1.2 What Is Accounting and Why Does It Exist?

Imagine a long-distance 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 which have not paid the current month’s rent. Or an accounting professor who, the day before final grades are due, loses the only copy of the disk containing the spreadsheet of all homework, quiz, and exam scores. Each of these hypothetical situations 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—such as making marks in a stick to tally how many sheep you have or moving beads on a string to track the score in a billiards game. The double-entry bookkeeping system used by businesses today has been in existence for over 500 years. But the importance of routine bookkeeping cannot be overstated; without bookkeeping, business is impossible.

To evaluate the importance of bookkeeping records, we’ll use a thought experiment. Suppose that sometime during the night, all college professors were to disappear from the face of the earth. Could life proceed normally the next day? Unfortunately, yes—except for those of us who disappear. Now, what if every copy of every novel ever written were to disappear during the night? The cultural loss would be incalculable, but the normal activities of the next day would not be noticeably affected. But what if we woke up tomorrow morning to find the bookkeeping records of all businesses worldwide destroyed during the night? Businesses that rely on up-to-the-minute customer account information, such as banks, simply could not open their doors. Retailers would have to insist on cash purchases, because no credit records could be verified. Manufacturers would have to do a quick count of existing inventories of raw materials and components to find out whether they could keep their production lines running. Suppliers would have to call all their customers, if they could remember who they were, to renegotiate purchase orders. Attorneys would find themselves in endless arguments about their fees because they would have no record of billable hours. Routine and dry as it may seem, the world simply could not function without bookkeeping.

Rudimentary bookkeeping is ancient (probably predating both language and money), but the modern system of double-entry bookkeeping still in use today (described later in our discussion of “The Accounting Information System”) was developed in the 1300s and 1400s in Italy by the merchants in the trading and banking centers of Florence, Venice, and Genoa. The key development in accounting in the last 500 years has been the use of bookkeeping data, not just to keep track of things, but to evaluate the performance and status of a business.1

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

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

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

• You plan to travel 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 evaluation questions, your checks must be coded by type of expenditure, the data must be broken 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? Most of us do the bookkeeping (usually), but we don’t structure the information to make it useful for evaluating our spending habits.

In sum, an accounting system is used by a business (1) to handle routine bookkeeping tasks and (2) to structure the information so it can be used to evaluate the performance and status of the business. These two functions of an accounting system are shown in Figure 1.2. A number of specific uses of accounting data for evaluation purposes are outlined in a later section of this chapter.

Accounting is formally defined as a system of providing “quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions.”2

The key features of this definition are the following:

• Numbers: Accounting is quantitative. 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.

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

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

• Future decisions based on past information: 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.

Questions Exercises