Through this course, you will start by addressing the two “big questions” of accounting: “What do I have?” and “How did I do over time?” You will see how the two key financial statements – the balance sheet and the income statement - are designed to answer these questions and then move on to consider how individual transactions aggregate to make up these financial statements. After developing a broad understanding of accounting and financial statements, you will begin to develop a more nuanced understanding of individual components of doing business, such as making a sale or building inventory. By considering many of the more common actions of a company, you will build your understanding of accounting, and explore these concepts by applying them across various types of transactions. Once you understand these individual concepts better, you will be ready to return to the overall financial statements and use them as informational tools, including building ratios. You can do this course standalone or to qualify for the residential component of the Finance for Strategic Decision-Making Executive Education program. For more information, see the FAQ below.
Why Do We Have Accounting?
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From the course by University of Michigan
Accounting for Decision Making
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From the lesson
Why Do We Have Accounting and How Can You Make it Work for You?
Every organized society needs information about its activities and accomplishments. Accounting was created to fulfill this need. In this module we will explore how accounting was designed to meet the needs of decision makers and what this means to you as a user of accounting information. We will discuss the concept behind accrual accounting including introducing the two primary accrual accounting financial statements - the balance sheet and income statement. This module will discuss the purpose and goal of those financial statements, but we will save your experience in creating those statements until module two. In lesson two of this module, we will explore some basic bookkeeping tools that will get you ready to create a set of financial statements. The material in this module is likely to take less than a week, but we will make up for it in module two.
Meet the Instructors
Greg MillerProfessor
Ross School of Business
Welcome to the first video of our course on Financial Accounting.
Since this is the first video, I'm going to begin right at the beginning and
talk about why we even have accounting.
The goal of accounting is to provide information to decision makers.
Every time you're using accounting or somebody else is using accounting to try
to get you to see things their way, you should keep this in mind.
It's meant to be a tool for decision making so
it makes sense to have it as part of that conversation, but
you also have to understand what's going into that accounting.
What kind of assumptions are there?
What kind of information did people have to even determining the accounting?
As we work through the course, you're going to learn exactly that, so
you'll be an informed user of accounting.
But probably the place to start with is, where did accounting even come from?
One of the common myths about accounting is that it was created by some old Italian
guy as the merchant class got stronger in city states there.
What people are really talking about there is double entry bookkeeping and
even that is probably not really true.
The truth of the matter is that accounting was created across
all ancient civilizations.
They each independently seem to have come to the idea that we
need something like accounting.
If you go to archaeological digs in Egypt, or in Asia, or in South America,
they find artifacts there all the time that indicates that accounting was one of
the very first institutions that was created by each of these civilizations.
Now why did each of these civilizations independently decide
that they needed to invent accounting?
Well accounting arose from a need for information.
Think about what happens as civilizations get bigger.
Organized activities start to become more and more important.
In order for society to be able to manage these organized activities,
they have to be able to track them.
They have to know what worked,
what didn't worked, maybe figure out who owes who what.
And accounting fulfilled this role for all of these societies.
Accountants sometimes forget this simple beginning, though.
We tend to get excited about jargon and
we put up other barriers that make it harder for others to understand.
I do this myself.
Now in our defense,
the world's become a lot more complicated than it was back in ancient Egypt.
And because of that, sometimes the things we're talking about are very complicated
but really, accounting still comes from commonsense.
And if we can just remember this and keep going back to that commonsense motivation,
then it won't be the accounting that makes it difficult for
us to understand the situation, it will be the underlying complications and
the economic reality that make that difficult for us.
Now as each of these civilizations was creating accounting,
they kept running into the same two big questions in life.
What are the two big questions in life?
Well the first is,
what is the financial condition of an organization on a given day?
And the second is,
how well did the organization perform over a given time period?
If you think about your own business,
you'll find that you ask yourself this question probably multiple times a day.
Where are we at right now?
Or how did we perform today, or last week, or over the last quarter?
These questions just come up as you're trying to run an organization, and
think about how to run a business.
In fact, even if I talked to my children about what's happening when they're trying
to run a lemonade stand, the same two questions come up.
I say, guys, what do you need to know?
And they'll say, well, what do we have right now?
How many lemons do we have?
Do we have tools to squeeze the lemons?
Do we have a table to put it all on?
And we need to know how we did over time.
Was it worth it for all of us to be out here?
Maybe their friend Sam was only there in the morning so he should only get paid for
that period of time.
So they're answering the same two questions.
As societies realized they kept coming back to these same two questions,
they realized it wasn't very efficient to keep recreating the answers each time
somebody asks them, and they decided they should start formalizing them.
As they formalized them, they realized,
well, we could create some sort of a tool that would get at each of these.
For the first question, what is the financial condition
of the organization on a given day, they created the Balance Sheet.
Now the second question, how did we do over time?
They created something called the income statement.
Pretty quickly, some clever people started to figure out, hey,
if the balance sheet's telling us where we were at at the beginning of the period,
and where we were at at the end of the period and the income statement's telling
us what happened over the period, then we should be able to tie the two together.
So they created this statement of stockholders' equity.
The three of these items together are all based on something called
accrual accounting.
Our next video is going to cover accrual accounting and then actually I'm going to
do videos on the balance sheet and income statement just after those.
So we'll fill all of this in with more detail.
Now even though accrual accounting's a great tool, this question of how well did
the organization perform over a certain time period is pretty complicated.
And people started to realize it would be useful to have an alternative
way of thinking of that too.
So the cash flow statement was created to help to answer that second question.
Now that we know about the two big questions in life, and
the fact that we're going to try to create tools to answer them, I want to talk
a little bit about the bigger environment in which accounting occurs.
There's underlying operations of every business entity, and I've already said
the idea of the financial statements is to capture those underlying operations so
that managers can use that to make decisions.
Now often in these financial statements provide the manager with
everything they need to know in order to make a decision.
But sometimes the financial statement doesn't quite give them the information
they want to have.
You may have to adjust the financial statement a little bit or
you might even have to go back to the underlying operations of the business and
grab some more information.
So you might supplement the financial statements with some sort of managerial
report, and combined with the financial statement, reach your decision.
About now you're probably asking yourself, well why don't you just do the financial
statements in a way that would allow you to answers those questions so
you don't need those extra reports?
There's actually two reasons for this.
The first is, think about your own job.
You're answering all sorts of different questions at different times.
The financial statements can provide a base for you, but
you're frequently going to have to modify that information a little bit
in order to answer the specific question you're interested in.
And perhaps more importantly,
it's not just managers who use these financial statements.
There's other groups who use them as well.
For example, the capital markets will use the financial statements to decide
about resource allocation.
Should I loan this company money?
Should I invest in their equity?
Maybe I should sell their equity.
On top of that,
there are outsiders who may reach contractual agreements with the company.
Should I go into a joint venture with them?
If I do then I want to make sure that I have contractual terms to protect me.
Should I work for them as an employee, etc?
Now if you're one of those outside entities, you don't want the company to be
able to decide and make up their accounting as they go along.
You'd rather that there be some sort of preset
accounting rules that you know are relatively standard across companies.
This is where GAAP or IFRS comes in.
GAAP is what we call it in the US, Generally Accepted Accounting Principles.
The idea is that all of the companies will follow some sort of
similar guidance on how they're going to do their rules.
IFRS, International Financial Reporting Standards is what's applied
around the world in most countries other than the United States.
And again, it gives us some set of overall rules that will say,
in general this is how you might want to think about the accountant.
As we work through the course,
you're going to see that both of these allow a lot of latitude to managers.
So, it's important that we understand these rules but also understand the way in
which managers can use that latitude to change their financial statements.
Now we don't just want a set of standard rules if we're an outsider.
We also want to make sure that they're being applied in a reasonable way.
And this is where the audit comes in.
Auditors are people who specialize in understanding those accounting rules and
also in understanding the underlying businesses,
the business operations that we've talked about.
An auditor will look at the financial statements and
say, they seem to generally follow the accounting rules they're supposed to and
match the business operations.
They can't be absolutely certain, but
it makes the financial statements a lot more credible to the outsiders.
Now, once those financial statements are done in a way that makes them clear and
useful to others, people can make decisions whether it's the managers,
the capital markets or the contractual parties.
Each of those decisions will actually come back and
impact the operations of the business moving forward which will impact
the future financial statements, which will impact the decisions again, and
we see that the circle just continues to go on and on and on.
This is the overall accounting environment that we're going to study.
We haven't covered something that people seem to think of
every time I tell them I'm an accountant which is, what about taxes?
The tax returns also come from the underlying operations of the business
entity, but they're actually pretty unrelated to the financial statements.
For the most part, tax returns follow their own set of rules.
Governments sets these tax rules in order to know when a company should have
the ability to actually pay them,
to make sure the government gets revenues to run their own business.
They also will set tax rules in a way to try to get companies to do things
that they want.
For example, they may allow a tax benefit if a company gives certain benefits to
their employees like healthcare.
Or they may give a tax benefit if you make a big capital investment
if they're trying to spur that sort of investment in the economy.
Because the government makes tax rules for these different reasons,
the information that goes into tax returns really is not the same
sort of information we want in financial statements to make our business decisions.
Whether we're managers within the firms or people outside of the firm
trying to decide whether and how I should do business with it.
For that reason,
the tax returns usually are done independent of the financial statements.
There's going to be a few exceptions to that I'll point out to you, but
the reason that I've left the tax returns in white here is, for the most part,
they don't impact the accounting environment that we're concerned about.
In the next video I'm going to make good on one of my promises.
I'm going to tell you all about accrual accounting and what that really means.
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