1.1 What’s the Purpose of Accounting?

Imagine a telephone company with no system in place to document who calls whom and how long they talk. Or a manager of a 300-unit apartment complex who has forgotten to write down which tenants have and have not paid this month’s rent. Or an accounting professor who, the day before final grades are due, loses the thumb drive containing the spreadsheet of all the homework, quiz, and exam scores. Each of these scenarios illustrates a problem with bookkeeping, the least glamorous aspect of accounting. Bookkeeping is the preservation of a systematic, quantitative record of an activity. Bookkeeping systems can be very primitive—cutting notches in a stick to tally how many sheep you have or moving beads on a string to track the score in a billiards game. But the importance of routine bookkeeping cannot be overstated; without bookkeeping, business is impossible.

Rudimentary bookkeeping is ancient, probably predating both language and money. The modern system of double-entry bookkeeping still in use today (described in Topic 3) was developed in the 1300s–1400s in Italy. The key development in accounting in the last 500 years has been the use of the bookkeeping data not just to keep track of things, but to evaluate the performance and health of a business.

This use of bookkeeping data as an evaluation tool may seem obvious to you, but it is a step that is often not taken. Let’s consider a bookkeeping system with which most of us are familiar—a checking account. Your checking account involves (or should involve) careful recording of the dates and amounts of all withdrawals and all deposits made, the maintenance of a running account total, and reconciliations with the monthly bank statement. Now, assume that you have a perfect checking account bookkeeping system. Will the system answer the following questions?

• Are you spending more for groceries this year than you did last year?

• What proportion of your monthly expenditures is fixed, meaning that you can’t change it except through a drastic change in lifestyle?

• You plan to study abroad next year; will you be able to save enough between now and then to pay for it?

In order to answer these kinds of questions, each withdrawal must be analyzed to determine the type of expenditure, your withdrawals must then be coded by type of expenditure, the data must be boiled down into summary reports, and past data must be used to forecast future patterns. How many of us use our checking account data like this? Not many. We do the bookkeeping (usually), but we don’t structure the information to be used for evaluation.

In summary, an accounting system is used by a business to

1. analyze transactions,

2. handle routine bookkeeping tasks, and

3. structure information so it can be used to evaluate the performance and health of the business.

Figure 1.1 illustrates the three functions of the accounting system.

Accounting is formally defined as a system for providing “quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions.” 1 Take a look at the key components of this definition:

• Quantitative. Accounting relates to numbers. This is a strength because numbers can be easily tabulated and summarized. It is a weakness because some important business events, such as a toxic waste spill and the associated lawsuits and countersuits, cannot be easily described by one or two numbers.

• Financial. The health and performance of a business are affected by and reflected in many dimensions—financial, personal relationships, community and environmental impact, and public image. Accounting focuses on just the financial dimension.

• Useful. The practice of accounting is supported by a long tradition of theory. U.S. accounting rules have a theoretical conceptual framework. Some people actually make a living as accounting theorists. However, in spite of its theoretical beauty, accounting exists only because it is useful.

• Decisions. Although accounting is the structured reporting of what has already occurred, this past information can only be useful if it impacts decisions about the future.

Making good decisions is critical for success in any business. When an important decision must be made, it is essential to use a rational decision-making process. The process is basically the same no matter how complex the issue. First, the issue or question must be clearly identified. Next, the facts surrounding the situation must be gathered and analyzed. Then, several alternative courses of action should be identified and considered before a decision is reached. Figure 1.2 summarizes this decision-making process.

One must be careful to make a distinction between a good decision and a good outcome. Often, factors outside the decision maker’s control affect the outcome of a decision. The decision-making process does not guarantee a certain result; it only ensures that a good decision is made. The outcome always has an element of chance. Part of business is learning how to protect yourself against bad outcomes. The first step in achieving a favorable outcome begins with making a good decision.

Accounting plays a vital role in the decision making process. An accounting system provides information that can be used to make knowledgeable financial decisions. The information supplied by accounting is in the form of quantitative data, primarily financial in nature, and relates to specific economic entities. An economic entity may be an individual, a business enterprise, or a nonprofit organization. A business, such as a grocery store or a car dealership, is operated with the objective of making a profit for its owners. The goal of a nonprofit organization, such as a city government or a university, is to provide services in an effective and efficient manner. Every entity, regardless of its size or purpose, must have a way to keep track of its economic activities and measure how well it is accomplishing its goals. Accounting provides the means for tracking activities and measuring results.

The Relationship of Accounting to Business

Business is the general term applied to the activities involved in the production and distribution of goods and services. Accounting is used to record and report the financial effects of business activities and, as mentioned earlier, is called the “language of business.” Without accounting information, many important financial decisions would be made blindly. Investors, for example, would have no way to distinguish between a profitable company and one that is on the verge of failure; bankers could not evaluate the riskiness of potential loans; corporate managers would have no basis for controlling costs, setting prices, or investing the company's resources; and governments would have no basis for taxing income.

All business enterprises have some activities in common. As shown in Figure 1.3, one common activity is the acquisition of monetary resources. These resources, often referred to as capital, come from three sources:

1. investors (owners),

2. creditors (lenders), and

3. the business itself in the form of earnings that have been retained.

Once resources are obtained, they are used to buy land, buildings, and equipment; purchase materials and supplies; pay employees; and meet any other operating expenses involved in the production and marketing of goods or services. When the product or service is sold, additional monetary resources (revenues) are generated. These resources can be used to pay loans or taxes and buy new materials, equipment, and other items needed to continue business operations. In addition, some of the resources may be distributed to owners as a return on their investment. Walmart, for example, uses the earnings from its operations to open new stores and purchase inventory for those new stores. Once the new stores are opened, they produce more funds that can then be used to open more stores. Walmart also distributes many of its resources back to its owners. Owners also receive a return on their investment through increases in the value of the stock.

Accountants play two roles with regard to these activities.

• Measuring and reporting. Accountants measure and communicate (report) the results of business activities—in other words, accountants keep score. To measure these results accurately, accountants follow a standard set of procedures referred to as the accounting cycle. The cycle includes several steps, which involve analyzing, recording, classifying, summarizing, and reporting the transactions of a business.

• Advising. Accountants advise managers on how to structure these activities so as to achieve the goals of the business, such as generating a profit, minimizing costs, and providing efficient services.

Questions Practice Exercises