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02-03-2019, 03:48 PM
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 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 in a balance sheet, while disclosures about operating results are displayed in an income statement. Data relating to an organization's liquidity and changes in its financial structure are shown in a statement of changes in financial position. Such financial statements are prepared to provide information about past performance, which in turn becomes a basis for readers to try to project what might happen in the future.
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 created a need for accounting techniques that were 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 held business corporations, owned by absentee stockholders and administered by professional managers, the role of accounting was further redefined.
Bookkeeping, which is a vital part of all accounting systems, was in the mid-20th century increasingly carried out by machines. The widespread use of computers broadened the scope of bookkeeping, and the term data processing now frequently encompasses bookkeeping.
Accounting Information
Accounting information can be classified into two categories: financial accounting or public information and managerial accounting or private information. Financial accounting includes information disseminated to parties that are not part of the enterprise proper—stockholders, creditors, customers, suppliers, regulatory commissions, financial analysts, and trade associations—although the information is also of interest to the company's officers and managers. Such information relates to the financial position, liquidity (that is, ability to convert to cash), and profitability of an enterprise.
Managerial accounting deals with cost-profit-volume relationships, efficiency and productivity, planning and control, pricing decisions, capital budgeting, and similar matters. This information is not generally disseminated outside the company. Whereas the general-purpose financial statements of financial accounting are assumed to meet 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.
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 accuracy 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, including some that are more concerned with operating efficiency and managerial effectiveness than with the accuracy of the accounting data.
The second specialized area of accounting is income taxation. Preparing an income-tax form 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 theory and 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 figuring taxes, however, is also needed in accounting, and many techniques of computing are common to both areas.
A third area of specialization is accounting for nonbusiness organizations, such as universities, hospitals, churches, trade and professional associations, and government agencies. 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.
Financial Reporting
Traditionally, the function of financial reporting was to provide proprietors 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.
After 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 has not become obsolete, financial reporting in the mid-20th century is 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 concept. As investors relied more on the potential of 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 footnotes to financial statements is a particularly visible example. Such footnotes disclose information that is not already included in the body of the financial statement. One footnote usually 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.
Footnotes also disclose information about lease commitments, contingent liabilities, pension plans, stock options, and foreign currency translation, as well as details about long-term debt (such as interest rates and maturity dates). A company having a widely distributed ownership usually includes among its footnotes the income it earned in each quarter, quarterly stock market prices of its outstanding shares of common stock, and information about the relative sales and profit contribution of its different industry segments.
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; only the accounting developments of recent decades are prescribed in statutory law. 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 understood.
The going-concern assumption states that it is expected that the entity will continue to operate indefinitely.
The historical-cost principle requires 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 with the expenses 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 cash assets—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 events even though their 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 conservatism doctrine states that when exposure to uncertainty and risk is significant, accounting measurement and disclosure should take a cautious and prudent stance until evidence shows sufficient lessening of the uncertainty and risk.
The Balance Sheet
Of the two traditional types of financial statements, the balance sheet relates to an entity's position, and the income statement relates to its activity. The balance sheet provides information about an organization's assets, liabilities, and owners' equity as of a particular date (such as 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 provide potential future service to the organization. Equities consist of the organization's liabilities together with the equity interest of its owners. (For example, a certain house is an asset worth $70,000; its unpaid mortgage is a liability of $45,000, and the equity of its owners is $25,000.)
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, merchandise inventory, and short-term investments in stocks and bonds. Long-lived assets encompass the physical plant—notably land, buildings, machinery, motor vehicles, computers, furniture, and fixtures. Long-lived assets also include real estate being held for speculation and intangibles such as patents and trademarks.
Liabilities are obligations that the organization must remit to other parties, such as creditors and employees. Current liabilities usually 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 are usually debts that will come due beyond one year—such as bonds, mortgages, and 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—that is, the stockholders—as consisting of two elements: (1) the amount originally invested by the stockholders; and (2) the corporation's cumulative reinvested income, or retained earnings (that is, income not distributed to stockholders as dividends), in which the stockholders have equity.
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 in 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 lists 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. Extraordinary—that is, unusual and infrequent—developments are also specifically disclosed.
Other Financial Statements
The income statement excludes the amount of assets withdrawn by the owners; in a corporation such withdrawn assets are called dividends. A separate activity-oriented statement, the statement of retained earnings, discloses income and redistribution to owners.
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; it presents the sources and the uses of the enterprise's funds by operating activities, investing activities, and financing activities. The statement identifies the cash generated or used by operations; the cash exchanged to buy and sell plant and equipment; the cash proceeds from stock issuances and long-term borrowings; and the cash used to pay dividends, to purchase the company's outstanding shares of its own stock, and to pay off debts.
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, 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 a general journal.
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 in two aspects or dimensions, referred to as its debit (or left side) and credit (or right side) aspects, and each of these two 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 promise of future payment, a liability would be created, and the journal entry would record an increase in the merchandise account (a debit) and an increase in the 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 the liability account (a credit). The subsequent payment of the wages would be a decrease in the cash account (a credit) and a decrease in the liability account (a debit).
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 the balance—that is, the net credit or debit—of each account 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.
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 successfully prepared, the bookkeeping portion of the accounting cycle is concluded.
Step Four
Once bookkeeping procedures have been completed, the accountant prepares certain 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).
Steps Five and Six
Once the adjustments are calculated, 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.
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.
Regulations and Standards
Until 1973, accounting principles in the United States had traditionally been established by certified public accountants. Such persons are accountants licensed by their state governments on the basis of educational background, a rigorous certification examination, and, in some jurisdictions, relevant field 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 by the general public must conform to rules set by the Securities and Exchange Commission, a federal government agency. Tax laws and regulations are administered at the federal level by the Internal Revenue Service and at the local level by state and municipal government agencies. 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 for contracts with parties that sell goods and services to the government. The nongovernmental Institute of Management Accounting, although not active in issuing technical standards, does administer a 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).
Accounting has a well-defined body of knowledge and rather definitive procedures. Nevertheless, standard setters continue to refine existing techniques and develop new approaches. Such activity is needed in part because of innovative business practices, newly enacted laws, and socioeconomic changes. Better insights, new concepts, and enhanced perceptions have also influenced the development of accounting theory apractices.
Personal record keeping often uses a simple single-entry system, in which amounts are 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 in a balance sheet, while disclosures about operating results are displayed in an income statement. Data relating to an organization's liquidity and changes in its financial structure are shown in a statement of changes in financial position. Such financial statements are prepared to provide information about past performance, which in turn becomes a basis for readers to try to project what might happen in the future.
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 created a need for accounting techniques that were 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 held business corporations, owned by absentee stockholders and administered by professional managers, the role of accounting was further redefined.
Bookkeeping, which is a vital part of all accounting systems, was in the mid-20th century increasingly carried out by machines. The widespread use of computers broadened the scope of bookkeeping, and the term data processing now frequently encompasses bookkeeping.
Accounting Information
Accounting information can be classified into two categories: financial accounting or public information and managerial accounting or private information. Financial accounting includes information disseminated to parties that are not part of the enterprise proper—stockholders, creditors, customers, suppliers, regulatory commissions, financial analysts, and trade associations—although the information is also of interest to the company's officers and managers. Such information relates to the financial position, liquidity (that is, ability to convert to cash), and profitability of an enterprise.
Managerial accounting deals with cost-profit-volume relationships, efficiency and productivity, planning and control, pricing decisions, capital budgeting, and similar matters. This information is not generally disseminated outside the company. Whereas the general-purpose financial statements of financial accounting are assumed to meet 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.
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 accuracy 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, including some that are more concerned with operating efficiency and managerial effectiveness than with the accuracy of the accounting data.
The second specialized area of accounting is income taxation. Preparing an income-tax form 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 theory and 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 figuring taxes, however, is also needed in accounting, and many techniques of computing are common to both areas.
A third area of specialization is accounting for nonbusiness organizations, such as universities, hospitals, churches, trade and professional associations, and government agencies. 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.
Financial Reporting
Traditionally, the function of financial reporting was to provide proprietors 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.
After 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 has not become obsolete, financial reporting in the mid-20th century is 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 concept. As investors relied more on the potential of 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 footnotes to financial statements is a particularly visible example. Such footnotes disclose information that is not already included in the body of the financial statement. One footnote usually 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.
Footnotes also disclose information about lease commitments, contingent liabilities, pension plans, stock options, and foreign currency translation, as well as details about long-term debt (such as interest rates and maturity dates). A company having a widely distributed ownership usually includes among its footnotes the income it earned in each quarter, quarterly stock market prices of its outstanding shares of common stock, and information about the relative sales and profit contribution of its different industry segments.
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; only the accounting developments of recent decades are prescribed in statutory law. 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 understood.
The going-concern assumption states that it is expected that the entity will continue to operate indefinitely.
The historical-cost principle requires 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 with the expenses 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 cash assets—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 events even though their 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 conservatism doctrine states that when exposure to uncertainty and risk is significant, accounting measurement and disclosure should take a cautious and prudent stance until evidence shows sufficient lessening of the uncertainty and risk.
The Balance Sheet
Of the two traditional types of financial statements, the balance sheet relates to an entity's position, and the income statement relates to its activity. The balance sheet provides information about an organization's assets, liabilities, and owners' equity as of a particular date (such as 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 provide potential future service to the organization. Equities consist of the organization's liabilities together with the equity interest of its owners. (For example, a certain house is an asset worth $70,000; its unpaid mortgage is a liability of $45,000, and the equity of its owners is $25,000.)
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, merchandise inventory, and short-term investments in stocks and bonds. Long-lived assets encompass the physical plant—notably land, buildings, machinery, motor vehicles, computers, furniture, and fixtures. Long-lived assets also include real estate being held for speculation and intangibles such as patents and trademarks.
Liabilities are obligations that the organization must remit to other parties, such as creditors and employees. Current liabilities usually 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 are usually debts that will come due beyond one year—such as bonds, mortgages, and 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—that is, the stockholders—as consisting of two elements: (1) the amount originally invested by the stockholders; and (2) the corporation's cumulative reinvested income, or retained earnings (that is, income not distributed to stockholders as dividends), in which the stockholders have equity.
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 in 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 lists 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. Extraordinary—that is, unusual and infrequent—developments are also specifically disclosed.
Other Financial Statements
The income statement excludes the amount of assets withdrawn by the owners; in a corporation such withdrawn assets are called dividends. A separate activity-oriented statement, the statement of retained earnings, discloses income and redistribution to owners.
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; it presents the sources and the uses of the enterprise's funds by operating activities, investing activities, and financing activities. The statement identifies the cash generated or used by operations; the cash exchanged to buy and sell plant and equipment; the cash proceeds from stock issuances and long-term borrowings; and the cash used to pay dividends, to purchase the company's outstanding shares of its own stock, and to pay off debts.
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, 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 a general journal.
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 in two aspects or dimensions, referred to as its debit (or left side) and credit (or right side) aspects, and each of these two 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 promise of future payment, a liability would be created, and the journal entry would record an increase in the merchandise account (a debit) and an increase in the 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 the liability account (a credit). The subsequent payment of the wages would be a decrease in the cash account (a credit) and a decrease in the liability account (a debit).
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 the balance—that is, the net credit or debit—of each account 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.
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 successfully prepared, the bookkeeping portion of the accounting cycle is concluded.
Step Four
Once bookkeeping procedures have been completed, the accountant prepares certain 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).
Steps Five and Six
Once the adjustments are calculated, 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.
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.
Regulations and Standards
Until 1973, accounting principles in the United States had traditionally been established by certified public accountants. Such persons are accountants licensed by their state governments on the basis of educational background, a rigorous certification examination, and, in some jurisdictions, relevant field 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 by the general public must conform to rules set by the Securities and Exchange Commission, a federal government agency. Tax laws and regulations are administered at the federal level by the Internal Revenue Service and at the local level by state and municipal government agencies. 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 for contracts with parties that sell goods and services to the government. The nongovernmental Institute of Management Accounting, although not active in issuing technical standards, does administer a 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).
Accounting has a well-defined body of knowledge and rather definitive procedures. Nevertheless, standard setters continue to refine existing techniques and develop new approaches. Such activity is needed in part because of innovative business practices, newly enacted laws, and socioeconomic changes. Better insights, new concepts, and enhanced perceptions have also influenced the development of accounting theory apractices.