Chapter 1 Introduction to Financial Accounting

Chapter 1

Welcome to Accounting 1

Before we dive into the mechanics of accounting, the debits and credits, journal entries and financial statements that will dominate your life this semester, we are going to investigate how financial accounting fits into our culture.  I am taking this approach to counter what I consider to be a fundamental flaw with many college level accounting and finance textbooks that focus almost exclusively on financial accounting mechanics and are supplemented with a plethora of glossy photos and irrelevant “feature stories” that provide students little guidance in understanding the context of their academic work.  The drawback to this method of teaching accounting is that students learn which buttons to push on their calculator and in what order… without knowing why.  Another motivation was to battle with what I consider to be outrageous pricing of textbooks used in American higher education.   There is little competition in the accounting textbook market and unsurprisingly, all of the books I reviewed retail for roughly the same price… what a coincidence.

Culture: The Role of Education

Culture is an integrated pattern of human knowledge, belief, and behavior that depends upon the capacity for symbolic thought and social learning.  You have been a student of our culture since your birth and your learning will continue until you die.  Without culture, man is a pointing/grunting Cro-Magnon hunter-gatherer.  We have a few examples of children who have been abandoned and raised by animals in the wild (feral children) and while Hollywood portrays the “unspoiled human” (Tarzan, Mowgli, Simba… ok Simba was a lion) as a romanticized super-human, unfortunately, real feral children (it really does happen) are tragic consequences of social failure.  If you are reading this, you are not a feral child, but if you are ignorant of a key aspect of our culture sometimes you may feel like one.  This book is designed to introduce you to the culture of commerce and economy, an important component of our shared culture.

Some aspects of your culture are unique, for example, some of you attend church on Sunday while others of you are avid fans of Dance of the Cossacks (http://preview.tinyurl.com/2dokt86).  This textbook describes components of a common culture shared by all people; you cannot opt out of it unless you want to live alone in a shack in the woods.  Every mechanical accounting topic covered in this textbook will be discussed in context of our culture, which makes it unique.  If you want to know why you are being asked to learn this academic material, then hopefully this book will help you discover the role of accounting in our society.

Epistemology

“Whoever is searching for the human being first must find the lantern” Nietzsche

Human knowledge is constructed by an individual’s perception and social experience.  The theory of human knowledge, known as epistemology, encompasses the following five questions:

1.     What is knowledge?

2.    How is knowledge acquired?

3.    What do people know?

4.    How do we know what we know?

5.    Why do we know what we know?

These questions outline a framework that enables the study of human knowledge.  A paradigm is a framework, or set of rules and boundaries for knowledge.  Without a framework, man is ineffective and must question everything, hence, he knows nothing.  Paradigms can be viewed as the structure of society… the culture and accepted norms that enable man to stand on the shoulders of those who came before him.  Absent a paradigm, man is alone, lacking rules for interacting with others and having to learn and understand everything on his own resulting in an absence of societal structure.  Therefore, even paradigms that are greatly flawed have value to mankind.  Understanding how paradigms are established and how they are destroyed and replaced by new ones will help you understand why you are studying accounting.

Paradigm Science

This textbook is presented through the lens of Thomas S. Kuhn’s The Structure of Scientific Revolutions.  This link has a couple of its chapters online http://www.marxists.org/reference/subject/philosophy/works/us/kuhn.htm, but I am requiring you to purchase the book (used copies on Amazon are $2).  I will be assigning sections for study and analysis and I will adopt Kuhn’s terminology when describing the different paradigms that are investigated in this course including the financial market paradigm, banking paradigm, accounting paradigm, and others.  Do a little investigating of your own on Kuhn.  I consider him to be the most important philosopher since the Age of Enlightenment, but you are going to have to discover him for yourself. 

      Kuhn recognized the role of paradigms in epistemology by observing that social scientists many times couldn’t agree on “the” question, let alone the method of scientifically finding an answer to “the” question, while natural scientists did not have this problem.  Yet he knew that based on history and his knowledge of the natural sciences, the answers from the natural scientists were no more absolute and permanent than were the answers of the social scientists.  New physical science discoveries can invalidate previously accepted “facts.”  For example, if man discovered that the interior of the moon contained an advanced civilization of lizard people, much of what he thought that he knew, including the paradigms governing many of our natural sciences would be proven wrong.  However, even if lizard people are not discovered, it is certain that many if not all natural science paradigms are imperfect and will be replaced as knowledge improves.  Through examination of historic natural science paradigm changes, Kuhn attempts to prove the importance of paradigms, even ones that are incomplete, in advancing man’s knowledge of the world around him.  For example, the periodic table of elements provides scientists a paradigm that facilitates study of the nature of chemicals.  However, scientists are aware of flaws and limitations in the paradigm and someday, it will be replaced with an improved paradigm, relegating the ubiquitous colorful poster that adorns science classrooms around the world to the trash bin of history.  In the meantime it is an invaluable tool that facilitates the dissemination of knowledge throughout the world.  While Kuhn primarily addresses natural science paradigms, he points out that a paradigm’s relationship to epistemology is the same for all human knowledge, natural (hard) science and social (soft) science.  In fact, Kuhn demonstrates that the concept of hard and soft science is a fallacy because human knowledge is not absolute in any scientific discipline and mankind must endeavor to continually improve his knowledge.

This textbook is designed to help you learn the structure of the financial accounting paradigm and its place in our culture.  The paradigm is flawed, some would say greatly.  However, it is the best one we have and it you want to be have a voice in discovering and creating a better paradigm; you must be an expert in the existing paradigm.  Your goal should be to learn its structure, including its rules and language, as well as its limitations and flaws.

Why This Course Matters

The vast majority of students who enroll in this course do so to improve their future earning power.  If this describes why you are taking the course… good on you, mate!   When I took this course at the University of Missouri, if you asked me why I was taking a class in accounting I probably would have answered: “because it is required.”  There is no need to feel ashamed for looking out for your own best interest, after all, that is the “invisible hand” that drives the economy.  Before going further, please visit http://www.econlib.org/library/Smith/smWN.html and read Book I, Chapter 2, Paragraph 2 from Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations.  Does Smith’s observation that “an invisible hand” drives the economy mean selfish behavior by all people improves overall national wealth?  If an individual steals from his neighbors, isn’t he acting in his own best interest?  Does public policy have any place in a free market?  Is there any example of a culture with no government structure that prospered?

Throughout this textbook I will be assigning short readings from the works of philosophical masters who envisioned, described and helped create our social and economic frameworks.  Accounting is a component of these frameworks, another brick in the wall if you will (http://www.youtube.com/watch?v=M_bvT-DGcWw).  If you do not understand our cultural framework, at best you will only learn mechanics and terminology with no context.  This approach is akin to learning which buttons to push on a machine, when and in what order.  While this can help you get a job, it works against you if the machine changes or another person learns the mechanical work and is willing to do it for one-fifth of what you are being paid. 

I wrote this textbook in order to inspire you to adopt a different approach to higher education, and I am going to appeal to your economic self-interest to convince you.  The biggest problem with using your college experience as a credentialing service is… it will not work because your professors do not have a clue exactly what you need to know to maintain gainful employment for an entire worklife.  How could they?  You are responsible for your education not your professor, Pink Floyd was spot-on.

Whenever possible I will assign readings from authoritative sources and original master works and while I will provide some guidance on points that I would like for you to consider, I am not going to provide a rote analysis for you to memorize and regurgitate back at exam time. Instead, I want for you to think for yourself and relate these readings to your life and environment.  Hopefully this class will spark the fires of your intellectual curiosity that will burn brightly for a lifetime.

Using numbers to tell a story

You are probably familiar with the U.S. Census Department sponsored survey regarding worklife earnings http://preview.tinyurl.com/3hlvzue.  Consider what the authors of this study are trying to communicate to their readers and how they are constructing their arguments.  As you read the pamphlet, think about the following:

1.     Terminology… worklife, synthetic worklife earnings, mean, median, education… how are these words defined?  Are these accepted definitions for all people or do some people define these words differently?

2.     Is the categorization of educational attainment appropriate?  Are all Bachelors degrees the same regardless of school or field of study?

3.     What is the purpose of the other variables identified in the study?

4.     In the Answers to Issues section the authors state “There is an education-earnings relationship.”  Is the same thing as saying “If you get more education you will earn more money?”

5.     What kind of public policy do you think this study would support?

6.     Is it possible that rich people can afford a better education so their children have higher levels of educational attainment?

Is this study an example of accounting?  Does this report contain any bias?  Are there any laws or rules that govern this report?

The Financial Accounting Paradigm

In Chapter V of The Structure of Scientific Revolutions Kuhn observed that a scientific community is a social system organized around a paradigm that provides its rules for communication and social interaction and enables “normal science” to take place.  Without the framework, the community does not exist.  The purpose of this textbook is to teach you the rules, language and theories of the Financial Accounting paradigm.  Like any paradigm, financial accounting is a flawed invention of man that can seem illogical at times.  However, as we learned from Kuhn, even a flawed paradigm is better than none at all.  To successfully complete this class, whether or not you plan on becoming an accountant, you must understand what is expected of you.  Upon completion of this course, you will have memorized the fundamental language and the mechanics of the scientists who practice financial accounting.  In order to do this, you are going to have to trust me when I tell you that you must memorize something.  If you do not master the material in Chapters 1 and 2, it will be nearly impossible for you to learn the rest of the material.  This is not a class that you can cram into your brain for the final examination.  On the other hand, this is not that difficult of a subject and if you devote the necessary time for the first several weeks of class, it will get easier. 

As you become more comfortable with the foundational material, I will challenge you to investigate the flaws and limitations of the paradigm and how it interacts with other paradigms.  Within the relatively narrow field of accounting there are many different professional paradigms.  For example; tax accounting, auditing, cost accounting, payroll and human resources are all professional communities that interact with the financial accounting paradigm professionals.  In some cases these communities use the same language and in some cases they do not.  The better you understand the importance of language and culture in paradigms, the more prepared you will be to work in a diverse organization that is comprised of multiple professional communities, some of which are not accounting related in any way, for example, legal, engineering, marketing and sales.  Furthermore, as you progress in your career, you will work with representatives from even more diverse paradigms outside of your organization.  Although financial accountants are probably the most fascinating people on the planet, if you are only equipped to work with other financial accountants, you are not well prepared for a career.

The language of financial accounting

This section contains the foundational language of financial accountants that we will be using throughout this textbook.  I will provide you some tips and mnemonics to help you be successful, but in the end you are going to have to practice over and over until you have committed this section to memory.  The first tip is to wipe your brain clean of any other meanings that you have assigned to these terms.  Treat this as if you are learning a new language.  Sometimes the financial accounting definitions will match what you already know, and sometimes they will not.  If you violate this first rule, you will be as we say in Nuevo Mexico “muy embarazada” or very embarrassed (for those of you who do not speak Spanish as fluently as I do).

This section must be mastered before proceeding to Chapter 2.  Until you can complete the Chapter 1 test, please do not go any further.  If you commit yourself to this material, you should be able to complete this task in about a week.  No TV, internet, reading the newspaper, etc. for one week until this task is completed.  Prepare note cards and keep them with you at all times, turn 20 minutes of unproductive time into a study opportunity.  If you cannot commit the time and effort to master this foundational material, it will be impossible to learn the material in this textbook in a meaningful way.  This is not the time for critical thinking or learning how or why.  This task requires brute force.

MEMORIZATION

FOUR FINANCIAL STATEMENTS – Table 1.1

Statement name	Heading: Period Ended or Date Certain	Account types from Trial Balance used on statement	Bottom Line
Income Statement (link)	For the period ended	Revenue and Expenses	Net Income
Retained Earnings Statement (link)	For the period ended (same heading as Income Statement)	Beginning Retained Earnings and Dividends	Ending Retained Earnings
Balance Sheet (link)	As of XX/XX/XXXX (Date Certain) snapshot in time… last day of Income Statement Period	Assets = Liabilities + Owners’ Equity (except Beginning Retained Earnings)	Proof that the accounting equation works…
Cash Flows Statement (link)	For the period ended (same heading as Income Statement)	None…	Change in cash in the period… transactions detailed into Operating, Investing and Financing categories

The four financial statements are required by G.A.A.P (Generally Accepted Accounting Principles) to be presented together along with related footnote disclosures.  Omitting one of the financial statements or a footnote disclosure could result in a reader being misled.  Use the mnemonic I R B C (Icky Rats Bite Cats) to remind you that these statements must be done in this order.  The Net Income is needed to calculate the Ending Retained Earnings which in turn is needed to complete the Balance Sheet.  The Cash Flows Statement uses information from all three statements.

SIX ACCOUNT TYPES – Table 1.2

We only have six types of accounts to memorize, easy peasy!  The mnemonic D A E L O R (Dave And Ed Live On Red), two hard working college students Dave and Ed study non-stop into the wee hours of the night.  To stay up and alert, they drink large quantities of Red Bull.

Account Type	Definition	Natural Balance	Financial Statement
Dividend	Assets distributed to stockholders	Debit	Retained Earnings
Asset	The cost of something purchased for the organization	Debit	Balance Sheet
Expense	A cost that expires (used) in a period	Debit	Income Statement
Liability	A debt that can be quantified	Credit	Balance Sheet
Owners’ Equity	The owners’ claim on assets (assets-liabilities)	Credit	Beginning Retained Earnings on Retained Earnings Statement, rest on Balance Sheet
Revenue	Value received for goods sold or services provided in the period	Credit	Income statement

Newt Becker, the pioneering financial accounting educator who founded the Becker CPA Review Course, coined the phrase “an ounce of memorization is worth a pound of logic.”  Think of your big beautiful brain as a semi-conductor…  you need to build some hard wiring instead of relying on thousands of lines of software code.

Keep in mind these definitions are pretty basic and we will beef them up as we go forward. 

Common Account Names – Table 1.3

The very first task when setting up an accounting system is to devise a chart of accounts.  I used to like to think of accounts as information buckets… places to store information.  Depending on the complexity of the organization and its information needs, the chart of accounts can include millions of accounts and sub-accounts.  For example, a company may have an account number 3000-101-12-78-01 that is used for Revenue (3000), Americas (101), Machinery division (12), Dozers (78), Yellow (01).  In this course we will not use account numbers, only names, and there will not be very many of them.  So… I want you to memorize them.  When a new topic requires some new General Ledger accounts, they will be added in a table like this:

Account Type	Account Name
Dividend	Cash dividend
Asset	Current: Cash, Accounts receivable, Interest receivable, Inventory, Supplies, Prepaid rent, Prepaid insurance, Prepaid expense Long-term: Land (used in business), Property Plant and Equipment, Accumulated depreciation (contra-asset), Patent, Long-term investment
Expense	Cost of goods sold, Income tax expense, Salaries expense, Maintenance expense, Rent expense, Selling expense, Shipping expense, Insurance expense, Rent expense, Unearned revenue, Utilities expense
Liability	Current: Accounts payable, Note payable (depending on term of note), Income taxes payable, Interest payable Long-term: Mortgage payable
Owners’ Equity	Common stock, Retained Earnings
Revenue	Sales revenue

Two conventions that I integrated into this table are classifying Assets and Liabilities as current or non-current and using red letters for contra-accounts.  You will learn more about both as you progress.

https://docs.google.com/document/d/1d8Ipcs8eW1TgOOt4UJqjKZl9dFzMfvuRaHRHw3EXPmw/edit