Understanding Business Accounting For Dummies, 2nd Edition (9 page)

How do you know if a business has actually followed the rules faithfully? We think it boils down to two factors. First is the competency and ethics of the accountants who prepared the financial reports. No substitute exists for expertise and integrity. But accountants often come under intense pressure to massage the numbers from the higher-level executives they work for.

Which leads to the second factor that allows you to know if a business has obeyed the dictates of accounting standards. Businesses have their financial statements audited by independent chartered or management accountants. In fact, limited companies are required by law to have annual audits and many private businesses hire accountants to do an annual audit, even if not legally required. The Companies Act 2006 has introduced some tough rules on how auditors, amongst others, should report on company accounts. Chapter 15 explains audits and why investors should carefully read the auditor's report on the financial statements.

Protecting investors: Sarbanes-Oxley and beyond

A series of high profile financial frauds in US-based businesses such as Enron and WorldCom in the mid-late 1990's badly shook people's confidence in US businesses. In response, the US government introduced the Sarbanes-Oxley Act, known less commonly but better understood as ‘the Public Company Accounting Reforms and Investor Protection Act - 2002'.

The central tenet of the Sarbanes-Oxley Act is to ensure truthfulness in financial reporting - a quest the accounting profession has been pursuing since Pacioli set out the rules of double-entry bookkeeping five centuries ago. The act closes the loopholes that creative accountants opened up, which made it difficult (and sometimes impossible) for shareholders to see how a business was performing until after the baddies had made off with the loot. The act applies to any business with shares listed on an American stock market that does business in the US - not just to US companies. The act is extremely complicated, so check out
www.sarbanes-oxley.com
for the lowdown on that act.

The British version, ‘the Companies (Audit, Investigations, and Community Enterprise) Act - 2004', is causing the accounting profession to clutch their collective heads. This knock-on effect from Sarbanes-Oxley means that all companies selling shares to the public have to make changes to their accounts and accounting standards. You can read up on the UK rules at the Office of the Public Sector Information Web site (go to
www.opsi.gov.uk
and click on ‘Legislation', ‘UK', ‘Acts', ‘Public Acts 2004', and finally on ‘Companies [Audit, Investigations and Community Enterprise] Act 2004').

The Accounting Department: What Goes On in the Back Office

As we discussed earlier in this chapter, bookkeeping (also called
record-keeping
) and financial reporting to managers and investors are the core functions of accounting. In this section, we explain another basic function of a business's accounting department: the back-office functions that keep the business running smoothly.

Most people don't realise the importance of the accounting department. That's probably because accountants do many of the back-office, operating functions in a business - as opposed to sales, for example, which is front-line activity, out in the open, and in the line of fire.

Typically, the accounting department is responsible for:

Payroll:
The total wages and salaries earned by every employee every pay period, which are called
gross wages
or
gross earnings,
have to be determined. In short, payroll is a complex and critical function that the accounting department performs: the correct amounts of income tax, social security tax, and other deductions from gross wages have to be calculated.

Cash inflows:
All cash received from sales and from all other sources has to be carefully identified and recorded, not only in the cash account but also in the appropriate account for the source of the cash received. In larger organisations, the
Chief Accountant
may be responsible for some of these cash flow and cash-handling functions.

Cash payments:
A business writes many cheques during the course of a year to pay for a wide variety of items including local business taxes, paying off loans, and the distribution of some of its profit to the owners of the business. The accounting department prepares all these cheques for the signatures of the officers of the business who are authorised to sign cheques, and keeps the relevant supporting documents and files for the company's records.

Purchases and stock:
Accounting departments are usually responsible for keeping track of all purchase orders that have been placed for stock (products to be sold by the business) and all other assets and services that the business buys - from postage stamps to forklift trucks. The accounting department also keeps detailed records on all products held for sale by the business and, when the products are sold, records the cost of the goods sold.

Capital accounting:
A typical business holds many different assets called
capital
- including office furniture and equipment, retail display cabinets, computers, machinery and tools, vehicles, buildings, and land. The accounting department keeps detailed records of these items.

The accounting department may be assigned other functions as well, but we think that this list gives you a pretty clear idea of the back-office functions that the accounting department performs. Quite literally, a business could not operate if the accounting department did not do these functions efficiently and on time.

Focusing on Business Transactions and Other Financial Events

Understanding that a great deal of accounting focuses on business transactions is very important.
Transactions
are economic exchanges between a business and the persons and other businesses with which the business deals. Transactions are the lifeblood of every business, the heartbeat of activity that keeps the business going. Understanding accounting, to a large extent, means understanding the basic accounting methods and practices used to record the financial effects of transactions.

A business carries on economic exchanges with six basic groups:

Its
customers,
who buy the products and services that the business sells.