Tracy John A. Accounting for Dummies
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What is the cash flow from the profit or loss for the period?
Did the business reinvest all its profit or distribute some of the profit to
owners?
Does the business have enough capital for future growth?
People read a financial report like a road map — to point the way and check
how the trip is going. Managing and putting money in a business is a financial
journey. A manager is like the driver and must pay attention to all the road signs;
investors and lenders are like the passengers who watch the same road
signs. Some of the most important road signs are the ratios between sales rev-
enue and expenses and their related assets and liabilities in the balance sheet.
In short, the purpose of financial reporting is to deliver important information
to the lenders and shareowners of the business that they need and are entitled
to receive. Financial reporting is part of the essential contract between a busi-
ness and its lenders and investors. This contract can be stated in a few words:
Give us your money, and we’ll give you the information you need to know
regarding how we’re doing with your money.
Financial reporting is governed by statutory and common law, and it should
be done according to ethical standards. Unfortunately, financial reporting
sometimes falls short of both legal and ethical standards.
Businesses assume that the readers of the financial statements and other
information in their financial reports are fairly knowledgeable about business
and finance in general, and understand basic accounting terminology and
measurement methods in particular. Financial reporting standards and prac-
tices, in other words, take a lot for granted about readers of financial reports.
Don’t expect to find friendly hand holding and helpful explanations in finan-
cial reports. I don’t mean to put you off, but reading financial reports is not
for sissies. You need to sit down with a cup of coffee and be ready for serious
concentration.
Staying on Top of Accounting and
Financial Reporting Standards
Standards and requirements for accounting and financial reporting don’t stand
still. For many years, changes in accounting and financial reporting standards
moved like glaciers — slowly and not too far. But, just like the climate has warmed,
the activity of the accounting and financial reporting authorities has warmed up.
In fact, it’s hard to keep up with the changes.
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Without a doubt, the rash of accounting and financial reporting scandals over
the last two decades or so was one major reason for the step-up in activity
by the standard setters. The Enron accounting fraud not only brought down a
major international CPA firm (Arthur Andersen) but also led to passage of the
Sarbanes-Oxley Act of 2002 and its demanding requirements on public compa-
nies regarding establishing and reporting on internal controls to prevent
financial reporting fraud.
The other major reason for the heightened pace of activity by the standard set-
ters is, in my opinion, the increasing complexity of doing business. When you
look at how business is being conducted these days, you find more and more
complexity — for example, the use of financial derivative contracts and instru-
ments. The legal exposure of businesses has expanded, especially in respect to
environmental laws and regulations. There is a move toward the internationaliza-
tion of accounting and financial reporting standards, as I discuss in Chapter 2.
In my view, the standard setters should be given a lot of credit for their attempts
to deal with the problems that have emerged in recent decades and for trying to
prevent repetition of the problems. But the price of doing so has been a rather
steep increase in the range and rapidity of changes in accounting and financial
reporting standards and requirements. Top-level managers of businesses have
to make sure that the top-level financial and accounting officers of the business
are keeping up with these changes and make sure that their financial reports
follow all current rules and regulations. Managers lean heavily on their chief
financial officers and controllers for keeping in full compliance with accounting
and financial reporting standards.
Making Sure Disclosure Is Adequate
The financial statements are the backbone of a financial report. In fact, a
financial report is not deserving of the name if the three primary financial state-
ments are not included. But a financial report is much more than just the finan-
cial statements; a financial report needs disclosures. Of course, the financial
statements themselves provide disclosure of important financial information
about the business. The term disclosures, however, usually refers to additional
information provided in a financial report.
The CEO of a public corporation, the president of a private corporation, or the
managing partner of a partnership has the primary responsibility to make sure
that the financial statements have been prepared according to U.S. generally
accepted accounting principles (GAAP) — or to international accounting stan-
dards, as the case may be — and that the financial report provides adequate dis-
closure. He or she works with the chief financial officer and controller of the
business to make sure that the financial report meets the standard of adequate
disclosure. (Many smaller businesses hire an independent CPA to advise them
on their financial reports.)
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For a quick survey of disclosures in financial reports, the following distinctions
are helpful:
Footnotes provide additional information about the basic figures included
in the financial statements. Virtually all financial statements need footnotes
to provide additional information for several of the account balances.
Supplementary financial schedules and tables to the financial state-
ments provide more details than can be included in the body of financial
statements.
A wide variety of other information is presented, some of which is
required if the business is a public corporation subject to federal regula-
tions regarding financial reporting to its stockholders. Other information
is voluntary and not strictly required legally or according to GAAP.
Footnotes: Nettlesome but needed
Footnotes appear at the end of the primary financial statements. Within the
financial statements, you see references to particular footnotes. And at the
bottom of each financial statement, you find the following sentence (or words to
this effect): “The footnotes are integral to the financial statements.” You should
read all footnotes for a full understanding of the financial statements, although I
should mention that some footnotes are dense and technical. For example, read
the footnote that explains how a public corporation put the value on its man-
agement stock options in order to record the expense for this component of
management compensation. Then take two aspirin to get rid of your headache.
Footnotes come in two types:
One or more footnotes are included to identify the major accounting
policies and methods that the business uses. (Chapter 7 explains that a
business must choose among alternative accounting methods for recording
revenue and expenses, and for their corresponding assets and liabilities.)
The business must reveal which accounting methods it uses for booking
its revenue and expenses. In particular, the business must identify its cost
of goods sold expense (and inventory) method and its depreciation
methods. Some businesses have unusual problems regarding the timing
for recording sales revenue, and a footnote should clarify their revenue
recognition method. Other accounting methods that have a material
impact on the financial statements are disclosed in footnotes as well.
Other footnotes provide additional information and details for many
assets and liabilities. For example, during the asbestos lawsuits that went
on for many years, the businesses that manufactured and sold these
products included long footnotes describing the lawsuits. Details about
stock option plans for executives are the main type of footnote to the
capital stock account in the owners’ equity section of the balance sheet.
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Some footnotes are always required; a financial report would be naked without
them. Deciding whether a footnote is needed (after you get beyond the obvious
ones disclosing the business’s accounting methods) and how to write the foot-
note is largely a matter of judgment and opinion, although certain standards
apply:
The Financial Accounting Standards Board (FASB) and its predecessors
have laid down many disclosure standards for businesses reporting
under U.S. generally accepted accounting principles.
The SEC mandates disclosure of a broad range of information for publicly
owned corporations.
International businesses abide by disclosure standards adopted by
the International Accounting Standards Board (IASB).
All this is quite a smorgasbord of disclosure requirements, to say the least.
One problem that most investors face when reading footnotes — and, for that
matter, many managers who should understand their own footnotes but find
them a little dense — is that footnotes often deal with complex issues (such
as lawsuits) and rather technical accounting matters. Let me offer you one
footnote that highlights the latter point. For your reading pleasure, a footnote
from the 2003 annual 10-K report of Caterpillar, Inc. filed with the SEC. (Just
try to make sense of it — I dare you.)
D. Inventories: Inventories are stated at the lower of cost or market. Cost is
principally determined using the last-in, first-out (LIFO) method. The value
of inventories on the LIFO basis represented about 75% of total inventories
at December 31, 2006, and about 80% of total inventories at December 2005,
and 2004.
If the FIFO (first-in, first out) method had been in use, inventories would
have been $2,403 million, $2,345 million and $2,124 million higher than
reported at December 31, 2006, 2005, and 2004, respectively.
Yes, these dollar amounts are in millions of dollars. But what does this mean?
Caterpillar’s inventory cost value for its inventories at the end of 2006 would
have been $2.4 billion higher if the FIFO accounting method had been used. In
other words, this particular asset would have been reported at a 38 percent
higher value than the $6.4 billion reported in its balance sheet at year-end
2006. Of course, you have to have some idea of the difference between the
two accounting methods — LIFO and FIFO — to make sense of this note (see
Chapter 7).
You may wonder how different the company’s annual profits would have been if
an alternative accounting method had been in use. A business’s managers can
ask its accounting department to do this analysis. But, as an outside investor,
you would have to compute these amounts yourself (assuming you had all the
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necessary information). Businesses disclose which accounting methods they
use, but they do not disclose how different annual profits would have been if
an alternative method had been used.
Other disclosures in financial reports
The following discussion includes a fairly comprehensive list of the various
types of disclosures (other than footnotes) found in annual financial reports
of publicly owned businesses. A few caveats are in order. First, not every
public corporation includes every one of the following items, although the
disclosures are fairly common. Second, the level of disclosure by private
businesses — after you get beyond the financial statements and footnotes —
is generally much less than in public corporations. Third, tracking the actual
disclosure practices of private businesses is difficult because their annual
financial reports are circulated only to their owners and lenders. (A private
business keeps its financial report as private as possible, in other words.) A
private business may include any or all of the following disclosures, but by
and large it is not required to do so (and, in my experience, very few do).
In addition to the three financial statements and footnotes to the financials,
public corporations typically include the following disclosures in their annual
financial reports to their stockholders:
Cover (or transmittal) letter: A letter from the chief executive of the
business to the stockholders, which usually takes credit for good news
and blames bad news on big government, unfavorable world political
developments, a poor economy, or some other thing beyond manage-
ment’s control. (See the sidebar “Warren Buffett’s annual letter to
Berkshire Hathaway shareholders” for a refreshing alternative.)
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Warren Buffett’s annual letter to Berkshire
Hathaway shareholders
I’d like to call your attention to one notable
exception to the generally self-serving and
slanted letter from a business’s chief executive
officer to its stockholders, which you find in
most annual financial reports. Warren Buffett is
the Chairman of the Board of Berkshire
Hathaway, Inc. He has become very well known
and is called the “Oracle of Omaha.” Mr.
Buffett’s letters are the epitome of telling it like
it is; they are very frank, sometimes with brutal
honesty, and quite humorous in places. You can
go the Web site of the company (www.
berkshirehathaway.com) and download
his most recent letter (and earlier ones if you
like). You’ll learn a lot about his investing philos-
ophy, and the letters are a delight to read even
though they’re relatively long (20+ pages usually).
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Management’s report on internal control over financial reporting: An
assertion by the chief executive officer and chief financial officer regard-
ing their satisfaction with the effectiveness of the internal controls of the
business, which are designed to ensure the reliability of its financial
reports (and to prevent financial and accounting fraud).
Highlights table: A table that presents key figures from the financial
statements, such as sales revenue, total assets, profit, total debt, owners’
equity, number of employees, and number of units sold (such as the number
of vehicles sold by an automobile manufacturer, or the number of “revenue
seat miles” flown by an airline, meaning one airplane seat occupied by a
paying customer for one mile). The idea is to give the stockholder a financial
thumbnail sketch of the business.
Management discussion and analysis (MD&A): Deals with the major
developments and changes during the year that affected the financial
performance and situation of the business. The SEC requires this disclo-
sure to be included in the annual financial reports of publicly owned
corporations.
Segment information: A report of the sales revenue and operating prof-
its (before interest and income tax, and perhaps before certain costs
that cannot be allocated among different segments) for the major divi-
sions of the organization, or for its different markets (international
versus domestic, for example).
Historical summaries: A financial history that extends back beyond the
years (usually three) included in the primary financial statements.
Graphics: Bar charts, trend charts, and pie charts representing financial
conditions; photos of key people and products.
Promotional material: Information about the company, its products, its
employees, and its managers, often stressing an overarching theme for
the year. Most companies use their annual financial report as an adver-
tising opportunity.
Profiles: Information about members of top management and the board
of directors. Of course, everyone appears to be well qualified for his or
her position. Negative information (such as prior brushes with the law)
is not reported.
Quarterly summaries of profit performance and stock share prices:
Shows financial performance for all four quarters in the year and stock
price ranges for each quarter (required by the SEC).
Management’s responsibility statement: A short statement indicating that
management has primary responsibility for the accounting methods used
to prepare the financial statements, for writing the footnotes to the state-
ments, and for providing the other disclosures in the financial report.
Usually, this statement appears near the independent CPA auditor’s report.
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Independent auditor’s report: The report from the CPA firm that performed
the audit, expressing an opinion on the fairness of the financial statements
and accompanying disclosures. Chapter 15 discusses the nature of audits
by CPAs and the audit reports that they present to the board of directors of
the corporation for inclusion in the annual financial report. Public corpora-
tions are required to have audits; private businesses may or may not have
their annual financial reports audited.
Company contact information: Information on how to contact the com-
pany, the Web site address of the company, how to get copies of the
reports filed with the SEC, the stock transfer agent and registrar of the
company, and other information.
No humor allowed: Finally, I should mention that annual financial
reports have virtually no humor — no cartoons, no one-liners, and no
jokes. (Well, the CEO’s letter to shareowners may have some humorous
comments, even when the CEO doesn’t mean to be funny.) I mention this
point to emphasize that financial reports are written in a somber and
serious vein. Many times in reading an annual financial report I have the
reaction that the company should lighten up a little. The tone of most
annual financial reports is that the fate of the Western world depends on
the financial performance of the company. Gimme a break!
Managers of public corporations rely on lawyers, CPA auditors, and their financial
and accounting officers to make sure that everything that should be disclosed in
the business’s annual financial reports is included, and that the exact wording of
the disclosures is not misleading, inaccurate, or incomplete. This is a tall order.
The field of financial reporting disclosure changes constantly.
Both federal and state laws, as well as authoritative accounting standards,
have to be observed in financial report disclosures. Inadequate disclosure is
just as serious as using wrong accounting methods for measuring profit and
for determining values for assets, liabilities, and owners’ equity. A financial
report can be misleading because of improper accounting methods or
because of inadequate or misleading disclosure. Both types of deficiencies
can lead to nasty lawsuits against the business and its managers.
Putting a Spin on the Numbers
(But Not Cooking the Books)
This section discusses two accounting tricks that involve manipulating, or
“massaging,” the accounting numbers. I don’t endorse either technique, but
you should be aware of both. In some situations, the financial statement num-
bers don’t come out exactly the way the business wants. With the connivance
of top management, accountants can use certain tricks of the trade — some
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would say sleight of hand, or shenanigans — to move the numbers closer to
what the business prefers. One trick improves the appearance of the short-
term solvency of the business and the cash balance reported in the balance
sheet at the end of the year. The other device shifts some profit from one
year to the next to report a smoother trend of net income from year to year.
I don’t mean to suggest that all businesses engage in these accounting
machinations — but many do. The extent of use of these unholy schemes
is hard to pin down because no business would openly admit to using them.
The evidence is fairly convincing, however, that many businesses massage
their numbers to some degree. I’m sure you’ve heard the term loopholes
applied to income tax. Well, some loopholes exist in financial statement
accounting as well.
Window dressing for fluffing
up the cash balance
Suppose you manage a business and your controller has just submitted for
your review the preliminary, or first draft, of the year-end balance sheet.
(Chapter 5 explains the balance sheet, and Figure 5-2 shows a complete bal-
ance sheet for a business.) Figure 12-1 shows the current assets and current
liabilities sections of the balance sheet draft.
Wait a minute: a zero cash balance? How can that be? Maybe your business
has been having some cash flow problems and you’ve intended to increase
your short-term borrowing and speed up collection of accounts receivable to
help the cash balance. Folks generally don’t like to see a zero cash balance —
it makes them kind of nervous, to put it mildly, no matter how you try to
cushion it. So what do you do to avoid setting off alarm bells?
Cash
Accounts receivable
Inventory
Prepaid expenses
Current assets
$0
$486,000
$844,000
$72,000
$1,402,000
Accounts payable
Accrued expenses payable
Income tax payable
Short-term notes payable
Current liabilities
$235,000
$187,000
$58,000
$200,000
$680,000
Figure 12-1:
Current
assets and
current
liabilities of
a business,
before
window
dressing.
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Your controller is probably aware of a technique called window dressing, a very
simple method for making the cash balance look better. Suppose your fiscal
year-end is October 31. Your controller takes the cash collections from cus-
tomers paying their accounts receivable that are actually received on November
1, 2, and 3, and records them as if these cash collections had been received on
October 31. After all, the argument can be made that the customers’ checks
were in the mail — that money is yours, as far as the customers are concerned.
Window dressing reduces the amount in accounts receivable and increases
the amount in cash by the same amount — it has absolutely no effect on your
profit figure for the period. It just makes your cash balance look a touch
better. Window dressing can also be used to improve other accounts’ bal-
ances, which I don’t go into here. All of these techniques involve holding the
books open — to record certain events that take place after the end of the
fiscal year (the ending balance sheet date) to make things look better than
they actually were at the close of business on the last day of the year.
Sounds like everybody wins, doesn’t it? You look like you’ve done a better job
as manager, and your lenders and investors don’t panic. Right? Wrong!
Window dressing is deceptive to your creditors and investors, who have
every right to expect that the end of your fiscal year as stated on your finan-
cial reports is truly the end of your fiscal year. I should mention, however,
that when I was in auditing I encountered situations in which a major lender
of the business was fully aware that it had engaged in window dressing. The
lender did not object because it wanted the business to fluff the pillows to
make its balance sheet look better. The loan officer wanted to make the loan
to the business look better. Essentially, the lender was complicit in the
accounting manipulation.
Window dressing could be a dangerous game to play. Window dressing could
be the first step on a slippery slope. A little window dressing today, and
tomorrow, who knows — maybe giving the numbers a nudge now will lead to
more serious accounting deceptions, such as profit smoothing techniques
(discussed next), or even out-and-out accounting fraud. Moreover, when a
business commits some accounting hanky-panky, should the chief executive
of the business brief its directors on the accounting manipulation? Things get
messy, to say the least!
Sanding the rough edges off profit
You should not be surprised when I tell you that business managers are
under tremendous pressure to make profit every year and to keep profit on
the up escalator year after year. Managers strive to make their numbers and
to hit the milestone markers set for the business. Reporting a loss for the
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year, or even a dip below the profit trend line, is a red flag that investors view
with alarm. Everyone likes to see a steady upward trend line for profit; no one
likes to see a profit curve that looks like a roller coaster. Most investors want
a smooth journey and don’t like putting on their investment life preservers.
Managers can do certain things to deflate or inflate profit (net income) recorded
in the year, which are referred to as profit smoothing techniques. Other names
for these techniques are income smoothing and earnings management. Profit
smoothing is like a white lie told for the good of the business and perhaps for
the good of managers as well. Managers know that there is always some noise
in the accounting system. Profit smoothing muffles the noise.
The general view in the financial community is that profit smoothing is not
nearly as serious as cooking the books, or juggling the books. These terms refer
to deliberate, fraudulent accounting practices such as recording sales revenue
that has not happened or not recording expenses that have happened.
Nevertheless, profit smoothing is still very serious and if carried too far could
be interpreted as accounting fraud. Managers can and do go to jail for fraudu-
lent financial statements. I discuss cooking the books in Chapter 15.
The pressure on public companies
Managers of publicly owned corporations whose stock shares are actively
traded are under intense pressure to keep profits steadily rising. Security ana-
lysts who follow a particular company make profit forecasts for the business,
and their buy-hold-sell recommendations are based largely on these earnings
forecasts. If a business fails to meet its own profit forecast or falls short of
stock analysts’ forecasts, the market price of its stock shares usually takes a
hit. Stock option and bonus incentive compensation plans are also strong
motivations for achieving the profit goals set for the business.
The evidence is fairly strong that publicly owned businesses engage in some
degree of profit smoothing. Frankly, it’s much harder to know whether private
businesses do so. Private businesses don’t face the public scrutiny and
expectations that public corporations do. On the other hand, key managers
in a private business may have bonus arrangements that depend on recorded
profit. In any case, business investors and managers should know about
profit smoothing and how it’s done.
Compensatory effects
Most profit smoothing involves pushing some amount of revenue and/or
expenses into years other than those in which they would normally be
recorded. For example, if the president of a business wants to report more
profit for the year, he or she can instruct the chief accountant to accelerate
the recording of some sales revenue that normally wouldn’t be recorded until
next year, or to delay the recording of some expenses until next year that nor-
mally would be recorded this year.
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