Purpose of Accounting

What is accounting?

Accounting is the language of business, which involves measuring the business activities of a company, and communicating those measurements to decision-makers. Such business activities include:

    - Operating activities: transactions that relate to the primary operations of the company (rent, salaries, taxes, ads, utilities, etc.)

    - Investing activities: transactions involving the purchase and sale of resources that are expected to benefit the company for several years (buying a new plant)

    - Financing activities: transactions the company has with investors (people who pay for ownership) and creditors (people who give loans)

How does accounting measure business activities?

Companies measure business activities using various records or "accounts". The common accounts you will see include:

    - Assets– total resources of a company, including cash (most liquid asset), inventory, property

    - Liabilities– amounts owed to creditors that will be paid overtime, including loans, business credit card, salaries

    - Stockholder's equity– amounts belonging to owners, including common stock and retained earnings

    - Revenues– amounts recognized when company sells products or provides services to customers, including sales revenue and investment revenue

    - Expenses– costs of providing products and services and other business activities during the current period which must be paid now, including wages and supplies costs

    - Net income– difference between revenue and expenses; also known as earnings or profits

    - Dividends– cash payments to stockholders; dividends are not expenses– they are distributions to the owners of the company

        - Importantly, companies decide how much of their profit to be dividends and how much is retained for future use

These records are tied together in the accounting equation and profit equation.

    - Accounting equation: Assets = liabilities (creditors' claims) + stockholders’ Equity (investors’/owners’ claim)

    - Profit equation: Net income = revenues - expenses

How does accounting communicate measurements?

There are four main financial statements that display accounting measurements.

The first is the income statement, which shows the company's ability to generate profit through a detailed version of the profit equation.

Income Statement
Revenues Service revenue Expenses Rent expense Supplies expense Salaries expense Utilities expense Interest expense Other expense Total expenses Net Income	$72000 $5000 $10000 $31000 $9000 $100 $2000 $58000 $14000

Second is the statement of stockholder's equity, which summarizes change in stockholders’ equity over an interval time and total stockholders’ equity at end of period. Stockholder's equity is only comprised common stock and retained earnings (net income minus dividends), which the statement shows.

Statement of Stockholders’ Equity
	Common Stock	Retained Earnings	Total Stockholders’ Equity
Beginning balance Issuance of common stock Add: Net income for the period Less: dividends Ending balance	$0 $200000 $200000	$0 $14000 ($4000) $10000	$0 $20000 $14000 ($4000) $210000

Third is the statement of cash flows, which summarizes change in cash over an interval time and total amount of cash at end of period. There are three types of cash flows, based on the three types of business activities:

    - Operating cash flows– cash receipts and payments for transactions involving revenue and expense

    - Investing cash flows– long term cash transactions for the purchase and sale of investments and long-term assets (buying new equipment)

    - Financing cash flows– transactions with lenders (repaying debt) and stockholders (paying dividends)

Statement of Cash Flows

Cash Flows from Operating Activities Cash inflows: From customers Cash outflows: For salaries For rent Net cash flows from operating activities Cash Flows from Investing Activities Purchase equipment Net cash flows from financing activities Cash Flows from Financing Activities Issue common stock Borrow from bank Pay dividends Net cash flows from financing activities Net increase in cash Cash at beginning of period Cash at end of period

$49000 ($28000) ($60000) ($39000) ($120000) ($120000) $200000 $120000 ($4000) $296000 $137000 $0 $137000

Finally is the balances sheet, which shows the company's assets, liabilities and stockholder's equity, as well as how they balance out in accordance with the accounting equation.

Balance Sheet
Assets Cash Accounts receivable Supplies Equipment, net Other assets Total assets	$137000 $27000 $13000 $118000 $55000 $350000	Liabilities Accounts payable Salaries payable Utilities payable Interest payable Notes payable Other liabilities Total liabilities Stockholders’ Equity Common stock Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity	$23000 $3000 $9000 $1000 $100000 $4000 $140000 $200000 $10000 $210000 $350000

How do decision-makers use accounting information?

Investors and creditors rely heavily on financial accounting information in making investment and lending decisions. Net income is most important: as an investor, you will make money from an increase in the stock price of a company in which you invest, and stock price increases when net income increases. Investors and creditors also use information reported in the balance sheet: If there are too many liabilities, then this may signal an inability to engage in new profit-making activities, which may make creditors force the company to declare bankruptcy.