal Revenue Service (IRS) and at the local level by state and municipal government agencies. Many countries other than the United States also have systems of accounting standards. The International Accounting Standards Board, based in London, England, exists to achieve international harmonization of accounting principles.

The United States has no standard-setting body for managerial accounting. From 1971 to 1980, however, the federal Cost Accounting Standards Board established accounting rules that apply to contracts entered into by parties that sell goods and services to the federal government. The nongovernmental Institute of Management Accounting administers a certification program, qualifying candidates for a certificate in management accounting (CMA). The Institute of Internal Auditors has a program enabling an accountant to be designated a certified internal auditor (CIA).

A

Accounting Reforms

At the beginning of the 21st century, the accounting profession in the United States was rocked by a series of scandals. In 2001 the Enron Corporation, a major energy-trading company, acknowledged that its financial statements for nearly five previous years were erroneous because the company had failed to follow generally accepted accounting practices. Instead of the massive profits it had reported, the company revealed that it had actually lost $586 million from 1997 through 2001. The U.S. Department of Justice indicted the CPA firm of Arthur Andersen LLP, Enron’s outside auditor and one of the largest accounting firms in the world. In 2002 a jury convicted Andersen of obstructing justice by shredding documents sought by the SEC.

The Enron scandal was followed in 2002 by another infamous case of accounting fraud involving another prominent corporation known as WorldCom, Inc., a major telecommunications company. The company admitted that it had failed to report more than $7 billion in expenses over five quarterly periods and had actually lost $1.2 billion during that period, although its financial reports indicated that it had been profitable. The vast sums of money involved made it the largest accounting fraud ever. As the year progressed, other major U.S. companies and their accounting firms came under SEC investigation.

The U.S. Congress responded to these accounting scandals by passing legislation that imposed the strictest government oversight of the accounting profession since the 1930s. The new law, known as the Public Company Accounting Reform and Investor Protection Act of 2002, created the Public Company Accounting Oversight Board, a five-member board under the supervision of the SEC. The law gave the board the authority to investigate and penalize accounting firms that audit the financial statements of publicly traded companies in a substandard manner. The board was required to set accounting rules and standards with the SEC’s approval and to perform annual audits of any accounting firm that supervises the financial reports of more than 100 public companies. The latter provision was regarded as one of the most important because the accounting profession had been self-policing until the board was created.

Under the law, all accounting firms that audit publicly traded companies must register with the federal government. The oversight board has the power to suspend accounting firms and individual CPAs found guilty of violations and may impose substantial fines against both individual accountants and a CPA firm. The board may also refer cases to the Justice Department for criminal prosecution. Observers said the law’s strongest sanction was the ability to suspend accountants who have committed violations from working for publicly traded companies.

The SEC selects the chairperson and the other four members of the oversight board. To insulate the board from influence by the accounting profession, only two members may be CPAs, and the chairperson cannot have been a practicing CPA for at least five years prior to the appointment. All board members must work exclusively for the board, and their terms are staggered over five-year periods.

Other reform measures under the new law required that chief executive officers (CEOs) and chief financial officers (CFOs) of publicly traded companies of a designated size sign statements affirming the accuracy of their firm’s financial reports. Any CEOs or CFOs who “willfully and knowingly” permit misleading information in those reports could face prison terms. The law also prohibited accounting firms from offering many consulting services to clients contemporaneously with a mandated audit. The purpose of this provision was to prevent conflicts of interest. During the Enron scandal, it was revealed that Andersen earned greater amounts of money from providing consulting services to Enron than it obtained from performing auditing services. Some critics asserted that this created an incentive for Andersen to ignore auditing problems.