Understanding Business Accounting For Dummies, 2nd Edition (7 page)

Accountants design the
internal controls
in an accounting system, which serve to minimise errors in recording the large number of activities that a business engages in over the period. The internal controls that accountants design can detect and deter theft, embezzlement, fraud, and dishonest behaviour of all kinds. In accounting, internal controls are the gram of prevention that is worth a kilo of cure.

An accountant seldom prepares a complete listing of all the details of the activities that took place during a period. Instead, he or she prepares a
summary financial statement,
which shows totals, not a complete listing of all the individual activities making up the total. Managers may occasionally need to search through a detailed list of all the specific transactions that make up the total, but this is not common. Most managers just want summary financial statements for the period - if they want to drill down into the details making up a total amount for the period, they ask the accountant for this more detailed backup information. Also, outside investors usually only see summary-level financial statements. For example, they see the total amount of sales revenue for the period but not how much was sold to each and every customer.

Financial statements are prepared at the end of each accounting period. A period may be one month, one quarter (three calendar months), or one year. One basic type of accounting report prepared at the end of the period is a ‘Where do we stand at the end of the period?' type of report. This is called the
balance sheet.
The date of preparation is given in the header, or title above this financial statement. A balance sheet shows two aspects of the business.

One aspect is the
assets
of the business, which are its economic resources being used in the business. The other aspect of the balance sheet is a breakdown of where the assets came from, or the sources of the assets. The asset
values
reported in the balance sheet are the amounts recorded when the assets were originally acquired. For many assets these values are recent - only a few weeks or a few months old. For some assets their values as reported in the balance sheet are the costs of the assets when they were acquired many years ago.

Assets are not like manna from heaven. They come from borrowing money in the form of loans that have to be paid back at a later date and from owners' investment of capital (usually money) in the business. Also, making profit increases the assets of the business; profit retained in the business is the third basic source of assets. If a business has, say, £2.5 million in total assets (without knowing which particular assets the business holds) you know that the total of its liabilities, plus the capital invested by its owners, plus its retained profit, adds up to £2.5 million.

In this particular example suppose that the total amount of the liabilities of the business is £1.0 million. This means that the total amount of
owners' equity
in the business is £1.5 million, which equals total assets less total liabilities. Without more information we don't know how much of total owners' equity is traceable to capital invested by the owners in the business and how much is the result of profit retained in the business. But we do know that the total of these two sources of owners' equity is £1.5 million.

The financial condition of the business in this example is summarised in the following
accounting equation
(in millions):

£2.5 Assets = £1.0 Liabilities + £1.5 Owners' Equity


Looking at the accounting equation you can see why the statement of financial condition is also called the balance sheet; the equal sign means the two sides have to balance

Double-entry bookkeeping
is based on this accounting equation - the total of assets on the one side is counter-balanced by the total of liabilities, invested capital, and retained profit on the other side. Double-entry bookkeeping is discussed in Chapter 2.

Other financial statements are different than the balance sheet in one important respect: They summarise the significant
flows
of activities and operations over the period. Accountants prepare two types of summary flow reports for businesses:

The
profit and loss account
summarises the inflows of assets from the sale of products and services during the period. The profit and loss account also summarises the outflow of assets for expenses during the period leading down to the well-known
bottom line,
or final profit, or loss, for the period.

The
cash flow statement
summarises the business's cash inflows and outflows during the period. The first part of this financial statement calculates the net increase or decrease in cash during the period from the profit-making activities reported in the profit and loss account.

The balance sheet, profit and loss account, and cash flow statement constitute the hard core of a financial report to those persons outside a business who need to stay informed about the business's financial affairs. These individuals have invested capital in the business, or the business owes them money and therefore they have a financial interest in how well the business is doing. These three key financial statements are also used by the managers of a business to keep themselves informed about what's going on and the financial position of the business. They are absolutely essential to helping managers control the performance of a business, identify problems as they come up, and plan the future course of a business. Managers also need other information that is not reported in the three basic financial statements. (Part III of this book explains these additional reports.)