Chapter 1: Introduction to Financial Accounting
- 1 Learning Objectives
- 2 Foreword
- 3 1.1 - The Business Environment
- 4 1.2 - Purpose of Accounting
- 5 1.3 - A Brief History of Accounting
- 6 1.4 - Users of Accounting Information
- 7 1.5 - Financial Accounting Courses
- 8 1.6 - The Role of Ethics in Financial Accounting
- 9 1.7 - Basics of How A Business is Operated
- 10 1.8 - Characteristics of Business Entities
- 11 1.9 - Accounting As a Profession
- 12 1.10 - Financial Accounting's Role in Financial Reporting
- 13 1.11 - Overview of Financial Accounting
- Learn about the modern business environment
- Understand the purpose of accounting
- Learn about the historical roots of accounting
- Understand the informational needs of accounting information users
- Understand the various financial accounting courses
- Learn about ethics as it relates to business and financial accounting
- Learn about business economic entities
- Learn about accounting as a profession
You are about to embark on an exciting journey into the world of financial accounting. If you are taking this course or reading this textbook then it probably means you are curious about financial accounting or similar subjects in the business world. As we progress through this course, you will be learning about all aspects of financial accounting from a theoretical and applied point of view. Mastering the concepts in this course is essential to becoming a true business professional. If you decide to progress to more advanced accounting courses then the fundamental theories taught in this course will be essential to your success.
Financial accounting is not simply a theoretical subject; it is a skill that must be applied to master the subject. The only way to learn these skills is by applying the skills to solve complex problems. We have a variety of practice problems, questions, and tools that will help you apply the concepts taught in this course. We also have simulation problems that will simulate how financial accounting is applied to real-world situations. To fully benefit from this course, you must do all of the practice problems and understand them completely.
We begin this chapter by giving you an introduction to the world of business and then show you how accounting information is essential to making important business decisions. Our goal is to begin with the "big picture" of accounting and then slowly progress to more detailed aspects of accounting. In this introductory chapter you will be introduced to the purpose and the history of accounting. You will learn why accounting is important and why it is such a valuable skill in today's modern business world. We will learn why ethics are the cornerstone of high-quality accounting information and you will be introduced to the profession of being an accountant. We will conclude the chapter by giving you a high-level overview of financial accounting.
1.1 - The Business Environment
A business is a formal economic entity or organization that provides goods or services for money. The business will use the factors of production: land, labor, and capital to provide goods and services to customers. The goal of a business is to satisfy the wants and needs of their customers. Businesses can range from tiny "mom and pop" businesses to multinational corporations which operate in multiple countries. Of critical importance to these businesses is the ability to make efficient and effective resource allocation decisions.
The modern business environment is very competitive as all businesses are competing with each other to obtain customers and provide the best products or services in the marketplace. In order to effectively compete, the businesses must be able to understand the world around them and be able to make effective decisions. One way of accomplishing this goal is by having relevant and reliable accounting information. Without relevant and reliable accounting information, it would be impossible to make effective business decisions because you would not be able to analyze the impact of transactions.
If we take a step back to analyze how businesses operate in a generalized form we will be able to better understand why accounting is important. In general terms, all businesses must perform the following critical tasks in order to successfully operate their business:
- Create strategic goals
- Secure financial resources
- Deploy capital to make investments
- Carry out day-to-day business operations
- Continuously improve or refine the strategic goals and business operations
Let's explore each of these goals in more detail.
1.1A - Create Strategic Goals
All companies must create strategic goals in order to achieve success. Companies have different strategic goals, but most have similar goals. Some of the more common goals are: maximizing profit potential, customer satisfaction, expanding to new markets, and achieving sustainable business operations. Some companies do not have profit oriented strategic goals. These companies are called not-for-profit companies or non-profits. A not-for-profit company's strategic goals will be focused on improving the overall wellbeing of society or a specific philanthropic goal. For non-profit companies, they are not working towards maximizing profits. They will work towards achieving their stated mission, such as, reducing poverty, helping the disabled, protecting animals, restoring the environment and so on. The strategic goals are created by the top levels of management. The board of directors of corporations or the majority owners of the business are usually the individuals who are responsible for creating strategic goals. For major businesses, strategic goals will often require specialized consultants such as lawyers, accountants or financial analysts to analyze the various dynamics associated with the strategic goal. The most common dynamics would be:
- Impact of government regulation on the strategy: If the company is expanding into a new market, the strategy could be impacted by decisions made by the government. The regulation could be beneficial to the strategy or negatively impact the strategy. A beneficial impact would be reduced tax rates, a business subsidy or access to key infrastructure (ports, railroads, roads, etc.). A negative impact would be possible nationalization of the assets (seizure by the government), increased tax rates or government corruption.
- Barriers to entry: A barrier to entry is a major obstacle that will make achieving the strategy more difficult. Some examples of barriers to entry might be the requirement of a large investment in critical assets (buildings, expensive machinery, access to patents, etc.), an exclusive license that must be obtained, or business zoning permits that must be obtained.
- Competition from competitors: Competitors might have a superior strategy that might make the current strategy obsolete. Likewise, when the business strategy is implemented, competitors will respond to the strategy by changing their business practices.
- Market forces of supply and demand: The supply and demand for goods and services are constantly changing. Ideally, a business would want to focus their strategy on markets where demand is increasing or in markets where supply is limited.
1.1B - Secure Financial Resources
Most businesses develop strategic goals that require the use of capital or money, to achieve the goal. In order to implement the strategy, financing must be obtained. Financing can come from a variety of sources. The most common form of financing comes in the form of loans from lenders (creditors). Lenders can offer either short-term (less than 12 months) or long-term (greater than 12 months) loans. The borrower agrees to repay the loaned funds with interest over the stated terms of the loan. If the borrower were to miss a payment or default (unable to repay) then the lender would use the court system in an attempt to obtain assets or repayment of the loan.
A company could also issue bonds to investors. A bond is a financial instrument where the company agrees to repay the bondholder the amount of the bond plus a stated interest rate. For large bond issues, the bonds are often traded among owners in a market that is similar to a stock market. Another way of obtaining financing is to sell ownership in the company in exchange for a cash investment. For large corporations, the additional ownership stake is issued through the use of offering stock in the company. Stock is a partial ownership in the business and entitles the owner to receive dividends from the corporation. The shareholder can also vote for the board of directors and other special matters in an annual shareholder vote. The overall goal of obtaining financial resources is to obtain the financing at a rate that is beneficial to the company. Managers must determine the financing strategy that is the most beneficial to the company over the long-term.
1.1C - Deploy Capital to Make Investments Related to the Strategic Goals
When sufficient financing has been achieved. The company will use the capital to purchase assets or make investments. The investments can involve using the funds for a variety of purposes. Some examples of investments might be the following:
- Undeveloped land, buildings, or machinery: Investments in this category are generally oriented towards establishing production of a good or service. Companies who make these types of investments are generally making long-term investments.
- Ownership in other businesses: A company might have a strategic goal that is focused on buying another competitor or developing a strategic investment in a company with key technology.
- Inventory: A retail business might need to invest in purchasing merchandise to sell in their stores. After the inventory is sold, the company will repurchase more inventory as necessary.
- Create New Technology: Technology, biotechnology or pharmaceutical companies might use the capital to invest in a research and development facility to invent new technology or products.
- Purchase existing intellectual property: A company might need access to patents, technology or other intangible assets in order to achieve their strategic goals.
1.1D - Carry Out the Day-to-Day Business Operations
When the company has created its primary operations, the company will need to manage day-to-day operations. Primary operations include: purchasing, production, marketing, administration, and research and development.
1.1E - Continuously Improve The Strategic Goals and Business Operations
The business environment is filled with competitive forces from other companies that require the company to refine and improve its operations. These forces will require the company to stay competitive and the only way to achieve that goal is by continuously refining operations. Refining operations could mean investing in improved technology, performing more research or developing marketing strategies.
Now that we have a general understanding of business, we can begin to study topics directly related to accounting and what role it plays in the business environment. As you can see from the above explanations, accounting information will be essential to carrying out all the tasks mentioned.
1.2 - Purpose of Accounting
Accounting at its most basic level is the information science that measures, records and communicates relevant business information to users of accounting information. With this definition in mind, accounting is often referred to as the language of business due to its ability to communicate important business information. Without a basic understanding of accounting, many important financial documents will be mysterious or incomprehensible to fully understand. For any individual who wants to use financial documents or have a career in the business world, a basic understanding of accounting is essential.
As was stated above, accounting measures, records and communicates relevant business information. Since these three functions are the basis of accounting, we should explain each one in complete detail:
- Measurement: Relevant business transactions will need to be evaluated in terms of economic impact on the company. Measurement is performed by calculating a monetary value by using a specific set of criteria. Measurement can be a tricky area in accounting due to the difficulty of measuring certain transactions that might involve uncertainty. Relevant business transactions could be sales to customers, obtaining a loan from a bank or the payment of wages to employees. A great deal of emphasis is placed on which transactions are relevant and to what extent they should be recorded.
- Recording: After the measurement has taken place, the transaction data must be written down, summarized and classified. Accounting information is recorded in ledgers. Ledgers can be in the form of a paper document or on a computer. The recording process can take place by a human manually recording the data or it can be automated by a computer. When a business transaction is recorded, it is said to be recognized.
- Communicating: Accounting information is useless unless it can communicate valuable information to internal or external users. The accounting information must be summarized into useful documents. In financial accounting, financial information is presented in the form of financial statements. For accounting information to be communicated effectively, it must be relevant, reliable and comparable. Information that cannot be quantified in the measuring process must be properly disclosed.
The ultimate goal of accounting information is to allow users of that information to make effective decisions.
1.3 - A Brief History of Accounting
The earliest known form of accounting dates to the Mesopotamian era (3100 BC – 539 BC) when writing, money, and counting were developed. During this era, temples became the center of commerce and taxation. The advancement of record keeping quickly gained a need. Similar record keeping systems were also noted during the time in different parts of the world. As civilizations advanced, accounting became more organized and the practice of auditing (verifying accuracy of the books) became common in Ancient Egypt. By the time of the Roman Empire (27 BC - 395 AD), detailed financial records were being created to record detailed information about the financial state of the Roman government. The field of accounting gradually gained widespread use, but remained mostly of simple methods.
Modern methods of accounting weren’t widely known until an Italian mathematician named Luca Pacioli published a book entitled Summa de arithmetica, geometria, proportioni et proportionalita (summary of arithmetic, geometry, proportions and proportionality). This book contained a summary of mathematical methods as well as the first recorded description of an accounting method called the double-entry system. It is important to note that Pacioli did not create the methods of double-entry accounting; he simply described the methods that were currently in use by Venetian merchants of the time. After the publication of summa de arithmetica, the book became the only textbook that covered accounting topics for the next 150 years and became the premier book for accounting apprentices to learn the profession. Many of the earliest known accounting vocabulary, such as debit, credit, account and journal, originated from Pacioli's writings. The summa was originally written in Italian, however, an English translation is available from the Pacioli Society.
Pacioli eloquently described the reasoning behind writing the summa's section on accounting:
"I have decided to compile an accounting manual. Such a manual is much needed by businessmen. I have put it together in such a way that, whenever necessary, everything essential to understand accounts and bookkeeping may readily be found. My wish is to provide the minimum number of accounting rules for businessmen to keep all their accounts and books in good order."
So why did it take so long for double-entry methods to be created in the first place? The answer has to do with the complexity of business transactions of the time. During the Venetian era, businesses began to become much more sophisticated in their structure and operation. Of notable significance during the time was the development of interest-based bank loans. Businesses began to create business operations that were largely financed by bank loans. A common theme seen throughout the development of accounting is that accounting methods are developed after complex business operations were created. As a result, many accounting research courses focus on understanding complex business transactions first and then devising methods to properly record and report those transactions.
The double-entry system of accounting described in the book allowed for recording advanced accounting transactions and became the basis for modern day accounting information systems. Based on this work, Luca Pacioli is often referred to as “the father of accounting” due to his contribution of recording the accounting methods used in a double-entry accounting system.
In the late 1880s, accounting professionals began to organize into trade organizations to advocate for the profession and create standardized sets of rules and methods. Of significance was the creation of the Institute of Chartered Accountants in England and Wales in 1880. Many aspects seen in modern professional accounting began to originate during the end of the 18th century, such as, a commonly accepted set of uniform accounting principles. The profession has continued on that path to the present day with the American Institute of Certified Public Accountants having approximately 418,000 members (2018).
1.4 - Users of Accounting Information
A user of accounting information is an individual or organization that relies upon accounting information to make decisions. Prior to creating accounting information, the end user’s informational needs are factored in. For example, external users need their financial information to be standardized to a set of rules while managers of the company will need accounting information that is very specific to internal operations. Ultimately, the end user of financial information creates the different types of accounting. Once we have identified the information user, we determine what type of information they will need to make their decisions. We then develop an accounting system to record specific information and create relevant reports based on the informational needs of the user. Here is a brief list of the different types of accounting and the type of information that is created:
- Financial Accounting: Standardized to a commonly accepted set of accounting principles and intended for external users.
- Managerial Accounting: Specifically generated accounting information used for internal management decision making.
- Cost Accounting: Specifically generated cost information related to costs that are internal to the company.
- Tax Accounting: Standardized to a set of accounting principles mandated by a taxing authority.
- Fund Accounting: Standardized to a set of accounting principles which emphasizes accountability.
As you can see from the above, financial accounting focuses on external information users while managerial accounting focuses on internal users. Realizing that financial accounting information is focused towards external users will explain why financial accounting focuses on specific attributes such as standardization of accounting principles.
The types of users of accounting information can be separated into two categories: external users and internal users.
1. External users are individuals or organizations that are outside of the company. The most common forms of external users are lenders (organizations that issue credit), investors (individuals or organizations that own or want to own part of the company), tax authorities, customers, suppliers, and government regulatory agencies. For external users, a primary focus on the accounting information is the need for standardization to allow for comparability. Just imagine if you are an investor and want to determine which company to invest your money in. You will need accounting information to compare each company. If that accounting information is not prepared based on the same set of standards, then it will be impossible to make a reliable investment decision. In other words, external users are going to need reliable accounting information in order to make effective resource allocation decisions (Should we invest in this company or sell our investment? Should we lend money to this company? etc.). Due to this need, financial accounting information is heavily standardized. Financial accounting communicates accounting information through the use of financial statements. Likewise, financial accounting focuses on the needs of external users as a priority.
2. Internal users are individuals, such as managers within the business entity, that need accounting information to make operational decisions. Compared to external users, internal users have very different needs compared to external users. Internal users need timely information and specific information. An engineering manager will need cost accounting information to determine if his prototype is going to be able to generate a profit based on the estimated selling price. Unlike financial accounting, managerial accounting information is not restricted to a standardized set of rules. The information will be specifically created to help make the correct decisions for the internal managers. Financial accounting can be utilized by internal users but it is generally more limited compared to information that is created specifically for their needs. Managerial accounting and cost accounting are accounting information systems that create accounting information for internal users.
The following is a brief summary of how each external user will use accounting information:
- Lenders: Lenders or creditors are in the business of lending money to individuals or businesses. A lender will need to be able to evaluate the creditworthiness of the borrower. Creditworthiness is the likelihood that a business will be able to repay the money borrowed plus any interest charged by the lender. The lender will use financial accounting information to make these decisions. The lender will factor in how much money the company is earning and how profitable the company is, as well as using many other factors.
- Investors: Investors are interested in investing their money (called capital) into investment ventures in the hope of increasing the amount of value of those investments. Investors have a lot of options in terms of where they can invest their money. One of those areas they can invest in is businesses. Investors will determine which company to invest in by using financial accounting information. The information most often used is in the form of financial statements which are standardized documents that allow comparison of business enterprises for investors.
- Tax Authorities: Governments around the world rely on tax revenue to fund government operations. To carry out the task of collecting taxes, the government must determine what is to be taxed and at what rate. The tax system is based on using accounting information to determine the tax. For example, an income tax will be levied on a company's net income or profits. The business will also need to retain adequate accounting records to be able to substantiate deductions or other calculations used when filing their tax returns.
- Customers: Customers will need to use accounting information when making purchasing decisions. For example, the customer might need to purchase 10 of a specific item. The customer would use the company's online inventory tracking system to see if the business has enough in stock to sell to the customer.
- Suppliers: Certain suppliers will be provided with accounting information in order to determine when to ship more goods to their customer. If the customer's inventory level declines below a certain point then the supplier will automatically ship more goods. As information technology increases, the amount of accounting information that is being shared between the customer and supplier is increasing. Increased sharing of accounting information results in greater efficiency for both businesses.
- Government Regulatory Agencies: Governments aren't only interested in collecting taxes. Governments impose regulations on businesses such as restrictions, pollution control and other requirements. The government will need to use the company's accounting information to determine if the business is in compliance with the regulation.
1.5 - Financial Accounting Courses
Financial accounting simply cannot be fully taught in one course. In order to provide for high academic standards and complete coverage of the topic, a series of courses is developed to learn the various aspects of financial accounting. This course serves as the basic or introductory course for a series of financial accounting courses. The general course track for financial accounting is as follows:
- Financial accounting - This course serves as an introductory course in financial accounting. Complex topics are generally excluded and these courses tend to focus on the fundamental theories underlying financial accounting. Basic accounting transactions are covered. Mastery of the material is this course is required for successful completion of more advanced financial accounting courses.
- Intermediate Financial Accounting - This course is the second set of courses in the financial accounting series. A course in intermediate accounting will begin to focus on the study of a reporting framework such as generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS). Intermediate accounting courses are generally oriented towards students who seek to specialize in the practice of accounting.
- Advanced Financial Accounting - This course is generally the final formal course in the study of financial accounting. Advanced accounting focuses on topics of financial accounting that are considered the most complex.
Other courses in accounting are generally beneficial as well, such as the following:
- Auditing: This course focuses on the practice of auditing financial statements. A financial statement auditor is a professional who analyzes a set of financial statements and determines if those statements are correct in regards to a financial reporting framework. An auditor will be required to fully understand how to apply all accounting methods found in the financial reporting framework and will need to use that information to determine how well a business entity has complied with those standards.
- Financial Accounting Research: This course focuses on teaching students how to figure out new ways to report financial transactions.
- Industry-Specific Financial Accounting: These courses will focus on financial accounting topics that are specific to an industry. Some example industries might be banking, energy, technology, healthcare or retail.
1.6 - The Role of Ethics in Financial Accounting
Since accounting is an information system, the quality of information is only reliable if the information is created according to a specific set of high-quality standards. Professionals who are delegated accounting or bookkeeping duties must maintain a high level of ethical decision making. In terms of accounting, ethical decision making should always focus on ensuring that accounting information is not deceptive to users. If the professional does not maintain their ethical standards, then the accounting statements might become susceptible to accounting fraud. An accounting fraud occurs when business management or the internal accounting staff intentionally decides to create misleading financial statements with the intent of deceiving internal or external users.
When an accounting fraud occurs, it can be devastating on users who have relied on those statements to make an investment, credit or other decisions. As a result, governments, businesses and professional organizations have all mandated a high level of ethical decision making for accounting and business professionals.
Accounting professionals must be properly trained to detect situations that would create an unethical decision. For example, an accounting professional should never modify the accounting records such that it reports information that is known to be misleading. Professionals should also place extra emphasis on how their actions would look to individuals who do not work for the firm. If an accountant employed for the company is seen taking large sums of cash in front of the office building, then that situation would appear to be highly unethical even if the transaction is ethical in reality.
Most companies have an ethical guidelines policy that requires all employees to abide by. Higher levels of management should set the "tone at the top" by always emphasizing ethical decision making as a top priority. Management should enforce the policies and make sure that ethical violations are properly investigated. Corrective actions should be performed immediately when ethical violations have occurred. On a fundamental level, all employees should strongly believe that ethical decision making is a priority. All employees should know the difference between "right and wrong" and how to detect unethical decisions when they are occurring or might occur.
For certain situations, ethical decision making becomes incredibly complex as situations become complicated. An employee might believe that he or she is making an ethical decision while in reality; they are unknowing making an unethical decision. In such situations, seeking outside advice and proper training will allow for these situations to be detected by employees early on.
Many prominent accounting professional organizations have established ethical guidelines that all accounting professionals should follow. The American Institute of Certified Public Accountants (AICPA) code of professional conduct is an example of ethical guidelines.
1.7 - Basics of How A Business is Operated
At a fundamental level, an accountant must understand how businesses conduct their daily operations. Understanding how the daily operations or other key events are conducted is important for being able to recognize what to record in the accounting records. We will review a high-level overview of how most businesses operate. Variations exist for other businesses based on what type of business they are operating. Those variations will be covered in later chapters.
When a business idea is established, the business founders will need to raise capital to setup the business. To raise capital for the business, they can either issue shares of common stock if they are a corporation or sell bonds. Common stock is a certificate that legally recognizes an ownership interest in a corporation by the owner of the share. Bonds are a financial instrument that will pay a fixed amount of money plus interest to the owner. When the bond is issued, the purchaser pays a certain amount of money which goes directly to the company issuing the bonds. The owner will receive periodic interest payments and at the end of the bond's life, the owner will receive the fixed amount of principle as stated on the bond. The proceeds from issuing common stock and bonds are used by the business to either begin operations or expand operations.
The company will use the bond or common stock proceeds to purchase equipment, hire employees or purchase other materials needed to begin the primary operations of the business. Primary operations are business activities which are designed to generate revenue for the business. Revenue is the money received by the business from their customers for providing goods or services. In the process of conducting primary operations, the business will have expenses that need to be paid. Expenses are bills that are due to suppliers, employees, or other service providers that are needed to conduct the business operations. If you subtract expenses from revenue, you will get net income (profit) or net loss. Profit is the amount of money that remains after all bills have been paid. For most businesses, they must generate profit to stay in business for the long-term. If the expenses exceed the revenue then this is called a loss meaning the company spent more money than it earned from operating the business.
The profit of the business can be used to reward owners through distributions of either cash or property. Corporations reward their shareholders through dividends. A dividend is a payment to the shareholder in either cash or property. The profit of the business can also be used to expand the business by acquiring other businesses, expanding operations or developing different products or services.
1.8 - Characteristics of Business Entities
Before we can review each type of business entity, we need to cover a few characteristics that may differentiate each business structure:
Liability: Liability refers to how much financial responsibility will be held by a business or individual in the event of business losses. In business terms, this often means who will be held financially responsible in the event that debts cannot be repaid or the business suffers losses from an action by a court of law. This issue brings about two distinct concepts called unlimited liability or limited liability. Unlimited liability means that the owners of the business will be held financially liable for losses incurred by the business. What this ultimately means is that creditors or a court of law can seize an individual’s personal assets (their personal home, personal car, personal bank accounts, etc.) in order to pay debts that were incurred by the business. Limited liability, on the other hand, means that the owners or investors will only be held liable up to the extent of their investment. However, courts can still seize personal assets of investors if fraud has occurred which resulted in the failure of the business.
Double Taxation: For certain business structures, primarily C-Corporations, the profits of the entity will be taxed a minimum of two times. When a corporation earns profit, the corporation will be levied a corporate income tax on those profits. If the corporation decides to declare dividends (a cash payment sent directly to shareholders based on how many shares they own and the type of shares they own) then, that shareholder will pay personal income taxes on those dividend payments. In essence the profit from the corporation is being taxed twice. Double taxation is considered a negative in terms of selecting a business structure. Based on our discussion of business entities, only the C-corporation suffers from double taxation. Note that the concept of double taxation can vary from country to country based on their tax policies. One country might double tax a specific entity structure while others will not.
Flow-through Entity: A flow-through entity is an important tax concept which means that income and expenses of the business “flow-through” the entity and on to the investors of the entity. The entity generally pays no taxes on the profit generated by the business. Instead, the profits are reported to each shareholder who then claims the income/expenses on their personal tax return. A flow-through entity is considered a superior business structure since it bypasses double taxation often associated with C-corporations.
As you can see from the above, many business structures have important tax characteristics. As a result, proper tax planning should be used when selecting a business structure. Now that we have some basic concepts down, we can discuss each business structure in detail.
It is important to note that the name of each business structure tends to vary from country to country, however, the following business structures are common to all countries. The naming conventions we use are specific to the United States.
Examples of economic entities could be the following business structures:
- Sole Proprietorship – A business owned and operated by one person. The owner is liable for all business debts and controls all business activity. Sole proprietorships are a popular way to start a business because no paperwork is required to form the business. Many businesses start as sole proprietorships and then convert over to other forms of business structures when necessary. The amount of initial investment (capital) to start a proprietorship is generally low and the owner retains all profit that is generated from the business. All business financial activity will flow to the owner of the business for tax purposes. In other words, a sole proprietorship is a flow-through entity.
- Partnership – Similar to a sole proprietorship except two or more owners control the business. Owners of a partnership are referred to as partners. A partnership agreement determines specific details on how the partnership is to be controlled. For example, the partnership agreement can determine how profits or losses are divided. It also includes specific functions for each partner. A general partnership means that each partner is fully liable for the debts of the partnership while a limited partnership will have limited liability for certain partners.
- General Partnerships: A general partnership has partners that are fully liable for all debts of the partnership with no partners having limited liability. Each partner can be held liable for debts or agreements entered into by the other partner which is a legal doctrine called mutual agency. The partnership agreement will govern who is delegated to perform which business functions. The partnership is a flow-through entity; all profits or losses will flow through to the partner's personal tax return.
- Limited Partnerships: A limited partnership is when at least one of the partners has unlimited liability (a general partner) while the remaining partners can be either limited partners or general partners. At least one of the partners must have limited liability otherwise it would be classified as a general partnership. The general partner will manage and run the partnership while the limited partners will not be active in management functions or operating the partnership. A limited partnership agreement is required and must be filed with the state of operation. Like all partnerships, a limited partnership is a flow-through entity.
- Corporation – A corporation is considered to be completely separate from the owners and is often chartered or incorporated by a government agency. A corporation is just like an individual in the sense that it can take out loans in the corporation’s name and enter into contracts or agreements. The corporation is controlled by a board of directors, which are elected by shareholders. Each share of stock is generally entitled to one vote. The board of director's ultimate goal is to make decisions on important business policies as well as elect officers and managers who will run the day-to-day operations of the corporation. The board of directors must also enforce the bylaws, or fundamental rules, of the corporation. The shareholders are the ultimate owners of the corporation. When a corporation is formed, the corporation issues shares to investors in exchange for the investor's money. The capital raised is then used to start the business operations or expand business operations of the corporation. Unlike sole proprietorships and partnerships, the shareholders of a corporation are able to freely sell their shares. Stock exchanges allow for the ability to buy and sell shares of stock of corporations. If a corporation goes out of business, the shareholders will only lose the amount they invested for the shares. The shareholders are protected by limited liability and therefore they will not be personally liable for the debts of the corporation. Corporations also benefit from having unlimited life which means the corporation does not dissolve with the death of the owner or significant board member.
- C-Corporations: A C-corporation is the most common form of corporation. This type of corporation can have an unlimited number of shareholders, and the corporation suffers from double-taxation since it is not a flow-through entity. Like all corporations, the shareholders have limited liability. Due to C-corporations being able to publicly trade their shares with the general public, C-corporations often face more stringent financial reporting requirements. C-corporations also tend to be the largest companies in the world due to their ability to raise large sums of capital from thousands or millions of investors.
- S-Corporations: An S-corporation is similar to a C-corporation except for some significant differences. The S-corporation was designed to eliminate some of the disadvantages of C-corporations, however, the S-corporation also has disadvantages over the C-corporation. The first significant disadvantage of S-corporations is that they are limited to only having 100 shareholders, unlike a C-Corporation which can have an unlimited number of shareholders. The major advantage is that an S-corporation is a flow-through entity and eliminates the C-corporation's disadvantage of double-taxation. The shareholders must be United States citizens, and the entity can only have one class of stock. If these requirements are not met then the corporation will be treated as a C-corporation for tax purposes.
- Limited-Liability Company (LLC): A limited-liability company is the most common type of business for mid-sized privately owned businesses. An LLC can have an unlimited number of owners, which are called members. The entity must have more than one owner and the entity is taxed as a flow-through entity if certain conditions are met. When the entity is formed, a set of articles of incorporation must be filed with the state of incorporation and have an operating agreement. The LLC entity has limited liability for owners as the name suggests.
- Governments – An entity which has political control over a geographic location and is responsible for creating laws. Governments often regulate and tax business entities as well as individuals. A government’s range of control is referred to as its jurisdiction.
- Not-For-Profits (NFPs) – An organization that operates without the intention of generating profits for its owners. Often times, not-for-profits have reduced or tax-free status. The goal of most not-for-profit organizations is to benefit a specific group of people or actively work to achieve a goal that benefits the common good.
|Sole Proprietorship||General Partnership||Limited Partnership||C-Corporation||S-Corporation||Limited Liability Company (LLC)|
|Owners||1 Maximum||2+ Minimum||Minimum 1 general partner and 1+ limited partner||Unlimited||Maximum 100 Shareholders||Unlimited|
|Governance||Sole Owner Operates||General Partners Manage by Agreement||Only General Partners Manage||Board of Directors Elected by Shareholders||Board of Directors Elected by Shareholders||Operated by Members based on Agreement|
|Managing Documents||None||General Partnership Agreement||Limited Partnership Agreement||Articles of Incorporation||Articles of Incorporation||Articles of Organization|
|Liability||Unlimited Liability||Unlimited Liability||General Partners have Unlimited Liability while Limited Partners have Limited Liability||Shareholders have Limited Liability||Shareholders have Limited Liability||Members have Limited Liability|
1.9 - Accounting As a Profession
Individuals who learn accounting can be employed by businesses as bookkeepers or accountants. Bookkeepers generally require less formal education compared to an accountant. A bookkeeper will primarily perform accounting activities related to measuring and recording transactions while an accountant will perform more difficult accounting functions that often require several years of study.
Within the accounting profession, there are several broad types of work that most accountants enter:
- Public Accounting: Accounting firms will employ accountants to sell services as auditors or tax professionals. An auditor is someone who reviews financial records and financial statements to determine if the correct accounting procedures have been followed and issues an independent opinion on the financial statements. A tax professional, on the other hand, prepares tax documents or provides tax advice to clients. In recent years, many large public accounting firms are diversifying their service offerings by offering information systems, litigation services and advisory services to clients. Public accounting firms can specialize in a specific service line or a specific industry.
- Private Accounting: Private companies will employ accountants to perform a variety of tasks. These tasks are often related to: general accounting, cost accounting, internal control functions, internal auditing and tax accounting.
- Government or Fund Accounting: Local governments need accounting information to be created. Each type of government will need specific types of accountants. The government's revenue department will need tax collectors and tax auditors while the central government will need budget accountants or general government accountants.
- Not-For-Profit Accounting: Not-for-profit organizations also must create accounting information to ensure that their financial affairs are in order. They also need accounting reports created to ensure they are using their donor's money efficiently.
Within the accounting profession, high levels of education will be required as well as professional certifications. The most common professional certification is the certified public accountant (CPA) or chartered accountant. As the profession becomes more specialized, many professionals are obtaining a variety of certifications. Some of which include the following:
- Certified Public Accountant (CPA) - Often considered the "highest level" of accounting certification. The certification process is comprehensive and includes areas of financial reporting, regulation, auditing and business concepts.
- Certified Management Accountant (CMA) - The CMA is oriented towards a managerial or an internal focus of accounting. The certification process consists of examinations on business analysis, management accounting, strategic management, and business applications.
- Certified Internal Auditor (CIA) - The CIA designation is for individuals who practice internal auditing. Internal auditing is evaluating a company's internal processes in order to provide recommendations for improvements.
- Certified Fraud Examiner (CFE) - The CFE designation is for individuals who work in industries that require the detection and prevention of fraud.
- Enrolled Agent (EA) - The EA designation is specific to the United States. An EA is an individual who is authorized by the US Department of Treasury to represent taxpayers before the Internal Revenue Service (IRS).
These certifications are generally specific to the United States. Other countries might have similar certifications to the above. If you plan on obtaining certification. You should research your local job market to determine which certifications are most beneficial to your career or future goals.
Within university level education, accountants often obtain bachelor, master’s or doctorate degrees in accounting or taxation.
Professional experience is also important to a professional's development. As the industry becomes more competitive, many accountants leverage their unique and diverse work experiences to stay competitive. Most accountants have come to realize that to stay competitive in the marketplace, one must continuously improve their technical skills as well as qualitative skills (communication, business etiquette, critical thinking ability, etc.). Many professional certifications as well as organizations have adopted this philosophy as well by requiring their employees to complete continuing professional education courses.
1.10 - Financial Accounting's Role in Financial Reporting
Overall, financial accounting is a subtopic of financial reporting. Financial reporting is the formal process by which a company reports their financial information. The creation of general purpose financial statements is a part of this process, but it also involves other steps. For companies that are publicly traded on stock exchanges, they must be audited annually by an independent accounting firm to ensure that the financial reports are not misleading. Most publicly traded companies are required to issue an annual report that explains in detail the financial results and the nature of the company's operations. The annual report in the United States is called a 10-k because this is the name of the form that is used by companies to file their annual report with the Securities and Exchange Commission (SEC). The SEC is a United States federal government regulatory agency charged with the mission of making sure that financial security issuers, such as corporations, do not take advantage of the financial system or investors. The SEC is in charge of enforcing the United State securities laws. The US securities laws are applicable to US SEC registered companies and non-US registered companies. A US SEC registered company is a United States company that trades stock or debt on national stock exchanges, such as, the New York Stock Exchange (NYSE). A non-US SEC registered company is any foreign company that utilizes the United States stock or debt markets for trading of their securities. Companies must also abide by a variety of other rules that are created by government agencies to ensure companies are not abusing the overall financial system.
1.11 - Overview of Financial Accounting
We will wrap this chapter up by covering a high-level overview of what Financial accounting is all about to give you a "big picture" view of financial accounting. Some topics mentioned in this overview might not be covered in this course as they are far too advanced for the scope of this course. This course is primarily focused on teaching the fundamental theories of accounting to provide you with a solid foundation for more advanced courses in accounting.
To begin our overview, we will start with the end goal of financial accounting. The end goal of financial accounting is to create financial information for investors, lenders and other individuals who are external to the entity. These financial statements must follow a standardized set of rules to allow for comparability of the information. They are often referred to as general purpose financial statements due to the financial statements being used by a variety of external users (all with different informational needs). In the United States, we use Generally Accepted Accounting Principles (GAAP) while in non-US countries use International Financial Reporting Standards (IFRS). The general consensus in the accounting profession is focused towards making a uniform set of accounting standards that will be applied to every set of financial statements in the world. This process is called convergence. Overall, there are four primary financial statements that are commonly used to communicate financial information, which are:
- Balance Sheet: Reports the entity's financial position at a specific date.
- Income Statement: Reports the entity's financial performance over a specific period of time.
- Statement of Retained Earnings: Reports the changes in retained earnings for a specific period.
- Statement of Cash Flows: Reports the changes in cash during a specific period of time.
In addition to these financial statements, companies must also report information that is not able to be easily recorded or measurable. For example, let's think about a pending lawsuit against a company. It would be difficult to be able to accurately figure out the results of this lawsuit as it is still pending in the courts. However, this information would be extremely important for external users. To communicate this information, companies would include this information as a disclosure that are included with the financial statements.
Financial accounting is primarily focused on how to report business transactions and information in the financial statements. While most transactions are easily recorded in the financial statements, not all of them are. Some transactions involve uncertainty about a variety of aspects. The example of the lawsuit above is a good example. In the case of uncertainty, the profession had developed a set of guidelines that must be followed to record these transactions.
Other aspects of financial accounting simply involve extremely complex methods or steps to record the transaction. Let's think about a situation where one company decides to buy another company. The records for both companies must be combined, which involves a complex set of actions to properly record this transaction. The topic of consolidations is taught in advanced financial accounting courses.
Emerging topics in financial accounting focus on complex financial instruments called derivatives. These transactions are very complex, and the number of ways they can be structured is virtually unlimited since it depends on how the transaction is agreed to be performed. This area of financial accounting is not yet fully developed and the profession is working towards creating a set of standardized rules on how to report these transactions or events that will impact the business.
Most of the fundamental theories behind these topics will be covered in later chapters.
In the next chapter we will be covering the fundamental theories behind financial accounting.