Tracy John A. Accounting for Dummies
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Table of Contents
Introduction..................................................................1
About This Book...............................................................................................1
Conventions Used in This Book .....................................................................2
What You’re Not To Read................................................................................4
Foolish Assumptions .......................................................................................5
How This Book Is Organized...........................................................................6
Part I: Opening the Books on Accounting ...........................................6
Part II: Figuring Out Financial Statements...........................................7
Part III: Accounting in Managing a Business.......................................7
Part IV: Preparing and Using Financial Reports .................................8
Part V: The Part of Tens.........................................................................8
Glossary...................................................................................................8
Icons Used in This Book..................................................................................9
Where to Go from Here....................................................................................9
Part I: Opening the Books on Accounting ......................11
Chapter 1: Accounting: The Language of Business,
Investing, Finance, and Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13
Accounting Is Not Just for Accountants......................................................14
Affecting both insiders and outsiders ...............................................14
Overcoming the stereotypes of accountants....................................15
Relating accounting to your personal financial life .........................16
Looking for Accounting in All the Right Places..........................................17
Taking a Peek into the Back Office...............................................................18
Focusing on Transactions.............................................................................21
Taking the Pulse of a Business: Financial Statements...............................23
Meeting the balance sheet and the accounting equation ...............24
Reporting profit and loss, and cash flows.........................................25
Respecting the importance of this trio..............................................26
Considering Accounting Careers .................................................................27
Certified public accountant (CPA) .....................................................27
The controller: The chief accountant in an organization................28
A springboard to other careers ..........................................................29
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Chapter 2: Financial Statements and Accounting Standards . . . . . . .31
Introducing the Information Content of Financial Statements.................32
Setting up the business example........................................................32
The income statement.........................................................................33
The balance sheet ................................................................................35
The statement of cash flows ...............................................................37
How Profit and Cash Flow from Profit Differ ..............................................40
Gleaning Key Information from Financial Statements...............................41
How’s profit performance?..................................................................41
Is there enough cash? ..........................................................................42
Can you trust the financial statement numbers?
Are the books cooked?.....................................................................43
Why no cash distribution from profit? ..............................................44
Keeping in Step with Accounting and Financial Reporting Standards....45
Recognizing U.S. standards.................................................................45
Getting to know the U.S. standard setters ........................................47
Going worldwide...................................................................................48
Noting a divide between public and private companies.................49
Recognizing how income tax methods influence
accounting methods.........................................................................50
Following the rules and bending the rules........................................51
Chapter 3: Bookkeeping and Accounting Systems . . . . . . . . . . . . . . . .53
Bookkeeping and Beyond..............................................................................54
Pedaling Through the Bookkeeping Cycle..................................................54
Managing the Bookkeeping and Accounting System.................................59
Categorize your financial information: The chart of accounts.......59
Standardize source document forms and procedures ....................61
Hire competent, trained personnel....................................................62
Enforce strong — I mean strong! — internal controls.....................63
Complete the process with end-of-period procedures....................65
Leave good audit trails ........................................................................66
Look out for unusual events and developments..............................66
Design truly useful reports for managers .........................................67
Double-Entry Accounting for Single-Entry Folks........................................68
Juggling the Books to Conceal Embezzlement and Fraud ........................70
Using Accounting Software...........................................................................72
Part II: Figuring Out Financial Statements....................75
Chapter 4: Reporting Revenue, Expenses, and the Bottom Line . . . . .77
Presenting a Typical Income Statement......................................................78
Taking care of some housekeeping details .......................................79
Your job: Asking questions!.................................................................81
Finding Profit ..................................................................................................84
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Getting Particular about Assets and Liabilities..........................................86
Making sales on credit → Accounts receivable asset......................86
Selling products → Inventory asset...................................................87
Prepaying operating costs → Prepaid expense asset......................87
Fixed assets → Depreciation expense ...............................................88
Unpaid expenses → Accounts payable, accrued expenses
payable, and income tax payable ..................................................89
Summing Up the Financial Effects of Profit.................................................91
Reporting Extraordinary Gains and Losses................................................92
Closing Comments .........................................................................................95
Chapter 5: Reporting Assets, Liabilities, and Owners’ Equity . . . . . . .97
Understanding That Transactions Drive the Balance Sheet.....................98
Presenting a Balance Sheet.........................................................................100
Kicking balance sheets out into the real world..............................102
Internal balance sheets............................................................103
External balance sheets...........................................................103
Judging solvency ................................................................................103
Current (short-term) assets ....................................................104
Current (short-term) liabilities ...............................................104
Current ratio..............................................................................105
Preparing multiyear statements.......................................................105
Coupling the Income Statement and Balance Sheet................................106
Sizing up assets and liabilities..........................................................108
Sales revenue and accounts receivable...........................................109
Cost of goods sold expense and inventory.....................................109
Fixed assets and depreciation expense...........................................110
SG&A expenses and their three balance sheet accounts..............111
Intangible assets and amortization expense ..................................112
Debt and interest expense ................................................................113
Income tax expense and income tax payable.................................114
Net income and cash dividends (if any)..........................................114
Financing a Business....................................................................................115
Costs and Other Balance Sheet Values......................................................117
Chapter 6: Reporting Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .119
Seeing the Big Picture of Cash Flows.........................................................119
Meeting the Statement of Cash Flows .......................................................122
Dissecting the Difference Between Cash Flow and Net Income.............125
Accounts receivable change.............................................................126
Inventory change................................................................................127
Prepaid expenses change..................................................................127
The depreciation factor.....................................................................128
Changes in operating liabilities ........................................................129
Putting the cash flow pieces together .............................................130
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Sailing Through the Rest of the Statement of Cash Flows......................131
Investing activities .............................................................................131
Financing activities ............................................................................132
Trying to Pin Down “Free Cash Flow”........................................................134
Being an Active Reader ...............................................................................135
Chapter 7: Choosing Accounting Methods:
Different Strokes for Different Folks . . . . . . . . . . . . . . . . . . . . . . . . . . .137
Reading Statements with a Touch of Skepticism .....................................138
Recognizing a business’s bias...........................................................138
Contrasting aggressive and conservative numbers.......................139
Figuring Out Why Financial Statements Differ .........................................141
Cash balance.......................................................................................142
Accounts receivable balance............................................................143
Inventory and cost of goods sold expense .....................................144
Cost of fixed assets, accumulated depreciation,
and depreciation expense .............................................................145
Accrued expenses payable liability balance...................................146
Wrapping things up............................................................................147
Calculating Cost of Goods Sold and Cost of Inventory ...........................148
The FIFO (first-in, first-out) method.................................................149
The LIFO (last-in, first-out) method .................................................150
The average cost method..................................................................152
Recording Inventory Losses under the Lower of Cost
or Market (LCM) Rule ..............................................................................153
Appreciating Depreciation Methods..........................................................154
Scanning the Expense Horizon...................................................................156
Part III: Accounting in Managing a Business...............159
Chapter 8: Deciding the Legal Structure for a Business . . . . . . . . . .161
Studying the Sources of Business Capital.................................................162
Deciding on debt ................................................................................162
Tapping two sources of owners’ equity...........................................163
Recognizing the Legal Roots of Business Entities ...................................165
Incorporating a Business ............................................................................165
Issuing stock shares...........................................................................166
Offering different classes of stock shares .......................................167
Determining the market value of stock shares...............................169
Keeping alert for dilution of share value.........................................170
Recognizing conflicts between stockholders and managers........172
Considering Partnerships and Limited Liability Companies..................173
Going It Alone: Sole Proprietorships .........................................................176
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Choosing the Right Legal Structure for Income Tax................................178
C corporations....................................................................................179
S corporations ....................................................................................180
Partnerships and LLCs ......................................................................181
Chapter 9: Analyzing and Managing Profit . . . . . . . . . . . . . . . . . . . . . .183
Helping Managers Do Their Jobs ...............................................................184
Following the organizational structure............................................184
Centering on profit centers...............................................................185
Presenting a P&L Template.........................................................................186
Reporting operating expenses on the object
of expenditure basis.......................................................................187
Reporting operating expenses on their cost behavior basis........187
Separating variable and fixed expenses ..........................................189
Variable expenses.....................................................................189
Fixed expenses..........................................................................190
Stopping at operating earnings ........................................................191
Focusing on margin — the catalyst of profit...................................192
Answering Two Critical Profit Questions..................................................192
How did you make profit? .................................................................192
How did you increase profit? ............................................................194
Looking More Closely at the Profit Center P&L Report ..........................195
Sales volume .......................................................................................195
Sales revenue ......................................................................................195
Cost of goods sold..............................................................................196
Variable operating expenses.............................................................196
Fixed operating expenses..................................................................197
Using the P&L Template for Decision-Making Analysis...........................198
Tucking Away Some Valuable Lessons ......................................................199
Recognize the leverage effect caused by fixed
operating expenses ........................................................................199
Don’t underestimate the impact of small
changes in sales price ....................................................................200
Know your options for improving profit .........................................201
Closing with a Boozy Example....................................................................202
Chapter 10: Financial Planning, Budgeting, and Control . . . . . . . . . .205
Exploring the Reasons for Budgeting ........................................................206
Modeling reasons for budgeting.......................................................207
Planning reasons for budgeting........................................................208
Management control reasons for budgeting...................................209
Additional benefits of budgeting, and a note of caution ...............210
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Realizing That Not Everyone Budgets.......................................................212
Avoiding budgeting ............................................................................212
Relying on internal accounting reports...........................................213
Making reports useful for management control ...................213
Making reports useful for decision-making...........................213
Making reports clear and straightforward ............................214
Watching Budgeting in Action ....................................................................214
Developing your profit strategy and budgeted profit report........216
Budgeting cash flow for the coming year........................................218
Considering Capital Expenditures and Other Cash Needs .....................220
Chapter 11: Cost Concepts and Conundrums . . . . . . . . . . . . . . . . . . . .223
Looking down the Road to the Destination of Costs...............................224
Are Costs Really That Important?..............................................................225
Becoming More Familiar with Costs..........................................................226
Direct versus indirect costs ..............................................................228
Fixed versus variable costs...............................................................229
Relevant versus irrelevant costs......................................................229
Actual, budgeted, and standard costs.............................................230
Product versus period costs.............................................................231
Assembling the Product Cost of Manufacturers ......................................232
Minding manufacturing costs ...........................................................232
Classifying costs properly.................................................................234
Calculating product cost ...................................................................236
Examining fixed manufacturing costs and production capacity......237
The burden rate........................................................................237
Idle capacity ..............................................................................238
The effects of increasing inventory........................................238
Puffing Profit by Excessive Production .....................................................240
Shifting fixed manufacturing costs to the future............................240
Cranking up production output........................................................241
Being careful when production output is out
of kilter with sales volume.............................................................243
Part IV: Preparing and Using Financial Reports...........245
Chapter 12: Getting a Financial Report Ready for Release . . . . . . . .247
Recognizing Management’s Role................................................................248
Keeping in Mind the Purpose of Financial Reporting..............................249
Staying on Top of Accounting and Financial Reporting Standards .......250
Making Sure Disclosure Is Adequate .........................................................251
Footnotes: Nettlesome but needed..................................................252
Other disclosures in financial reports.............................................254
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Putting a Spin on the Numbers (But Not Cooking the Books) ...............256
Window dressing for fluffing up the cash balance .........................257
Sanding the rough edges off profit...................................................258
The pressure on public companies........................................259
Compensatory effects ..............................................................259
Two profit histories..................................................................260
Management discretion in the timing
of revenue and expenses......................................................261
Going Public or Keeping Things Private ...................................................263
Reports from publicly owned companies .......................................263
Reports from private businesses .....................................................264
Dealing with Information Overload............................................................265
Browsing based on your interests....................................................265
Recognizing condensed versions.....................................................266
Using other sources of business information.................................267
Statement of Changes in Owners’ Equity..................................................267
Chapter 13: How Lenders and Investors Read a Financial Report . . . .271
Knowing the Rules of the Game .................................................................272
Becoming a More Savvy Investor...............................................................273
Comparing Private and Public Business Financial Reports....................274
Analyzing Financial Statements with Ratios.............................................276
Gross margin ratio..............................................................................278
Profit ratio ...........................................................................................280
Earnings per share (EPS), basic and diluted...................................280
Price/earnings (P/E) ratio .................................................................282
Dividend yield.....................................................................................283
Book value and book value per share..............................................284
Return on equity (ROE) ratio............................................................286
Current ratio .......................................................................................287
Acid-test ratio .....................................................................................287
Return on assets (ROA) ratio and financial leverage gain ............288
Frolicking Through the Footnotes .............................................................289
Checking for Ominous Skies in the Auditor’s Report..............................291
Chapter 14: How Business Managers Use a Financial Report . . . . .293
Building on the Foundation of the External Financial Statements ........294
Seeking out problems and opportunities........................................294
Avoiding information overload.........................................................294
Gathering Financial Condition Information ..............................................295
Cash......................................................................................................296
Accounts receivable...........................................................................297
Inventory .............................................................................................298
Prepaid expenses ...............................................................................298
Fixed assets and accumulated depreciation...................................299
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Accounts payable...............................................................................300
Accrued expenses payable ...............................................................300
Income tax payable ............................................................................301
Interest-bearing debt..........................................................................302
Owners’ equity....................................................................................303
Culling Profit Information............................................................................303
Margin: The catalyst of profit ...........................................................304
Sales revenue and expenses .............................................................305
Digging into Cash Flow Information...........................................................306
Distinguishing investing and financing cash flows
from operating cash flows.............................................................307
Managing operating cash flows ........................................................308
Chapter 15: Audits and Accounting Fraud . . . . . . . . . . . . . . . . . . . . . . .311
Exploring the Need for Audits....................................................................312
What’s in an Auditor’s Report ....................................................................313
The clean (unqualified) opinion.......................................................313
Other kinds of audit opinions...........................................................314
Who’s Who in the World of Audits.............................................................315
Standing Firm When Companies Massage the Numbers, or Not ...........316
Discovering Fraud, or Not...........................................................................318
Who Audits the Auditors?...........................................................................319
Part V: The Part of Tens .............................................321
Chapter 16: Ten Accounting Tips for Managers . . . . . . . . . . . . . . . . . .323
Reach Break-Even, and Then Rake in Profit..............................................323
Set Sales Prices Right...................................................................................324
Distinguish Profit from Cash Flow .............................................................325
Call the Shots on Accounting Policies.......................................................326
Budget Wisely...............................................................................................327
Get the Accounting Information You Need ...............................................328
Tap into Your CPA’s Expertise.....................................................................329
Critically Review Your Fraud Controls ......................................................329
Lend a Hand in Preparing Your Financial Reports...................................330
Sound Like a Pro in Talking about Your Financial Statements ...............331
Chapter 17: Ten Tips for Reading a Financial Report . . . . . . . . . . . . .333
Get in the Right Frame of Mind ..................................................................333
Decide What to Read ...................................................................................335
Improve Your Accounting Savvy................................................................336
Judge Profit Performance............................................................................336
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Track Profit into Earnings per Share .........................................................337
Confront Extraordinary Gains and Losses................................................338
Compare Cash Flow and Profit...................................................................339
Look for Signs of Financial Distress...........................................................340
Recognize the Risks of Restatement and Fraud.......................................340
Remember the Limits of Financial Reports ..............................................341
Glossary: Slashing Through the Accounting
Jargon Jungle............................................................343
Index........................................................................357
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