Tracy John A. Accounting for Dummies
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and so on. Also, the manager needs a list of the various liability risks of
owning and using the fixed assets. The manager has to decide whether the
risks should be insured.
Accounts payable
As you know, individuals have credit scores that affect their ability to borrow
money and the interest rates they have to pay. Likewise, businesses have credit
scores. If a business has a really bad credit rating, it may not be able to buy on
credit and may have to pay exorbitant interest rates. I don’t have space here to
go into the details of how credit rankings are developed for businesses. Suffice
it to say that a business should pay its bills on time. If a business consistently
pays its accounts payable late, this behavior gets reported to a credit rating
agency (such as Dun & Bradstreet).
The manager needs a schedule of accounts payable that are past due (beyond
the credit terms given by the vendors and suppliers). Of course, the manager
should know the reasons that the accounts have become overdue. The man-
ager may have to personally contact these creditors and convince them to
continue offering credit to the business.
Frankly, some businesses operate on the principle of paying late. Their standard
operating procedure is to pay their accounts payable two, three, or more weeks
after the due dates. This could be due to not having adequate cash balances or
wanting to hang on to their cash as long as possible. Years ago, IBM was notori-
ous for paying late, but because its credit rating was unimpeachable, it got away
with this policy.
Accrued expenses payable
The controller should prepare a schedule for the manager that lists the major
items making up the balance of the accrued expenses payable liability account.
Many operating liabilities accumulate or, as accountants prefer to say, accrue
during the course of the year that are not paid until sometime later. One main
example is employee vacation and sick pay; an employee may work for almost a
year before being entitled to take two weeks vacation with pay. The accountant
records an expense each payroll period for this employee benefit, and it accu-
mulates in the liability account until the liability is paid (the employee takes his
vacation). Another payroll-based expense that accrues is the cost of federal and
state unemployment taxes on the employer.
Accrued expenses payable can be a tricky liability from the accounting point
of view. There’s a lot of room for management discretion (or manipulation,
depending on how you look at it) regarding which particular operating liabilities
to record as expense during the year, and which not to record as expense until
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they are paid. The basic choice is whether to expense as you go or expense
later. If you decide to record the expense as you go through the year, the
accountant has to make estimates and assumptions, which are subject to
error. Then there’s the question of expediency. Employee vacation and sick
pay may seem to be obvious expenses to accrue, but in fact many businesses
do not accrue the expense on the grounds that it’s simply too time consum-
ing and, furthermore, that some employees quit and forfeit the rights to their
vacations.
Many businesses guarantee the products they sell for a certain period of
time, such as 90 days or one year. The customer has the right to return the
product for repair (or replacement) during the guarantee period. For exam-
ple, when I returned my iPod for repair, Apple should have already recorded
in a liability account the estimated cost of repairing iPods that will be returned
after the point of sale. Businesses have more “creeping” liabilities than you
might imagine. With a little work, I could list 20 or 30 of them, but I’ll spare you
the details. My main point is that the manager should know what’s in the
accrued expenses payable liability account, and what’s not. Also, the manager
should have a good fix on when these liabilities will be paid.
Income tax payable
It takes an income tax professional to comply with federal and state income
tax laws on business. The manager should make certain that the accountant
responsible for its tax returns is qualified and up-to-date.
The controller should explain to the manager the reasons for a relatively large
balance in this liability account at the end of the year. In a normal situation, a
business should have paid 90 percent or more of its annual income tax by the
end of the year. However, there are legitimate reasons that the ending balance
of the income tax liability could be relatively large compared with the annual
income tax expense — say 20 or 30 percent of the annual expense. It behooves
the manager to know the basic reasons for a large ending balance in the
income tax liability. The controller should report these reasons to the chief
financial officer and perhaps the treasurer of the business.
The manager should also know how the business stands with the IRS, and
whether the IRS has raised objections to the business’s tax returns. The busi-
ness may be in the middle of legal proceedings with the IRS, which the man-
ager should be briefed on, of course. The CEO and (perhaps other top-level
managers) should be given a frank appraisal of how things may turn out and
whether the business is facing any additional tax payments and penalties.
Needless to say, this is very sensitive information, and the controller may
prefer that none of it be documented in a written report.
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Finally, the chief executive officer working closely with the controller should
decide how aggressive to be on income tax issues and alternatives. Keep in
mind that tax avoidance is legal, but tax evasion is illegal. As you probably
know, the income tax law is exceedingly complex, but ignorance of the law is
no excuse. The controller should make abundantly clear to the manager
whether the business is walking on thin ice in its income tax returns.
Interest-bearing debt
In Figure 14-1, the balance sheet reports two interest-bearing liabilities: one for
short-term debts (those due in one year or less) and one for long-term debt.
The reason is that financial reporting standards require that external balance
sheets report the amount of current liabilities so the reader can compare this
amount of short-term liabilities against the total of current assets (cash and
assets that will be converted into cash in the short term). Interest-bearing debt
that is due in one year or less is included in the current liabilities section of the
balance sheet. (See Chapter 5 for more details.)
The amounts of the short-term and long-term debt accounts reported in the
external balance sheet are not enough information for the manager.
The best practice is to lay out in one comprehensive schedule for the man-
ager all the interest-bearing obligations of the business. The obligations
should be organized according to their due (maturity) dates, and the sched-
ule should include other relevant information such as the lender, the interest
rate on each debt, the plans to roll over the debt (or not), the collateral, and
the main covenants and restrictions on the business imposed by the lender.
Recall that debt is one of the two sources of capital to a business (the other
being owners’ equity, which I get to next). The sustainability of a business
depends on the sustainability of its sources of capital. The more a business
depends on debt capital, the more important it is to manage its debt well and
maintain excellent relations with its lenders.
Raising and using debt and equity capital, referred to as financial manage-
ment or corporate finance, is a broad subject that extends beyond the scope
of this book. For more information, look at Small Business Financial Management
Kit For Dummies (Wiley) — a book that my son, Tage C. Tracy, and I coauthored,
which explains the financial management function in more detail.
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Owners’ equity
External balance sheets report two kinds of ownership accounts: one for
capital invested by the owners in the business and one for retained earnings
(profit that has not been distributed to shareowners). In Figure 14-1, just one
invested capital account is shown in the owners’ equity section, as if the busi-
ness has only one class of owners’ equity. In fact, business corporations, limited
liability companies, partnerships, and other types of business legal entities can
have complex ownership structures. The owners’ equity sections in their bal-
ance sheets report several invested capital accounts — one for each class of
ownership interest in the business.
Broadly speaking, the manager faces three basic issues regarding the owners’
equity of the business:
Is more capital needed from the owners?
Should some capital be returned to the owners?
Can and should the business make a cash distribution from profit to the
owners and, if so, how much?
These questions belong in the field of financial management and extend beyond
the scope of this book. However, I should mention that the external financial
statements are very useful in deciding these key financial management issues.
For example, the manager needs to know how much total capital is needed to
support the sales level of the business. The asset turnover ratio (annual sales
revenue divided by total assets) provides a good touchstone for determining
the amount of capital that is needed for sales.
The external financial report of a business does not disclose the individual
shareowners of the business and the number of shares each person or insti-
tution owns. The manager may want to know this information. Any major
change in the ownership of the business usually is important information to
the manager.
Culling Profit Information
The sales and expenses of a business over a period of time are summarized in
a financial statement called the income statement. Profit (sales revenue minus
expenses) is the bottom line of the income statement. Chapter 4 explains the
externally reported income statement, as well as how sales revenue and
expenses are interconnected with the operating assets and liabilities of the
business. The income statement fits hand in glove with the balance sheet.
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Chapter 9 explains internal profit reports to managers, which are called P&L
(profit and loss) reports. P&L reports should be designed to help managers
in their profit analysis and decision making. Chapter 9 is the logical take-off
point for this section, in which I discuss the types of profit information man-
agers need.
Margin: The catalyst of profit
A business makes profit by earning total margin that exceeds its total
fixed expenses for the period. Margin equals sales revenue minus all variable
expenses of generating the sales revenue. Cost of goods sold is the main
variable expense for companies that sell products. Most businesses have
other significant variable expenses, which depend either on sales volume
(the quantity of products or services sold) or the dollar amount of sales
revenue. P&L reports to managers should separate variable from fixed
operating expenses, in order to measure margin.
Figure 14-2 presents a skeleton of the P&L report. No dollar amounts are given
because I focus on the kinds of information that managers need in order to ana-
lyze and control profit. Note that operating expenses below the gross margin
line are classified between variable and fixed. Therefore, the P&L report
includes margin (profit before fixed operating expenses). Income statements in
external financial reports do not classify the behavior of operating expenses.
The P&L report stops at the operating profit line, or earnings before interest
and income tax expenses. (Interest is in the hands of the chief financial offi-
cer of the business, and income tax is best left to tax professionals.)
* Also called operating earnings, and earnings before
interest and taxes (EBIT)
Start with
Deduct
Equals
Deduct
Equals
Deduct
Equals
Sales revenue
Cost of goods sold expense
Gross margin
Variable operating expenses
Margin
Fixed operating expenses
Operating profit*
Figure 14-2:
Skeleton of
a P&L (profit
and loss)
report.
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Most businesses sell a wide variety of products and have many sources of
sales revenue. The margins per unit on each source of sales vary. It’s quite
unusual to find a business that earns the same margin ratio on all its sales.
The manager needs information on sales revenue and margin for each main-
stream source of sales. But the term “mainstream source of sales” will have
very different meanings for each business. In analyzing profit, one of the main
challenges facing business managers is deciding how to organize, categorize,
and aggregate the huge volume of data on sales and expenses.
For example, consider a hardware store in Boulder, Colorado that sells more
than 100,000 different products (including different sizes of the same products).
Suppose it has ten key managers with sales and profit responsibility. This means
that each manager would be responsible for 10,000 different sources of sales. It
would be possible to report every specific sale to the manager, but this would
be absurd! The same is true for a high-volume retailer like Target or Costco. For
a Honda or Toyota auto dealer, on the other hand, reporting each new car sale
to the manager would be practical.
Regardless of how sales are reported to the manager, all variable expenses of
each sales source should be matched against the sales revenue in order to
determine margin for that source. The alternative is to match only the cost of
goods sold expense with sales revenue, which means that the manager knows
only gross margin instead of final margin (after variable operating expenses
are also deducted from sales revenue).
Sales revenue and expenses
In this section, I offer examples of sales revenue and expense information that
managers need that is not reported in the external income statement of a
business. Given the very broad range of different businesses and different
circumstances, I can’t offer much detail.
Here’s a sampling of the kinds of accounting information that business managers
need either in their P&L reports or in supplementary schedules and analyses:
Sales volumes (quantities sold) for all sources of sales revenue.
List sales prices and discounts, allowances, and rebates against list
sales prices. For many businesses (but not all), sales pricing is a two-
sided affair that starts with list prices (such as manufacturer’s suggested
retail price) and includes deductions of all sorts from the list prices.
Sales returns — products that were bought but later returned by
customers.
Special incentives offer by suppliers that effectively reduce the pur-
chase cost of products.
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Abnormal charges for embezzlement and fraud losses.
Significant variations in discretionary expenses from year to year, such
as repair and maintenance, employee training costs, and advertising.
Illegal payments to secure business, including bribes, kickbacks, and
other under-the-table payments. Keep in mind that businesses are not
willing to admit to making such payments, much less report them in
internal communications. Therefore, the manager should know how
these payments are disguised in the accounts of the business.
Sales revenue and margin for new products.
Significant changes in fixed costs and reasons for the changes.
Expenses that surged much more than increases in sales volume or
sales revenue.
New expenses that show up for first time.
Accounting changes (if any) regarding when sales revenue and expenses
are recorded.
The above items do not constitute an exhaustive list. But the list covers many
important types of information that managers need in order to interpret their
P&L reports and to plan profit improvements in the future. Analyzing profit is a
very open-ended process. There are many ways to slice and dice sales and
expense data. Managers have only so much time at their disposal, but they
should take the time to understand and analyze the main factors that drive
profit.
Digging into Cash Flow Information
Chapter 6 explains the statement of cash flows included in a business’s external
financial report. Cash flows are divided into three types:
Cash flows from operating activities (“operating” refers to making sales
and incurring expenses in the process of earning profit)
Cash flows from investing activities (outlays for new long-term assets
and proceeds from disposals of these assets)
Cash flows from financing activities (borrowing and repaying debt; raising
capital from and returning capital to owners; and cash distributions
from profit to owners)
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Distinguishing investing and financing
cash flows from operating cash flows
Investing and financing decisions are the heart of business financial manage-
ment. Every business must secure and invest capital. No capital, no business —
it’s as simple as that. Inadequate capital clamps limits on the growth potential of
a business. In larger businesses, the financing and investing activities are the
domain of the chief financial officer (CFO), who works with other high-level
executives in setting the financial strategies and policies of the business.
The field of financial management — raising capital for a business and deploying
its capital — is beyond the scope of this book. For more information, you can
refer to the book I coauthored with my son, Small Business Financial Management
Kit For Dummies (Wiley).
This section concentrates on cash flow from operating activities. These cash
flows are in the domain of managers with operating responsibilities — man-
agers who have responsibilities for sales and the expenses that are directly
connected with making sales. These managers should understand the cash
flow impacts of their sales and expenses. (See the sidebar “Cash flow charac-
teristics of sales and expenses.”) Their sales and expense decisions drive the
operating activity cash flows of the business.
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Cash flow characteristics of sales and expenses
In reading their P&L reports, managers should
keep in mind that the accountant records sales
revenue when sales are made — regardless of
when cash is received from customers. Also,
the accountant records expenses to match
expenses with sales revenue and to put
expenses in the period where they belong —
regardless of when cash is paid for the
expenses. The manager should not assume that
sales revenue equals cash inflow, and that
expenses equal cash outflow.
The cash flow characteristics of sales and
expenses are summarized as follows:
Cash sales generate immediate cash inflow.
Keep in mind that sales returns and sales
price adjustments after the point of sale
reduce cash flow.
Credit sales do not generate immediate
cash inflow. There’s no cash flow until the
customers’ receivables are actually col-
lected. There’s a cash flow lag from credit
sales.
Many operating costs are not paid until sev-
eral weeks (or months) after they are
recorded as expense; and a few operating
costs are paid before the costs are charged
to expense.
Depreciation expense is recorded by
reducing the book value of an asset and
does not involve cash outlay in the period
when it is recorded. The business paid out
cash when the asset was acquired.
(Amortization expense on intangible assets
is the same.)
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Managing operating cash flows
In a small, one-owner/one-manager business, one person has to manage both
profit and cash flow from profit. In larger businesses, managers who have profit
responsibility may or may not have cash flow responsibility. The profit manager
may ignore the cash flow aspects of his sales and expense activities. The
responsibility for controlling cash flow falls on some other manager. Of course,
someone should manage the cash flows of sales and expenses. The following
comments speak to this person in particular.
The net cash flow during the period from carrying on profit-making operations
depends on the changes in the operating assets and liabilities directly connected
with sales revenue and expenses. Figure 14-3 highlights these assets and liabili-
ties, and also retained earnings. Changes in these accounts during the year
determine the cash flow from operating activities. In other words, changes in
these accounts boost or crimp cash flow.
Note that retained earnings is highlighted in Figure 14-3. Profit increases this
owners’ equity account. Profit is the starting point for determining cash flow
from operating activities. (Alternatively, a business may use the direct
method for determining and reporting cash flow from operating activities,
which I explain in Chapter 6.)
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
Changes in these accounts affect cash flow from operating activities.
Figure 14-3:
Assets and
liabilities
affecting
cash flow
from
operating
activities.
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The cash flow from profit is determined as follows:
1. Start with the accounting profit number, usually labeled net income.
2. Add depreciation expense (and amortization expense, if any) because
there is no cash outlay for the expense during the period.
3. Deduct increases or add decreases in operating assets because
• An increase requires additional cash outlay to build up the asset.
• A decrease means part of the asset is liquidated and provides
cash.
4. Add increases or deduct decreases in operating liabilities because
• An increase means less cash is paid out than the expense.
• A decrease means more cash is paid out to reduce the liability.
You may ask: What about changes during the year in those balance sheet
accounts that are not highlighted in Figure 14-3? Well, these changes are
reported either in the cash flow from investing activities or the cash flow from
financing activities sections of the statement of cash flows. So, all balance
sheet account changes during the year end up in the statement of cash flows.
The manager should closely monitor the changes in operating assets and lia-
bilities (see Figure 14-3). A good general rule is that each operating asset and
liability should change about the same percent as the percent change in the
sales activity of the business. If sales revenue increases, say, 10 percent, then
operating assets and liabilities should increase about 10 percent. The per-
cents of increases in the operating assets and liabilities (in particular,
accounts receivable, inventory, accounts payable, and accrued expenses
payable) should be emphasized in the cash flow report to the manager. The
manager should not have to take out his calculator and do these calculations.
Controlling cash flow from profit (operating activities) means controlling
changes in the operating assets and liabilities of making sales and incurring
expenses: There’s no getting around this fact of business life. There’s no
doubt that cash flow is king. You can be making good profit, but if you don’t
turn the profit into cash flow quickly, you are headed for big trouble.
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