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. We have to rely on financial reports from the entity to know what’s going on. Therefore, we need to have a good grip on the financial statements included in the financial reports. For all practical purposes, financial reports are the only source of financial information we get directly from a business or other organization.
By the way, the employees of a business — even though they obviously have a stake in the success of the business — don’t necessarily receive its financial reports. Only the investors in the business and its lenders are entitled to receive the financial reports. Of course, a business could provide this information to employees who aren’t shareowners, but generally speaking, most businesses do not. The financial reports of public businesses are in the public domain, so their employees can easily secure a copy. However, most businesses don’t automatically mail financial reports to all employees.
In your personal financial life, a little accounting knowledge is a big help for understanding investing in general, how investment performance is measured, and many other important financial topics. With some basic accounting knowledge, you’ll sound much more sophisticated when speaking with your banker or broker. We can’t promise you that learning accounting will save you big bucks on your income taxes, but it can’t hurt and will definitely help you understand what your tax preparer is talking about.
Using accounting in your personal financial life
We’re sure you know the value of learning personal finance and investing fundamentals. (Given the big push these days on improving financial literacy, we recommend Personal Finance For Dummies and Investing For Dummies by Eric Tyson, MBA, both published by Wiley.) A great deal of the information you use in making personal finance and investment decisions is accounting information. However, we do have one knock on books in these areas: They don’t make clear that you need a solid understanding of financial statements to make good use of the financial information.
We’re all affected by the profit performance of businesses, even though we may not be fully aware of just how their profit performance affects our jobs, investments, and taxes. For example, as an employee, your job security and your next raise depend on the business’s making a profit. If the business suffers a loss, you may be laid off or asked to take a reduction in pay or benefits. Business managers get paid to make profit happen. If the business fails to meet its profit objectives or suffers a loss, its managers may be replaced (or at least not get their bonuses). As authors, we hope our publisher continues to make a profit so we can keep receiving our royalty checks.
Your investments in businesses, whether direct or through retirement accounts and mutual funds, suffer if the businesses don’t turn a profit. We hope the stores we trade with make profit and continue in business. The federal government and most states depend on businesses making profit so they can collect income taxes from them.
Accounting extends into many nooks and crannies of your life. You’re doing accounting when you make entries in your checkbook and when you fill out your federal income tax return. When you sign a mortgage on your home, you should understand the accounting method the lender uses to calculate the interest amount charged on your loan each period. Individual investors need to understand accounting basics in order to figure their return on invested capital. And it goes without saying that every organization, profit-motivated or not, needs to know how it stands financially.
Seeing accounting at work
Accounting methods must fit the nature of the entity being accounted for and how the entity carries out its purpose. Accounting is not a case of one size fits all. Here’s a quick sweep of the radar screen to give you an idea of different types of entities that accounting methods are adapted to:
Accounting for profit-motivated businesses
