Tracy John A. Accounting for Dummies
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Typical Business, Inc.
(Dollar amounts in thousands)
Balance Sheet at December 31, 2009
Cash
Accounts receivable
Inventory
Prepaid expenses
Current assets
Property, plant, and equipment
Accumulated depreciation
Net of depreciation
Total assets
Assets Version A
$2,045
$2,570
$2,750
$550
$7,915
$12,225
($7,435
$4,790
$12,705
$2,165
$2,600
$3,450
$600
$8,815
$12,450
($6,415
$6,035
$14,850
))
)
)
)
)
Version C Difference
($120)
($30)
($700)
($50)
($900)
($225)
($425)
($650)
($1,550)
)
)
)
)
Income Statement for Year Ended December 31, 2009
Sales revenue
Cost of goods sold expense
Gross margin
Selling, general, and
administrative expenses
Operating earnings
Interest expense
Earnings before income tax
Income tax expense
Net income
Version A
$25,775
($14,580
$11,195
($8,830
$2,365
($400
$1,965
($615
$1,350
$26,000
($14,300
$11,700
($8,700
$3,000
($400
$2,600
($910
$1,690
Version C Difference
($225
($280
($505
($130
($635
$0
($635
$295
($340
Accounts payable
Accrued expenses payable
Income tax payable
Short-term notes payable
Current liabilities
Long-term notes payable
Owners’ equity:
Invested capital
Retained earnings
Total owners’ equity
Total liabilities and owners’ equity
Liabilities and Owners’ Equity
$765
$965
$115
$2,250
$4,095
$4,000
$3,250
$1,955
$5,205
$13,300
$765
$900
$115
$2,250
$4,030
$4,000
$3,250
$3,570
$6,820
$14,850
$0
$65
$0
$0
$65
$0
$0
($1,615
($1,615
($1,550
)
)
)
)
)
)
)
)
)
)
Figure 7-1:
Two
versions of
financial
statements
for the
business.
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The “A” in Version A stands for actual and aggressive. What I mean by aggres-
sive is that the business adopted accounting methods that maximize its
recorded profit, and it used certain techniques to make its year-end financial
condition look as positive as possible.
Some businesses go the opposite direction. They adopt conservative
accounting methods to record profit performance, and they wouldn’t think of
tinkering with their financial statements at the end of the year, even when
their profit performance falls short of expectations and their financial condi-
tion has some trouble spots. In Figure 7-1, the “C” in Version C stands for con-
servative and cautious.
Now, you may very well ask, “Where in the devil did you get the numbers for
Version C?” The dollar amounts in Version C are my best estimates of what
conservative and cautious numbers would be for this business — a company
that has been in business for several years, has made a profit most years, and
has not gone through bankruptcy.
Figuring Out Why Financial
Statements Differ
Look at the third column on the right in Figure 7-1. These are the differences
between the two financial statement versions. In the balance sheet the differ-
ences are concentrated in assets; only one liability is different. In total, assets
are $1.55 million lower and liabilities are $65,000 higher. These differences are
the results of recording slightly lower amounts of sales revenue and signifi-
cantly higher amounts of expenses in the conservative Version C scenario.
Remember the following about revenue and expenses:
Recording sales revenue increases an asset (or decreases a liability in
some cases).
Recording an expense either decreases an asset or increases a liability.
Most of the balance sheet differences in Figure 7-1 are caused by higher amounts
of expenses in the Version C scenario. The cumulative amount of net income
recorded over the years by the business in the Version C scenario is $1,615,000
less than in Version A:
$1,550,000 smaller amount of assets + $65,000
higher amount of liabilities = $1,615,000
less net income recorded over the years
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At the end of each year, the amount of annual net income is recorded in the
retained earnings owners’ equity account. As you can see in Figure 7-1, the
retained earnings balance in Version C is exactly $1,615,000 less than in
Version A. This is a sizable amount, to be sure. But keep in mind that it took
all the years of its existence to accumulate that $1,615,000 amount. The net
income difference for its latest year (2009) is responsible for only part of the
cumulative, total difference in retained earnings.
Sales revenue and every expense except interest are different between
Versions A and C. Net income in Version C is $340,000 (about 20 percent)
lower than in Version A.
Suppose that in putting a market value on the business, you use the earnings
multiple method. (For more information on the valuation of a small business,
see Small Business Financial Management Kit For Dummies, written by myself
and my son, Tage C. Tracy [Wiley]). Suppose you are willing to pay six times the
most recent annual profit of the business. (I certainly don’t mean to suggest that
six times earnings is a standard multiple for all small businesses.) In Version A,
you would offer $10.74 million for the business ($1.69 million net income × 6 =
$10.74 million). In Version C, you would offer only $8.1 million ($1.35 million net
income × 6 = $8.1 million). If the business had used more conservative account-
ing methods, you would offer $2.64 million less for the business!
The following sections briefly explain each of the differences in Figure 7-1, except
the retained earnings difference that I explain just above. I keep the explanations
relatively brief and to the point. The idea is to give you a basic taste of some of
the main reasons for the differences. Note: From here on, instead of referring to
Version A and Version C, I will call the two different situations Company A and
Company C. Remember that Company A uses aggressive accounting methods
that boost recorded profit, and Company C uses conservative accounting meth-
ods that dampen recorded profit.
Cash balance
Company A engaged in what is called window dressing, which I discuss in
Chapter 12. Company A held its books open for a few days after the close of
the fiscal year in order to record additional cash collections from its accounts
receivable. It’s as if the cash had been received on December 31, 2009, even
though the cash was not actually deposited in its checking account until the
first week in January 2010. Isn’t this cheating? Well, yes; it’s like telling a small
fib or a white lie.
The reason a business would do some window dressing is to improve the
cash balance in its ending balance sheet. A business knows that when its
creditors and shareowners read its ending balance sheet they pay particular
attention to how its cash balance stacks up against its liabilities. Also, keeping
the books open for a few days (only for cash collections of accounts receivable)
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makes the company’s ending accounts receivable balance appear to be more
under control because the balance is a smaller percent of total sales for the
year. This gives the impression that the credit terms extended to customers
are under good management, and the ending balance of accounts receivable
is not too large (which would indicate that too many customers are late in
paying their amounts owed the business).
Accounts receivable balance
One reason the ending balance of accounts receivable is lower is explained in
the previous section: Company A did some window dressing. But there are
two other reasons as well:
Company C waits a little longer to record sales made on credit than Com-
pany A, to be more certain that all aspects of delivering products and
the acceptance by customers are finalized and there is little chance of the
products being returned by the customers. This delay in recording sales
causes its accounts receivable balance to be slightly lower, because at
December 31, 2009 it had not yet recorded some credit sales that were
still in the process of final acceptance by the customers.
Businesses should be consistent from year to year regarding when they
record sales. For some businesses, the timing of recording sales revenue
is a major problem — especially when the final acceptance by the cus-
tomer depends on performance tests or other conditions that must be
satisfied. Some businesses engage in channel stuffing by forcing their
dealers or customers to take delivery of more products than they
ordered. A good rule to follow is to read the company’s footnote in its
financial statements that explains its revenue recognition method, and
see whether there is anything unusual about it. If the footnote is vague,
be careful — be very careful!
If products are returnable and the deal between the seller and buyer
does not satisfy normal conditions for a completed sale, the recording of
sales revenue should be postponed until the return privilege no longer
exists. For example, some products are sold on approval, which means
the customer takes the product and tries it out for a few days or longer
to see if the customer really wants it.
Company C is stricter about writing off a customer’s past due balance as
uncollectible. After it has made a reasonable effort to collect the debt but
a customer still hasn’t sent a check, Company C writes off the balance as
a bad debts expense. It decreases the past due accounts receivable balance
to zero and records an expense of the same amount. Company A, in con-
trast, waits much longer to write off a customer’s past due amount. In the
long run Company A still has to write off a customer’s debt if it has been
outstanding too long — but it waits until the last minute to make the
write-off entry.
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Inventory and cost of goods sold expense
The business in the example sells products, mainly to other businesses. A
business either manufactures the products its sells or purchases products for
resale to customers. (Chapter 11 explains the determination of product costs
for manufacturing businesses.) At this point it is not too important whether the
business manufactures or purchases the products it sells. What is important is
that the costs of its products have drifted upward over time because of inflation
and other factors. Therefore, the business has had to increase its sales prices to
keep up with the product cost increases.
There are two ways to deal with product cost inflation:
Push the higher, most recent costs through to cost of goods sold
expense as soon as possible.
Follow the chronological order of acquisition and let the older product
costs go out to cost of goods sold before the more recent product costs
are charged out to expense.
I explain these two methods in the later section “Calculating Cost of Goods
Sold and Cost of Inventory.”
Company A uses the method that minimizes cost of goods sold expense and
maximizes cost of ending inventory. Company C, in contrast, uses the method
that maximizes cost of goods sold expense and minimizes cost of ending inven-
tory. Note in Figure 7-1 that Company C’s ending inventory is $700,000 lower and
its cost of goods sold expense for the year is $280,000 higher. Over the years its
cost of goods sold expense has been charged with $700,000 that Company A has
not yet charged to the expense. Company C’s cost of goods sold expense in 2009
is $280,000 higher than Company A; the remainder of the $700,000 cumulative
difference in inventory cost is attributable to prior years.
Actually, not all of the cumulative $700,000 inventory difference and not all of
the $280,000 cost of goods sold difference in 2009 is due to the different inven-
tory and cost of goods sold expense methods used by the companies. Part of
each difference is due to how each company applies, and puts into practice,
the lower of cost or market (LCM) accounting rule. I explain this topic later in
the chapter; see the section “Recording Inventory Losses under the Lower of
Cost or Market (LCM) Rule.” Company C is tougher and stricter in implement-
ing the LCM procedure. It records higher amounts of inventory write-down at
the end of the year, which increases its cost of goods sold expense (or some
other expense account).
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Cost of fixed assets, accumulated
depreciation, and depreciation expense
All accountants agree that the costs of long-term operating assets that have
limited useful lives to a business should be spread out over those predicted
useful lives instead of being charged off entirely to expense in the year of acqui-
sition. These long-lived operating assets are labeled property, plant and equip-
ment in Figure 7-1, and less formally are called fixed assets. (The cost of land
owned by a business is not depreciated because land is a property right that
has perpetual life.) The allocation of the cost of a fixed asset over its estimated
useful economic life to a business is called depreciation. The principle of depre-
ciation is beyond criticism, but the devil is in the details.
The original costs of fixed assets should theoretically include certain costs in
addition to their purchase or construction costs. However, in actual practice
these fringe costs are not always included in the original cost of fixed assets.
For example, it is theoretically correct to include installation costs of putting
into place and connecting electrical and other power sources of heavy machin-
ery and equipment. It is correct to include the cost of painting logos on the sides
of delivery trucks. The cost of an older building just bought by a business should
include the preparatory clean-up costs and the safety inspection cost. But, as I
say, in practice a business may not include such additional costs in the original
costs of its fixed assets.
Company A does include most of these additional costs in the original costs
of its fixed assets, which means that the cost balances of its fixed assets are
higher. These additional costs are not expensed immediately but are included
in the total amount to be depreciated over future years. Also, Company A uses
what is called straight-line depreciation, which spreads out the cost of a fixed
asset evenly over the years of its useful life to the business.
In contrast, Company C does not include any costs other than purchase or
construction costs in its fixed asset accounts, which means these additional
costs are charged to expense immediately and are not delayed to future years.
Also, and most importantly, Company C uses what is called accelerated depreci-
ation for allocating the cost of its fixed assets to expense. Higher amounts are
allocated to early years and smaller amounts to later years. Only the original
cost is allocated to expense over time, but there is a front-end loading on the
early years using accelerated depreciation.
I explain the straight-line and accelerated depreciation methods later in the
chapter (see the section “Appreciating Depreciation Methods”). For now, note in
Figure 7-1 that the original cost of Company C’s property, plant, and equipment
is $225,000 smaller than Company A’s, and its accumulated depreciation balance
is $425,000 higher. The company’s depreciation expense is not disclosed as a
separate expense in the income statement shown in Figure 7-1. We can’t tell
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from the information in the income statement the amount of 2009 deprecia-
tion expense between the two companies. But Company C’s depreciation
expense for the year is higher because the business has been growing and
increasing its investments in new fixed assets.
Accrued expenses payable
liability balance
Most products are sold with expressed or implied warranties and guarantees.
Even if good quality controls are in place, some products sold by a business
don’t perform up to promises, and the customers want the problems fixed. A
business should estimate the cost of these future obligations and record this
amount as an expense in the same period that the goods are sold (along with
the cost of goods sold expense, of course); it should not wait until customers
actually return products for repair or replacement. After being in business a
few years, a company can forecast with reasonable accuracy the percent of
products sold that will be returned for repair or replacement under the guar-
antees and warranties offered to its customers. However, brand new products
that have no track record may be a serious problem in this regard.
Company A does not make the effort to estimate future product warranty and
guaranty costs; it records these costs on a when-paid basis. It waits until it
actually incurs these costs to record an expense. The company has decided
that the understatement of its liabilities is not significant.
Company C, on the other hand, takes the high road and goes to the trouble to
estimate the amount of future costs for the products it has already sold.
Therefore, its accrued expenses payable liability account is $65,000 higher
than Company A’s. The difference of this particular expense for the year
between the two versions is a bit tricky to determine. (I won’t delve into
details here.) Furthermore, the $65,000 higher amount of the liability includes
accruals that a business records to recognize other unpaid expenses at the
end of the year.
A typical business at the end of the year has certain costs that will not be paid
until sometime in the future — costs that are an outgrowth of the current
year’s operating activities. For example, a business should accrue (calculate
and record) the amount it owes to its employees for vacation and sick pay. A
business may not have received its property tax bill yet, but it should estimate
the amount of tax to be assessed and record the proper portion of the annual
property tax to the current year. One expense accrual is easy to calculate: the
accumulated interest on notes payable that hasn’t been paid yet at the end of
the year. Calculating this amount is straightforward because the amount bor-
rowed and the interest rate are definite.
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Wrapping things up
In Figure 7-1, you should note that the accounts payable liability is the same in
both versions. These short-term operating liabilities are definite amounts that
have definite due dates. There are no accounting choices or options in record-
ing accounts payable. Also in Figure 7-1, I keep the income tax payable the same
in both versions. If the business had used different accounting methods for
determining its annual taxable income, its annual income tax expense would
have been different, and the ending amount of its income tax payable liability
might be a little different. This point is not that important to go into here.
Figure 7-1 presents just one alternative scenario regarding how different
accounting methods cause differences in the financial statements of a com-
pany. The differences in Figure 7-1 are not unrealistic in my opinion. But to be
frank, my alternative numbers are no more than educated guesses. Businesses
keep only one set of books. Even a business itself doesn’t know how different
its financial statements would be if it had used different accounting methods.
Financial report readers can read the footnotes to determine whether liberal
or conservative accounting methods are being used, but footnotes are not
easy to read. Plus, they don’t allow you to determine what profit would have
been and how the balance sheet amounts would be different if alternative
accounting methods had been used.
So, why don’t I include the statement of cash flows in the financial statements
comparison in Figure 7-1? Generally speaking, this financial statement, which
summarizes cash flows for the year, is the same no matter which accounting
methods are used by a business. Cash flows are recorded when cash is actu-
ally received or disbursed; cash flow entries don’t depend on which accrual-
based accounting methods are used. However, a business may engage in window
dressing at the end of the year (see the earlier section “Cash balance”). In this sit-
uation, the cash flow from operating activities is higher because the business has
recorded cash flows that actually did not take place until after the end of its
accounting year.
If you own or manage a business, I strongly encourage you to get involved in
deciding which accounting methods to use for measuring your profit and how
these methods are actually implemented. Chapter 16 explains that a manager
has to answer questions about his or her financial reports on many occasions,
so you should know which accounting methods are used to prepare the finan-
cial statements. However, “get involved” does not mean manipulating the
amounts of sales revenue and expenses recorded in the year — to make profit
look higher, to smooth fluctuations in profit from year to year, or to improve
the amounts of assets and liabilities reported in your ending balance sheet.
You shouldn’t even consider doing these things. (Of course these manipula-
tions go on in the real world. Some people also drive under the influence, but
that doesn’t mean you should.)
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Calculating Cost of Goods Sold
and Cost of Inventory
One main accounting decision that must be made by companies that sell
products is which method to use for recording the cost of goods sold expense,
which is the sum of the costs of the products sold to customers during the
period. You deduct cost of goods sold from sales revenue to determine gross
margin — the first profit line on the income statement (refer to Figure 7-1). Cost
of goods sold is a very important figure, because if gross margin is wrong,
bottom-line profit (net income) is wrong.
A business acquires products either by buying them (retailers and distribu-
tors) or by producing them (manufacturers). Chapter 11 explains how manu-
facturers determine product cost; for retailers, product cost is simply purchase
cost. (Well, it’s not entirely this simple, but you get the point.) Product cost is
entered in the inventory asset account and is held there until the products are
sold.
When a product is sold, but not before, the product cost is taken out of inven-
tory and recorded in the cost of goods sold expense account. You must be
absolutely clear on this point. Suppose that you clear $700 from your salary
for the week and deposit this amount in your checking account. The money
stays in your bank account and is an asset until you spend it. You don’t have
an expense until you write a check.
Likewise, not until the business sells products does it have a cost of goods
sold expense. When you write a check, you know how much it’s for — you
have no doubt about the amount of the expense. But when a business with-
draws products from its inventory and records cost of goods sold expense,
the expense amount is in some doubt. The amount of expense depends on
which accounting method the business selects.
A business can choose between two opposite methods to record its cost of
goods sold and the cost balance that remains in its inventory asset account:
The first-in, first-out (FIFO) cost sequence
The last-in, first-out (LIFO) cost sequence
Other methods are acceptable, but these two are the primary options. Caution:
Product costs are entered in the inventory asset account in the order acquired,
but they are not necessarily taken out of the inventory asset account in this
order. The different methods refer to the order in which product costs are taken
out of the inventory asset account. You may think that only one method is
appropriate — that the sequence in should be the sequence out. However,
generally accepted accounting principles (GAAP) permit alternative methods.
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The choice between the FIFO and LIFO accounting methods does not depend
on the actual physical flow of products. Generally speaking, products are
delivered to customers in the order the business bought or manufactured the
products — one reason being that a business does not want to keep products
in inventory too long because the products might deteriorate or show their
age. So, products generally move in and move out of inventory in a first-in,
first-out sequence. Nevertheless, a business may choose the last-in, first-out
accounting method.
The FIFO (first-in, first-out) method
With the FIFO method, you charge out product costs to cost of goods sold
expense in the chronological order in which you acquired the goods. The pro-
cedure is that simple. It’s like the first people in line to see a movie get in the
theater first. The ticket-taker collects the tickets in the order in which they
were bought.
Suppose that you acquire four units of a product during a period, one unit at
a time, with unit costs as follows (in the order in which you acquire the
items): $100, $102, $104, and $106. By the end of the period, you have sold
three of these units. Using FIFO, you calculate the cost of goods sold expense
as follows:
$100 + $102 + $104 = $306
In short, you use the first three units to calculate cost of goods sold expense.
The cost of the ending inventory asset, then, is $106, which is the cost of the
most recent acquisition. The $412 total cost of the four units is divided between
$306 cost of goods sold expense for the three units sold and the $106 cost of the
one unit in ending inventory. The total cost has been accounted for; nothing has
fallen between the cracks.
FIFO works well for two reasons:
Products generally move into and out of inventory in a first-in, first-out
sequence: The earlier acquired products are delivered to customers
before the later acquired products are delivered, so the most recently
purchased products are the ones still in ending inventory to be delivered
in the future. Using FIFO, the inventory asset reported in the balance
sheet at the end of the period reflects recent purchase (or manufacturing)
costs, which means the balance in the asset is close to the current
replacement costs of the products.
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