Tracy John A. Accounting for Dummies
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A business hires a law firm that does a lot of legal work during the year,
but the company doesn’t pay the bill until the following year.
A business matches retirement contributions made by its employees but
doesn’t pay its share until the following year.
A business has unpaid bills for telephone service, gas, electricity, and
water that it used during the year.
Accountants use three different types of liability accounts to record a busi-
ness’s unpaid expenses:
Accounts payable: This account is used for items that the business buys
on credit and for which it receives an invoice (a bill). For example, your
business receives an invoice from its lawyers for legal work done. As
soon as you receive the invoice, you record in the accounts payable lia-
bility account the amount that you owe. Later, when you pay the invoice,
you subtract that amount from the accounts payable account, and your
cash goes down by the same amount.
Accrued expenses payable: A business has to make estimates for sev-
eral unpaid costs at the end of the year because it hasn’t yet received
invoices for them. Examples of accrued expenses include the following:
• Unused vacation and sick days that employees carry over to the fol-
lowing year, which the business has to pay for in the coming year
• Unpaid bonuses to salespeople
• The cost of future repairs and part replacements on products that
customers have bought and haven’t yet returned for repair
• The daily accumulation of interest on borrowed money that won’t
be paid until the end of the loan period
Without invoices to refer to, you have to examine your business opera-
tions carefully to determine which liabilities of this sort to record.
Income tax payable: This account is used for income taxes that a busi-
ness still owes to the IRS at the end of the year. The income tax expense
for the year is the total amount based on the taxable income for the
entire year. Your business may not pay 100 percent of its income tax
expense during the year; it may owe a small fraction to the IRS at year’s
end. You record the unpaid amount in the income tax payable account.
Note: A business may be organized legally as a pass-through tax entity for
income tax purposes, which means that it doesn’t pay income tax itself
but instead passes its taxable income on to its owners. Chapter 8
explains these types of business entities. The example I offer here is for
a business that is an ordinary corporation that pays income tax.
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Summing Up the Financial
Effects of Profit
Business managers should understand not only how to make profit, but also
the financial effects of making profit. Profit does not simply mean an increase
in cash. Sales revenue and expenses affect several assets other than cash and
operating liabilities. I realize that I make this point several times in this chap-
ter, so forgive me if I seem to be harping. I simply want to drive home the
importance of understanding this fact.
Making profit involves additional transactions that are closely allied with sales
and expenses. These tightly connected transactions include the following:
Collecting cash from customers for credit sales made to them, which
takes place after recording the sales revenue
Purchasing (or manufacturing) products that are put in inventory and
held there until the products are sold sometime later, at which time the
cost of products sold is charged to expense in order to match up with
the revenue from the sale
Paying certain costs in advance of when they are charged to expense
Paying for products bought on credit and for other items that are not
charged to expense until sometime after the purchase
Paying for expenses that have been recorded sometime earlier
Making payments to the government for income tax expense that has
already been recorded
These allied transactions are the “before and after” of recording sales and
expense transactions. The allied transactions are not reported as such in a
financial statement. However, the allied transactions change assets and liabil-
ities, and they definitely affect cash flow. I explain how the changes in assets
and liabilities caused by the allied transactions affect cash flow in Chapter 6.
Figure 4-2 is a summary of the changes in assets and liabilities during the
year that are caused by a company’s profit-making activities — including the
sales and expense transactions (summarized in the income statement) and
the allied transactions (which are not reported in a financial statement). This
sort of summary is not usually prepared for business managers, nor is such a
summary presented in external financial reports. But it is a useful way to sum
up the financial consequences of making profit.
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Note in Figure 4-2 that I use descriptive names for the assets and liabilities,
instead of the formal account titles that you see in actual financial state-
ments. You can refer to the formal account titles earlier in the chapter (see
the section “Getting Particular about Assets and Liabilities”). When explain-
ing the balance sheet in Chapter 5, I stick to the formal titles of the accounts.
Other transactions also change the assets, liabilities, and owners’ equity of a
business, such as borrowing money and buying new fixed assets. These non-
revenue and non-expense transactions are reported in the statement of cash
flows, which I explain in Chapter 6.
Reporting Extraordinary
Gains and Losses
I have a small confession to make: The income statement example shown in
Figure 4-1 is a sanitized version as compared with actual income statements
in external financial reports. If you took the trouble to read 100 income state-
ments, you’d be surprised at the wide range of things you’d find in these
statements. But I do know one thing for certain you would discover.
Typical Business Inc.
Summary of Changes in Assets and Liabilities
from Sales and Expenses and Allied Transactions
Through Year Ended December 31, 2009
Cash
Receivables from credit sales
Cost of unsold products in inventory
Amount of expenses paid in advance
Cost of fixed assets, net of depreciation
Change in total assets
Assets
$1,515,000
$450,000
$725,000
$75,000
($775,000
)
$125,000
$150,000
$25,000
$1,990,000
$300,000
$1,690,000
Payables for products and things bought on credit
Unpaid expenses
Income tax payable
Change in liabilities
Net income for year
Liabilities
Figure 4-2:
Summary of
changes in
assets and
liabilities
from sales,
expenses,
and their
allied
transactions
during the
year.
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Many businesses report unusual, extraordinary gains and losses in addition to
their usual revenue, income, and expenses. In these situations, the income
statement is divided into two sections:
The first section presents the ordinary, continuing sales, income, and
expense operations of the business for the year.
The second section presents any unusual, extraordinary, and nonrecur-
ring gains and losses that the business recorded in the year.
The road to profit is anything but smooth and straight. Every business expe-
riences an occasional discontinuity — a serious disruption that comes out of
the blue, doesn’t happen regularly or often, and can dramatically affect its
bottom-line profit. In other words, a discontinuity is something that disturbs
the basic continuity of its operations or the regular flow of profit-making
activities.
Here are some examples of discontinuities:
Downsizing and restructuring the business: Layoffs require severance
pay or trigger early retirement costs; major segments of the business
may be disposed of, causing large losses.
Abandoning product lines: When you decide to discontinue selling a
line of products, you lose at least some of the money that you paid for
obtaining or manufacturing the products, either because you sell the
products for less than you paid or because you just dump the products
you can’t sell.
Settling lawsuits and other legal actions: Damages and fines that you
pay — as well as awards that you receive in a favorable ruling — are
obviously nonrecurring extraordinary losses or gains (unless you’re in
the habit of being taken to court every year).
Writing down (also called writing off) damaged and impaired assets:
If products become damaged and unsellable, or fixed assets need to be
replaced unexpectedly, you need to remove these items from the assets
accounts. Even when certain assets are in good physical condition, if
they lose their ability to generate future sales or other benefits to the
business, accounting rules say that the assets have to be taken off the
books or at least written down to lower book values.
Changing accounting methods: A business may decide to use a different
method for recording revenue and expenses than it did in the past, in
some cases because the accounting rules (set by the authoritative
accounting governing bodies — see Chapter 2) have changed. Often,
the new method requires a business to record a one-time cumulative
effect caused by the switch in accounting method. These special items
can be huge.
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Correcting errors from previous financial reports: If you or your
accountant discovers that a past financial report had an accounting
error, you make a catch-up correction entry, which means that you
record a loss or gain that had nothing to do with your performance
this year.
According to financial reporting standards (GAAP), which I explain in
Chapter 2, a business must make these one-time losses and gains very visible
in its income statement. So in addition to the main part of the income state-
ment that reports normal profit activities, a business with unusual, extraordi-
nary losses or gains must add a second layer to the income statement to
disclose these out-of-the-ordinary happenings.
If a business has no unusual gains or losses in the year, its income statement
ends with one bottom line, usually called net income (which is the situation
shown in Figure 4-1). When an income statement includes a second layer, that
line becomes net income from continuing operations before unusual gains and
losses. Below this line, each significant, nonrecurring gain or loss appears.
Say that a business suffered a relatively minor loss from quitting a product
line and a very large loss from adopting a new accounting standard. The
second layer of the business’s income statement would look something like
the following:
Net income from continuing operations $267,000,000
Discontinued operations, net of income taxes ($20,000,000)
Earnings before cumulative effect of changes $247,000,000
in accounting principles
Cumulative effect of changes in accounting principles, ($456,000,000)
net of income taxes
Net earnings (loss) ($209,000,000)
The gains and losses reported in the second layer of an external income
statement are generally complex and may be quite difficult to follow. So
where does that leave you? In assessing the implications of extraordinary
gains and losses, use the following questions as guidelines:
Were the annual profits reported in prior years overstated?
Why wasn’t the loss or gain recorded on a more piecemeal and gradual
year-by-year basis instead of as a one-time charge?
Was the loss or gain really a surprising and sudden event that could not
have been anticipated?
Will such a loss or gain occur again in the future?
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Every company that stays in business for more than a couple of years experi-
ences a discontinuity of one sort or another. But beware of a business that
takes advantage of discontinuities in the following ways:
Discontinuities become continuities: This business makes an extraordi-
nary loss or gain a regular feature on its income statement. Every year
or so, the business loses a major lawsuit, abandons product lines, or
restructures itself. It reports “nonrecurring” gains or losses from the
same source on a recurring basis.
A discontinuity is used as an opportunity to record all sorts of write-
downs and losses: When recording an unusual loss (such as settling a
lawsuit), the business opts to record other losses at the same time, and
everything but the kitchen sink (and sometimes that, too) gets written
off. This so-called big-bath strategy says that you may as well take a big
bath now in order to avoid taking little showers in the future.
A business may just have bad (or good) luck regarding extraordinary events
that its managers could not have predicted. If a business is facing a major,
unavoidable expense this year, cleaning out all its expenses in the same year
so it can start off fresh next year can be a clever, legitimate accounting tactic.
But where do you draw the line between these accounting manipulations and
fraud? All I can advise you to do is stay alert to these potential problems.
Closing Comments
The income statement occupies center stage; the bright spotlight is on this
financial statement because it reports profit or loss for the period. But remem-
ber that a business reports three primary financial statements — the other
two being the balance sheet and the statement of cash flows, which I discuss
in the next two chapters. The three statements are like a three-ring circus. The
income statement may draw the most attention, but you have to watch what’s
going on in all three places. As important as profit is to the financial success of
a business, the income statement is not an island unto itself.
Also, keep in mind that financial statements are supplemented with footnotes
and contain other commentary from the business’s executives. If the financial
statements have been audited, the CPA firm includes a short report stating
whether the financial statements have been prepared in conformity with
GAAP. Chapter 15 explains audits and the auditor’s report.
I don’t like closing this chapter on a sour note, but I must point out that an
income statement you read and rely on — as a business manager, investor,
or lender — may not be true and accurate. In most cases (I’ll even say in the
large majority of cases), businesses prepare their financial statements in
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good faith, and their profit accounting is honest. They may bend the rules a
little, but basically their accounting methods are within the boundaries of
GAAP even though the business puts a favorable spin on its profit number.
But some businesses resort to accounting fraud and deliberately distort their
profit numbers. In this case, an income statement reports false and mislead-
ing sales revenue and/or expenses in order to make the bottom-line profit
appear to be better than the facts would support. If the fraud is discovered at
a later time, the business puts out revised financial statements. Basically, the
business in this situation rewrites its profit history. I wish I could say that
this doesn’t happen very often, but the number of high-profile accounting
fraud cases in recent years has been truly alarming. The CPA auditors of
these companies did not catch the accounting fraud, even though this is one
purpose of an audit. Investors who relied on the fraudulent income state-
ments ended up suffering large losses.
Anytime I read a financial report, I keep in mind the risk that the financial
statements may be “stage managed” to some extent — to make year-to-year
reported profit look a little smoother and less erratic, and to make the finan-
cial condition of the business appear a little better. Regretfully, financial state-
ments don’t always tell it as it is. Rather, the chief executive and chief
accountant of the business fiddle with the financial statements to some
extent. I say much more about this tweaking of a business’s financial state-
ments in later chapters.
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Chapter 5
Reporting Assets, Liabilities,
and Owners’ Equity
In This Chapter
Identifying three basic types of business transactions
Classifying assets and liabilities
Connecting revenue and expenses with their assets and liabilities
Examining where businesses go for capital
Understanding balance sheet values
T
his chapter explores one of the three primary financial statements
reported by businesses — the balance sheet, which is also called the
statement of financial condition and the statement of financial position. This
financial statement is a summary at a point in time of the assets of a business
on the one hand, and the liabilities and owners’ equity sources of the busi-
ness on the other hand. It’s a two-sided financial statement, which can be
condensed in the accounting equation:
Assets = Liabilites + Owners’ equity
The balance sheet may seem to stand alone — like an island to itself —
because it’s presented on a separate page in a financial report. But keep
in mind that the assets and liabilities reported in a balance sheet are the
results of the activities, or transactions, of the business. Transactions are
economic exchanges between the business and the parties it deals with:
customers, employees, vendors, government agencies, and sources of capi-
tal. Transactions are the stepping stones from the start-of-the year to the end-
of-the-year financial condition.
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Understanding That Transactions
Drive the Balance Sheet
A balance sheet is a snapshot of the financial condition of a business at an
instant in time — the most important moment in time being at the end of the
last day of the income statement period. If you read Chapter 4, you’ll notice
that I continue using the same business example in this chapter. The fiscal, or
accounting, year of the business ends on December 31. So its balance sheet
is prepared at the close of business at midnight December 31. (A company
should end its fiscal year at the close of its natural business year or at the
close of a calendar quarter — September 30, for example.) This freeze-frame
nature of a balance sheet may make it appear that a balance sheet is static.
Nothing is further from the truth. A business does not shut down to prepare
its balance sheet. The financial condition of a business is in constant motion
because the activities of the business go on nonstop.
The activities, or transactions, of a business fall into three basic types:
Operating activities: This category refers to making sales and incurring
expenses, and also includes the allied transactions that are part and
parcel of making sales and incurring expenses. For example, a business
records sales revenue when sales are made on credit, and then, later,
records cash collections from customers. Another example: A business
purchases products that are placed in its inventory (its stock of prod-
ucts awaiting sale), at which time it records an entry for the purchase.
The expense (the cost of goods sold) is not recorded until the products
are actually sold to customers. Keep in mind that the term operating
activities includes the allied transactions that precede or are subsequent
to the recording of sales and expense transactions.
Investing activities: This term refers to making investments in assets
and (eventually) disposing of the assets when the business no longer
needs them. The primary examples of investing activities for businesses
that sell products and services are capital expenditures, which are the
amounts spent to modernize, expand, and replace the long-term operat-
ing assets of a business.
Financing activities: These activities include securing money from debt
and equity sources of capital, returning capital to these sources, and
making distributions from profit to owners. Note that distributing profit to
owners is treated as a financing transaction, not as a separate category.
Wondering where to find these transactions in a financial report? See the
sidebar “How transactions are reported in financial statements.”
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Figure 5-1 shows a summary of changes in assets, liabilities, and owners’
equity during the year for the business example I introduce in Chapter 4.
Notice the middle three columns in Figure 5-1, for each of the three basic
types of activities of a business. One column is for changes caused by its
revenue and expenses and their allied transactions during the year, which
collectively are called operating activities. The second column is for changes
caused by its investing activities during the year. The third column is for the
changes caused by its financing activities.
Typical Business, Inc.
Statement of Changes in Assets, Liabilities, and Owners’ Equity
for Year Ended December 31, 2009
(Dollar amounts in thousands)
Cash
Accounts receivable
Inventory
Prepaid expenses
Fixed assets, net of depreciation
Assets
Beginning
Balances
$1,515
$450
$725
$75
($775
$1,990
)
$2,275
$2,150
$2,725
$525
$5,535
$13,210
Operating
Activities
Investing
Activities
($1,275
$1,275
)
Financing
Activities
($350
($350
)
)
Ending
Balances
$2,165
$2,600
$3,450
$600
$6,035
$14,850
Accounts payable
Accrued expenses payable
Income tax payable
Interest-bearing debt
O.E.-invested capital
O.E.-retained earnings
Liabilities & owners’ equity
$125
$150
$25
$1,690
$1,990
$640
$750
$90
$6,000
$3,100
$2,630
$13,210
$250
$150
($750
($350
)
)
$765
$900
$115
$6,250
$3,250
$3,570
$14,850
Figure 5-1:
Summary of
changes in
assets,
liabilities,
and owners’
equity
during the
year.
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How transactions are reported
in financial statements
Sales revenue and expenses, as well as any
gains or losses that are recorded in the period,
are reported in the income statement. However,
the total flows during the period of the allied
transactions
connected
with sales and expenses
are not reported. For example, the total of cash
collections from customers from credit sales
made to them is not reported. The net changes
in the assets and liabilities directly involved in
operating activities are reported in the statement
of cash flows (see Chapter 6). Financing and
investing transactions are also found in the
statement of cash flows. (Reporting the cash
flows from investing and financing activities is
one of the main purposes of the statement of
cash flows.)
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