heads buried in a torrent of details. Accountants have no choice; they have to be detail-oriented. At the same time, they have to see how the details fit into the overall scheme of things. The avalanche of details is condensed into accounting reports that disclose relatively few aggregate accounts. One reason for learning accounting is to understand what these collective accounts include.
Thinking about where assets come from
We explain later that accountants decide how to record transactions, which are economic exchanges (see the later section “Focusing on Transactions”). Many people aren’t aware of the double duty of accountants in recording transactions. Accountants look at things from two points of view — the give and the take of the transaction. This is called double-entry accounting, which we explain in Chapter 3. The following example illustrates the two-sided nature of accounting.
Suppose a business reports $1,000,000 in total assets at the end of its most recent year. Most people, quite naturally, focus on the makeup of its assets (how much cash, for example). But the composition of its assets is only half the financial picture of a business. You’ve heard the expression that there are two sides to every story. Well, in accounting, there are two sides to the financial condition of a business.
Accounting deals with assets, of course. Accountants are equally concerned with the sources of the assets. In this example, the $1,000,000 in assets comes from three sources: $300,000 liabilities; $500,000 capital; and $200,000 surplus. You probably have a good idea of what liabilities are. Capital is money invested in the business by the owners. Surplus is profit that has been earned and not distributed to the owners. The sum of all three sources taken together equals the total assets of the business. The books are in balance.
Asking about profit
Businesses are profit motivated, so a natural question is “How much profit did the business earn over the last year?” Suppose the business had $120,000 surplus at the beginning of the year, and the business didn’t distribute any of its profit to its owners during the year. Therefore, the business earned $80,000 profit for the year: $120,000 surplus at start of year → $200,000 surplus at end of year = $80,000 gain in surplus, which is the profit for the year.
Sorting out stereotypes of accountants
We recently saw a cartoon in which the young son of clowns is standing in a circus tent and is dressed as a clown, but he’s holding a briefcase. He’s telling his clown parents that he’s running away to join a CPA firm. This cartoon plays off the stereotype of a CPA (certified public accountant) as a boring “bean counter” who wears a green eyeshade, has no sense of humor, and possesses the personality of an undertaker (no offense to morticians). Maybe you’ve heard the joke that an accountant with a personality is one who looks at your shoes when he’s talking to you instead his own shoes.
Like most stereotypes, there’s an element of truth in this image of accountants. As a CPA and accounting professor for more than 40 years (coauthor John) and a financial and accounting consultant for more than 36 years (coauthor Tage), we’ve met and known a large number of accountants. Most accountants are not as gregarious as used-car salespeople (though some are). Accountants certainly are more detail-oriented than your average person, and they’re a little more comfortable with complex calculations. Accountants are very good at one thing: Examining both sides of financial transactions — the give and the take, what was gotten and what was given. Accountants know better than anyone that, as economists are fond of saying, there’s no such thing as a free lunch.
Because accountants work with numbers and details, you hear references to accountants as bean counters, digit heads, number nerds, and other names we don’t dare mention here. Accountants take these snide references in stride and with good humor. Actually, accountants rank among the most respected professionals in many polls. Many people and businesses rely on their accountants for business, financial, and even investment advice. Accountants are much more than preparers of your tax returns.
If you walked down a busy street in Chicago, Denver, New York, or Los Angeles, we doubt that you could pick out the accountants. We have no idea whether accountants have higher or lower divorce rates, whether they go to church more frequently, whether most are Republicans or Democrats, or whether they generally sleep well at night. We do think overall that accountants are more honest in paying their income taxes, although we have no proof of this. (And yes, we know of a couple of accountants who tried to cheat on their federal income tax returns.)
Providing Vital Financial Information
In a nutshell, accountants “keep the books” of businesses — and of not-for-profit (NFP) and government entities also — by following systematic methods to record the financial activities of the entity. All this recordkeeping is done for one primary purpose: to create the database necessary for the preparation of complete, accurate, reliable, and timely financial reports, tax returns, and other types of financial communications. In financial reports, accounting information is presented in the form of financial statements that are packaged with other information such as explanatory footnotes and a letter from top management. Accountants design financial reports for nonaccountants, such as business owners, lenders, and investors.
Financial reports are sent to people who have a stake in the outcomes of the activities. If you own stock in Microsoft, for example, or you have money in a mutual fund, you receive regular financial reports. If you invest your hard-earned money in a private business or a real estate venture, or if you save money in a credit union, you receive regular financial reports. If you’re a member of a nonprofit association or organization, you’re entitled to receive regular financial reports. We hope you carefully read these financial reports, but if you don’t — or if you do yet don’t understand what you’re reading — it could be that you don’t understand the language of accounting.
One important reason for studying accounting is to make sense of the financial statements in the financial reports you get. We guarantee that Warren Buffett knows accounting and how to read financial statements. We sent him a copy of our book How to Read a Financial Report (John Wiley & Sons, Inc.). In his reply, he said he planned to recommend it to his “accounting challenged” friends.
Recognizing users of accounting information
People who use accounting information fall into two broad groups: insiders (internal users) and outsiders (external users).
Business managers are insiders; they have the authority and responsibility to run a business. They need a good understanding of accounting terms and the methods used to measure profit and put values on assets and liabilities. Accounting information is indispensable for planning and controlling the financial performance and condition of the business. Likewise, administrators of NFP and governmental entities need to understand the accounting terminology and measurement methods in their financial statements.
The rest of us are outsiders. We aren’t privy to the day-to-day details of a business or organization.