Tracy John A. Accounting for Dummies
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For a company you’ve invested in (or are considering investing in), I suggest
that you do a quick read-through of the footnotes and identify the ones that
seem to have the most significance. Generally, the most important footnotes
are those dealing with the following matters:
Stock options awarded by the business to its executives: The additional
stock shares issued under stock options dilute (thin out) the earnings per
share of the business, which in turn puts downside pressure on the market
value of its stock shares, assuming everything else remains the same.
Pending lawsuits, litigation, and investigations by government agen-
cies: These intrusions into the normal affairs of the business can have
enormous consequences.
Employee retirement and other post-retirement benefit plans: Your
main concerns here should be whether these future obligations of the
business are seriously underfunded. I have to warn you that this particu-
lar footnote is one of the most complex pieces of communication you’ll
ever encounter. Good luck.
Debt problems: It’s not unusual for companies to get into problems with
their debt. Debt contracts with lenders can be very complex and are
financial straitjackets in some ways. A business may fall behind in making
interest and principal payments on one or more of its debts, which triggers
provisions in the debt contracts that give its lenders various options to
protect their rights. Some debt problems are normal, but in certain cases
lenders can threaten drastic action against a business, which should be
discussed in its footnotes.
Segment information for the business: Public businesses have to report
information for the major segments of the organization — sales and
operating profit by territories or product lines. This gives a better
glimpse of the different parts making up the whole business. (Segment
information may be reported elsewhere in an annual financial report
than in the footnotes, or you may have to go to the SEC filings of the
business to find this information.)
These are a few of the important pieces of information you should look for in
footnotes. But you have to stay alert for other critical matters that a business
may disclose in its footnotes, so I suggest scanning each and every footnote
for potentially important information. Finding a footnote that discusses a
major lawsuit against the business, for example, may make the stock too
risky for your stock portfolio.
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Checking for Ominous Skies
in the Auditor’s Report
The value of analyzing a financial report depends on the accuracy of the report’s
numbers. Understandably, top management wants to present the best possible
picture of the business in its financial report. The managers have a vested inter-
est in the profit performance and financial condition of the business; their yearly
bonuses usually depend on recorded profit, for instance. As I mention several
times in this book, the top managers and their accountants prepare the financial
statements of the business and write the footnotes. This situation is somewhat
like the batter in a baseball game calling the strikes and balls. Where’s the
umpire?
Independent CPA auditors are like umpires in the financial reporting game. The
CPA comes in, does an audit of the business’s accounting system and methods,
and gives a report that is attached to the company’s financial statements.
Publicly owned businesses are required to have their annual financial reports
audited by independent CPA firms, and many privately owned businesses have
audits done, too, because they know that an audit report adds credibility to the
financial report.
What if a private business’s financial report doesn’t include an audit report?
Well, you have to trust that the business prepared accurate financial statements
following authoritative accounting and financial reporting standards and that
the footnotes to the financial statements cover all important points and issues.
Unfortunately, the audit report gets short shrift in financial statement analysis,
maybe because it’s so full of technical terminology and accountant doubles-
peak. But even though audit reports are a tough read, anyone who reads and
analyzes financial reports should definitely read the audit report. Chapter 15
provides more information on audits and the auditor’s report.
The auditor judges whether the business’s accounting methods are in accor-
dance with appropriate accounting and financial reporting standards — gen-
erally accepted accounting principles (GAAP) for businesses in the United
States. In most cases, the auditor’s report confirms that everything is hunky-
dory, and you can rely on the financial report. However, sometimes an audi-
tor waves a yellow flag — and in extreme cases, a red flag. Here are the two
important warnings to watch out for in an audit report:
The business’s capability to continue normal operations is in doubt
because of what are known as financial exigencies, which may mean a
low cash balance, unpaid overdue liabilities, or major lawsuits that the
business doesn’t have the cash to cover.
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One or more of the methods used in the report are not in complete
agreement with appropriate accounting standards, leading the auditor to
conclude that the numbers reported are misleading or that disclosure is
inadequate. (Look for language in the auditor’s report to this effect.)
Although auditor warnings don’t necessarily mean that a business is going
down the tubes, they should turn on that light bulb in your head and make
you more cautious and skeptical about the financial report. The auditor is
questioning the very information on which the business’s value is based, and
you can’t take that kind of thing lightly.
Also, just because a business has a clean audit report doesn’t mean that the
financial report is completely accurate and aboveboard. As I discuss in Chapter
15, auditors don’t always catch everything, and they sometimes fail to discover
major accounting fraud. Also, the implementation of accounting methods is
fairly flexible, leaving room for interpretation and creativity that’s just short of
cooking the books (deliberately defrauding and misleading readers of the finan-
cial report). Some massaging of the numbers is tolerated, which may mean that
what you see on the financial report isn’t exactly an untarnished picture of the
business. I explain window dressing and profit smoothing — two common exam-
ples of massaging the numbers — in Chapter 12.
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Chapter 14
How Business Managers Use
a Financial Report
In This Chapter
Recognizing the limits of external financial statements
Locating detailed financial condition information
Identifying more in-depth profit information
Looking for additional cash flow information
I
f you’re a business manager, I strongly suggest that you read Chapter 13
before continuing with this one. Chapter 13 discusses how a business’s
lenders and investors read its financial reports. These stakeholders are enti-
tled to regular financial reports so they can determine whether the business
is making good use of their money. The chapter explains key ratios that the
external stakeholders can use for interpreting the financial condition and
profit performance of a business.
Business managers should understand the financial statement ratios in
Chapter 13. Every ratio does double duty; it’s useful to business lenders and
investors and equally useful to business managers. For example, the profit
ratio and return on assets ratio are extraordinarily important to both the
external stakeholders and the managers of a business — the first measures
the profit yield from sales revenue, and the second measures profit on the
assets employed by the business.
But as important as they are, the external financial statements do not provide
all the accounting information that managers need to plan and control the
financial affairs of a business. Managers need additional information. Managers
who look no further than the external financial statements are being very
shortsighted — they don’t have all the information they need to do their jobs.
The accounts reported in external financial statements are like the table of con-
tents of a book; each account is like a chapter title. Managers need to do more
than skim chapter titles. As the radio personality Paul Harvey would say, man-
agers need to look at the rest of the story.
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This chapter looks behind the accounts reported in the external financial
statements. I explain the types of additional accounting information that man-
agers need in order to control financial condition and performance, and to
plan the financial future of a business.
Building on the Foundation of the
External Financial Statements
Managers are problems solvers. Every business has some problems, perhaps
even some serious ones. However, external financial statements are not
designed to expose those problems. Except in extreme cases — in which the
business is obviously in dire financial straits — you’d never learn about its
problems just from reading its external financial statements. To borrow lyrics
from an old Bing Crosby song, external financial statements are designed to
“accentuate the positive, eliminate the negative . . . [and] don’t mess with
Mister In-Between.”
Seeking out problems and opportunities
Business managers need more accounting information than what’s disclosed
in external financial statements for two basic purposes:
To alert them to problems that exist or may be emerging that threaten the
profit performance, cash flow, and financial condition of the business
To suggest opportunities for improving the financial performance and
health of the business
A popular expression these days is “mining the data.” The accounting system
of a business is a rich mother lode of management information, but you have
to dig that information out of the accounting database. Working with the con-
troller (chief accountant), a manager should decide what information she
needs beyond what is reported in the external financial statements.
Avoiding information overload
Business manages are very busy people. Nothing is more frustrating than get-
ting reams of information that you have no use for. For that reason, the con-
troller should guard carefully against information overload. While some types
of accounting information should stream to business managers on a regular
basis, other types should be provided only on as as-needed basis.
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Ideally, the controller reads the mind of every manager and provides exactly
the accounting information that each manager needs. In practice, that can’t
always happen, of course. A manager may not be certain about which infor-
mation she needs and which she doesn’t. The flow of information has to be
worked out over time.
Furthermore, how to communicate the information is open to debate and
individual preferences. Some of the additional management information can
be put in the main body of an accounting report, but most is communicated
in supplemental schedules, graphs, and commentary. The information may
be delivered to the manager’s computer, or the manager may be given the
option to call up selected information from the accounting database of the
business.
My point is simply this: Managers and controllers must communicate — early
and often — to make sure managers get what they need without being swamped
with unnecessary data. No one wants to waste precious time compiling reports
that are never read. So before a controller begins the process of compiling
accounting information for managers’ eyes only, be sure there’s ample commu-
nication about what each manager needs.
Gathering Financial
Condition Information
The balance sheet — one of three primary financial statements included in a
financial report — summarizes the financial condition of the business. Figure
14-1 lists the basic accounts in a balance sheet, without dollar amounts for
the accounts and without subtotals and totals. Just 12 accounts are given in
Figure 14-1: five assets (counting fixed assets and accumulated depreciation
as only one account), five liabilities, and two owners’ equity accounts. A busi-
ness may report more than just these 12 accounts. For instance, a business
may invest in marketable securities, or have receivables from loans made to
officers of the business. A business may have intangible assets. A business
corporation may issue more than one class of capital stock and would report
a separate account for each class. And so on. The idea of Figure 14-1 is to
focus on the core assets and liabilities of a typical business.
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Cash
The external balance sheet reports just one cash account. But many busi-
nesses keep several bank checking and deposit accounts, and some (such as
gambling casinos and food supermarkets) keep a fair amount of currency on
hand. A business may have foreign bank deposits in euros, English pounds,
or other currencies. Most businesses set up separate checking accounts for
payroll; only payroll checks are written against these accounts.
Managers should monitor the balances in every cash account in order to
control and optimize the deployment of their cash resources. So, information
about each bank account should be reported to the manager.
Managers should ask these questions regarding cash:
Is the ending balance of cash the actual amount at the balance sheet
date, or did the business engage in window dressing in order to inflate its
ending cash balance? Window dressing refers to holding the books open
after the ending balance sheet date in order to record additional cash
inflow as if the cash was received on the last day of the period. Window
dressing is not uncommon. (For more details, see Chapter 12.) If window
dressing has gone on, the manager should know the true, actual ending
cash balance of the business.
Were there any cash out days during the year? In other words, did the
company’s cash balance actually fall to zero (or near zero) during the
year? How often did this happen? Is there a seasonal fluctuation in cash
flow that causes “low tide” for cash, or are the cash out days due to run-
ning the business with too little cash?
Are there any limitations on the uses of cash imposed by loan covenants
by the company’s lenders? Do any of the loans require compensatory
balances that require that the business keep a minimum balance relative
Assets
Cash
Accounts receivable
Inventory
Prepaid expenses
Fixed assets
Accumulated depreciation
Liabilities
Accounts payable
Accrued expenses payable
Income tax payable
Short-term notes payable
Long-term notes payable
Owners’ Equity
Invested capital
Retained earnings
Figure 14-1:
Hardcore
accounts
reported in
a balance
sheet.
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to the loan balance? In this situation the cash balance is not fully available
for general operating purposes.
Are there any out-of-the-ordinary demands on cash? For example, a busi-
ness may have entered into buyout agreements with a key shareholder
or with a vendor to escape the terms of an unfavorable contract. Any
looming demands on cash should be reported to managers.
Accounts receivable
A business that makes sales on credit has the accounts receivable asset —
unless it has collected all its customers’ receivables by the end of the year,
which is not very likely. To be more correct, the business has hundreds or
thousands of individual accounts receivable from its credit customers. In its
external balance sheet, a business reports just one summary amount for all
its accounts receivable. However, this total amount is not nearly enough
information for the business manager.
Here are questions a manager should ask about accounts receivable:
Of the total amount of accounts receivable, how much is current (within
the normal credit terms offered to customers), slightly past due, and
seriously past due? A past due receivable causes a delay in cash flow
and increases the risk of it becoming a bad debt (a receivable that ends
up being partially or wholly uncollectible).
Has an adequate amount been recorded for bad debts? Is the company’s
method for determining its bad debts expense consistent year to year?
Was the estimate of bad debts this period tweaked in order to boost or
dampen profit for the period? Has the IRS raised any questions about
the company’s method for writing off bad debts? (Chapter 7 discusses
bad debts expense.)
Who owes the most money to the business? (The manager should
receive a schedule of customers that shows this information.) Which
customers are the slowest payers? Do the sales prices to these cus-
tomers take into account that they typically do not pay on time?
It’s also useful to know which customers pay quickly to take advantage
of prompt payment discounts. In short, the payment profiles of credit
customers are important information for managers.
Are there “stray” receivables buried in the accounts receivable total? A
business may loan money to its managers and employees or to other
businesses. There may be good business reasons for such loans. In any
case, these receivables should not be included with accounts receivable,
which should be reserved for receivables from credit sales to cus-
tomers. Other receivables should be listed in a separate schedule.
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Inventory
For businesses that sell products, inventory is typically a major asset. It’s
also typically the most problematic asset from both the management and
accounting points of view. First off, the manager should understand the
accounting method being used to determine the cost of inventory and the
cost of goods sold expense. (You may want to quickly review the section in
Chapter 7 that covers this topic.) In particular, the manager should have a
good feel regarding whether the accounting method results in conservative
or liberal profit measures.
Managers should ask these questions regarding inventory:
How long, on average, do products remain in the warehouse before they
are sold? The manager should receive a turnover analysis of inventory that
clearly exposes the holding periods of products. Slow-moving products
cause nothing but problems. The manager should ferret out products that
have been held in inventory too long. The cost of these sluggish products
may have to be written down or written off, and the manager has to autho-
rize these accounting entries. The manager should review the sales
demand for slow-moving products, of course.
If the business uses the LIFO method (last-in, first-out), was there a LIFO
liquidation gain during the period that caused an artificial and one-time
boost in profit for the year? (I explain this aspect of the LIFO method in
Chapter 7.)
The manager should also request these reports:
Inventory reports that include side-by-side comparison of the costs and
the sales prices of products (or at least the major products sold by the
business). It’s helpful to include the mark-up percent for each product,
which allows the manager to focus on mark-up percent differences from
product to product.
Regular reports summarizing major product cost changes during the
period, and forecasts of near-term changes. It may be useful to report
the current replacement cost of inventory assuming it’s feasible to
determine this amount.
Prepaid expenses
Generally, the business manager doesn’t need too much additional informa-
tion on this asset. However, there may be a major decrease or increase in this
asset from a year ago that is not consistent with the growth or decline in sales
from year to year. The manager should pay attention to an abnormal change in
the asset. Perhaps a new type of cost has to be prepaid now, such as insurance
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coverage for employee safety triggered by an OSHA audit of the employee
working conditions in the business. A brief schedule of the major types of
prepaid expenses is useful.
Fixed assets and accumulated depreciation
Fixed assets is the all-inclusive term for the wide range of long-term operating
assets used by a business — from buildings and heavy machinery to office
furniture. Except for the cost of land, the cost of a fixed asset is spread over
its estimated useful life to the business; the amount allocated to each period
is called depreciation expense. The manager should know the company’s
accounting policy regarding which fixed assets are capitalized (the cost is
recorded in a fixed asset account) and which are expensed immediately (the
cost is recorded entirely to expense at the time of purchase).
Most businesses adopt a cost limit below which minor fixed assets (a screw-
driver, stapler, or wastebasket, for example) are recorded to expense instead
of being depreciated over some number of years. The controller should alert
the manager if an unusually high amount of these small cost fixed assets were
charged off to expense during the year, which could have a significant impact
on the bottom line.
The manager should be aware of the general accounting policies of the busi-
ness regarding estimating useful lives of fixed assets and whether the
straight-line or accelerated methods of allocation are used. Indeed, the man-
ager should have a major voice in deciding these policies, and not simply
defer to the controller. In Chapter 7, I explain these accounting issues.
Using accelerated depreciation methods may result in certain fixed assets
that are fully depreciated. These assets should be reported to the manager —
even though they have a zero book value — so the manager is aware that
these fixed assets are still being used but no depreciation expense is being
recorded for their use.
Generally, the manager does not need to know the current replacement costs
of all fixed assets — just those that will be replaced in the near future. At the
same time, it is useful for the manager to get a status report on the com-
pany’s fixed assets, which takes more of an engineering approach than an
accounting approach. The status report includes information on the capacity,
operating efficiency, and projected remaining life of each major fixed asset.
The status report should include leased assets that are not owned by the
business and which, therefore, are not included in the fixed asset account.
The manager needs an insurance summary report for all fixed assets that are
(or should be) insured for fire and other casualty losses, which lists the types
of coverage on each major fixed asset, deductibles, claims during the year,
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