Why Do We Have Accounting?

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.

Accounting for Decision Making

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