Tracy John A. Accounting for Dummies
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Look for Signs of Financial Distress
A business can build up a good sales volume and have very good profit mar-
gins, but if the company can’t pay its bills on time, its profit opportunities
could go down the drain. Solvency refers to the prospects of a business
being able to meet its debt and other liability payment obligations on time.
Solvency analysis asks whether a business will be able to pay its liabilities,
looking for signs of financial distress that could cause serious disruptions in
the business’s profit-making operations. Even if a business has a couple bil-
lion bucks in the bank, you should ask: How does its solvency look?
Frankly, detailed solvency analysis of a business is best left to the pros. The
credit industry has become very sophisticated in analyzing solvency. For
example, bankruptcy prediction models have been developed that have
proven useful. I don’t think the average financial report reader should spend
the time to calculate solvency ratios. For one thing, many businesses mas-
sage their accounting numbers to make their liquidity and solvency appear
to be better than they are at the balance sheet date.
Although many accountants and investment analysts would view my advice
here as heresy, I suggest that you just take a quick glance at the company’s
balance sheet. How do its total liabilities stack up against its cash, current
assets, and total assets? Obviously, total liabilities should not be more than
total assets. Duh! And obviously, if a company’s cash balance is close to zero,
things are bad. Beyond these basic rules, things are a lot more complex.
Many businesses carry a debt load you wouldn’t believe, and some get into
trouble even though they have hefty cash balances.
The continued solvency of a business depends mainly on the ability of its
managers to convince creditors to continue extending credit to the business
and renewing its loans. The credibility of management is the main factor, not
ratios. Creditors understand that a business can get into a temporary bind
and fall behind on paying its liabilities. As a general rule, creditors are slow
to pull the plug on a business. Shutting off new credit may be the worst thing
lenders and other creditors could do. Doing so may put the business in a
tailspin, and its creditors may end up collecting very little. Usually, it’s not in
their interest to force a business into bankruptcy — doing so is a last resort.
Recognize the Risks of Restatement
and Fraud
In 2007, the CEO of one of the Big Four global CPA firms testified before a
blue-ribbon federal government panel on the state of auditing and financial
reporting. He said that one out of every ten financial reports issued by public
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companies is revised and restated at a later time. If that’s true, there’s a 10
percent chance that the financial statements you’re reading are not entirely
correct and could be seriously misleading. An earlier study of financial
restatements arrived at a much lower estimate. You’d think that the inci-
dence of companies having to redo their financial reports would be extremely
rare, but you see financial restatements with alarming regularity.
When a business restates its original financial report and issues a new ver-
sion, it does not make restitution for any losses that investors suffered by
relying on the originally reported financial statements. In fact, few companies
even say they’re sorry when they put out revised financial statements.
Generally, the language explaining financial restatements is legalistic and
exculpatory. “We didn’t do anything wrong” seems to be the underlying
theme. This attitude is hard to swallow.
All too often the reason for the restatement is that someone later discovered
that the original financial statements were based on fraudulent accounting.
As I explain in Chapter 15, CPAs don’t have a very good track record for dis-
covering financial reporting fraud. What it comes down to is this: Investors
take the risk that the information in financial statements they use in making
decisions is subject to revision at a later time. I suppose you could go to the
trouble of searching for a business that has never had to restate its financial
statements, but there’s always a first time, of course.
Remember the Limits
of Financial Reports
There’s a lot more to investing than reading financial reports. Financial
reports are an important source of information, but investors also should
stay informed about general economic trends and developments, political
events, business takeovers, executive changes, technological changes, and
much more. Undoubtedly, the information demands required for investing
have helped fuel the enormous popularity of mutual funds; investors offload
the need to keep informed to the investment managers of the mutual fund.
Many advertisements of financial institutions stress this point — that you
have better things to do with your time.
When you read financial statements, keep in mind that these accounting
reports are somewhat tentative and conditional. Accountants make many
estimates and predictions in recording sales revenue and income, and
expenses and losses. Some soft numbers are mixed in with hard numbers in
financial statements. In short, financial statements are iffy to some extent.
There’s no getting around this limitation of accounting.
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Having said that, let me emphasize that financial reports serve an indispens-
able function in any developed economy. We really couldn’t get along without
financial reports, despite their limits and problems. People wouldn’t know
which way to turn in a financial information vacuum. Even though the finan-
cial air is polluted, we need the oxygen of financial reports to breathe.
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Appendix
Glossary: Slashing Through the
Accounting Jargon Jungle
A
BC: The acronym for activity-based costing, which is a cost allocation
scheme that allocates the cost of support functions in an organization
(such as maintenance) based on the units of activity of the support function
that are used by other departments and processes in the business.
accounting: The methods and procedures for identifying, analyzing, record-
ing, accumulating, and storing information and data about the activities of an
entity that have financial results, and preparing summary reports of these
activities internally for managers and externally for those entitled to receive
financial reports about the entity. A business’s managers, investors, and
lenders depend on accounting reports called financial statements to make
informed decisions. Accounting also encompasses preparing tax returns that
must be filed with government tax authorities by the entity, and facilitating
day-to-day operating functions.
accounting equation: Assets = Liabilities + Owners’ Equity. This equation
expresses the fundamental duality, or two-sided nature, of accounting and is
useful for explaining double-entry accounting, which uses debits and credits
for recording transactions. It summarizes the balance or equality of an
entity’s assets and the sources of its assets, which fall into two categories:
liabilities and owners’ equity.
accounting fraud (also called cooking the books): The deliberate falsification
or manipulation of accounting numbers to make the profit performance and/or
the financial condition of a business appear better than reality. Accounting
fraud is sophisticated and even fools the CPA auditors of a business. Recent
years have seen an embarrassing number of high-profile accounting fraud
cases, which resulted in the establishment of a new federal regulatory agency
with broad powers over public companies and the CPA auditors of public busi-
nesses: the Public Company Accounting Oversight Board (PCAOB).
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accounts payable: One main type of the short-term operating liabilities of a
business, in which are recorded the amounts owed to vendors or suppliers
for the purchase of products, supplies, parts, and services that are bought
on credit. Generally these liabilities are non-interest bearing (although an
interest charge may be added as a penalty for late payment).
accounts receivable: The short-term asset in which are recorded the
amounts owed to the business from sales of products and services on credit
to its customers. Customers are not normally charged interest, unless they
do not pay their bills when due. The balance of this asset in a balance sheet
is net of write-offs for uncollectible amounts (bad debts).
accrual-basis accounting: Recording the financial effects of economic events
when they happen, as opposed to simple cash accounting. Using accrual-
basis accounting, revenue is recorded when sales are made (rather than
when cash is received from customers), and expenses are recorded to match
with sales revenue or in the period benefited (rather than when expenses are
paid). The accrual basis of accounting is seen in the recording of assets such
as receivables from customers, inventory (cost of products not yet sold), and
cost of long-term assets (fixed assets) — and in the recording of liabilities
such as accounts payable to vendors and payables for unpaid expenses.
accrued expenses payable: The generic term for liability accounts used to
record the gradual accumulation of unpaid expenses, such as vacation pay
earned by employees and profit-based bonus plans that aren’t paid until the
following period. Note: The specific title of this liability varies from business
to business; you may see accrued liabilities, accrued expenses, or some other
similar account title.
accumulated depreciation: The total cumulative amount of depreciation
expense that has been recorded since the fixed assets being depreciated
were acquired. In the balance sheet, the amount in this account is deducted
from the original cost of fixed assets. The balance of cost less accumulated
depreciation is included in the book value of the fixed assets.
acid-test ratio: An alternative name for the quick ratio.
adjusting entries: At the end of the period, these important entries are
recorded to complete the bookkeeping cycle. These end-of-period entries
record certain expenses to the period (such as depreciation) and update rev-
enue, income, expenses, and losses for the period. Note: This term also refers
to making correcting entries when accounting errors are discovered.
amortization: The allocation of the cost of an intangible asset over its
expected useful life to the business. Amortization expense is recorded on the
straight-line basis (equal amounts each period).
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asset turnover ratio: Annual sales revenue divided by total assets (at year-
end, or the average total assets during the year).
audit report: The opinion on the financial report of a business issued by a
CPA firm upon its completion of auditing the company’s financial statements
and footnotes. The audit report states whether the financial statements are in
conformity with applicable U.S. or international financial reporting standards.
A “clean opinion” means the CPA auditor has no serious disagreements with
the financial report of the business.
bad debt: The expense that arises from a customer’s failure to pay the
amount owed to the business from a credit sale. When the credit sale was
recorded, the accounts receivable asset account was increased. When it
becomes clear that this debt owed to the business will not be collected, the
asset is written down and the amount is charged to bad debts expense.
balance sheet: This financial statement summarizes the assets, liabilities,
and owners’ equity of a business at a moment in time. It’s prepared at the
end of every profit period and whenever else it is needed. The main elements
of a balance sheet are called accounts — such as cash, inventory, notes
payable, and capital stock. Each account has a dollar amount, which is called
its balance. But be careful: The fact that the accounts have balances is not
the reason this financial statement is called a balance sheet. Rather, the
equality (or balance) of assets with the total of liabilities and owners’ equity
is the reason for the name. This financial statement is also called the state-
ment of financial condition and the statement of financial position.
book value (of assets and owners’ equity): Refers to the recorded amounts
on the books (accounting records) of a business, which are reported in its
balance sheet. Often this term is used to emphasize that the amounts
recorded in the accounts of the business are less than the current replace-
ment costs of certain assets, or less than the market value of owners’ equity.
break-even: The annual sales volume or sales revenue at which total margin
equals total annual fixed expenses — that is, the exact sales amount at which
the business covers its fixed expenses and makes a zero profit and avoids a
loss. Break-even is a useful point of reference in analyzing profit performance
and the effects of making sales in excess of break-even.
capital expenditures: Outlays for fixed (long-term) assets in order to over-
haul or replace old fixed assets or to expand and modernize the long-lived
operating resources of a business. Fixed assets is a broad category that
includes buildings, machinery, equipment, vehicles, furniture, fixtures, and
computers. These operating assets have useful lives from 3 to 39 (or more)
years. The term “capital” implies that substantial amounts are invested for
many years.
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capital stock: The ownership shares issued by a corporation for capital
invested in the business by owners. Total capital is divided into units of own-
ership called capital stock shares. In the old days, you actually got engraved
certificates as legal evidence of your ownership of a certain number of
shares. Today, book entry is the norm: Your ownership is recorded in the
books, or records, of the registrar for the stock shares. A business corpora-
tion must issue at least one class of capital stock, called common stock. It may
also issue other classes of stock, such as preferred stock.
cash flow: An ambiguous term that can refer to several different sources of or
uses of cash. Some friendly advice: Always use this term with which source
or use of cash you have in mind!
cash flow from operating activities: Equals the total cash inflow from sales
and other income during the period minus the total cash outflow for expenses
and losses during the period. This important number is reported in the first
section of the statement of cash flows; it is not found in the income statement.
certified public accountant (CPA): The CPA designation is a widely recog-
nized and respected badge of a professional accountant. A person must meet
educational and experience requirements and pass a national uniform exam
to qualify for a state license to practice as a CPA. Many CPAs are not in public
practice; they work for business organizations, government agencies, and
nonprofit organizations, or they teach accounting (a plug for educators here
if you don’t mind). CPAs in public practice do audits of financial statements,
and they also provide tax, management, and financial consulting services.
common stock: The one class of capital stock that must be issued by a busi-
ness corporation. It has the most junior, or “last in line,” claim on the busi-
ness’s assets in the event of liquidation, after all liabilities and any senior
capital stock (such as preferred stock) are paid. Owners of common stock
receive dividends from profit only after preferred stockholders (if any) are
paid. Owners of common stock generally have voting rights in the election
of the board of directors, although a business may issue both voting and
nonvoting classes of common stock.
comprehensive income: Includes net income reported in the income state-
ment plus certain rather technical gains and losses that are recorded but
don’t necessarily have to be included in the income statement. In other
words, the effects of these developments can bypass the income statement.
Most companies report these special types of gains and losses (if they have
any) in their statement of changes in owners’ (stockholders’) equity.
controller: The chief accounting officer of an organization. The controller
may also serve as the chief financial officer (CFO) in a business or other
organization, although in large organizations the two jobs are usually split.
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cooking the books: See accounting fraud. Should not be confused with the
lesser offenses of massaging the numbers and income smoothing.
current assets: Includes cash plus accounts receivable, inventory, and pre-
paid expenses (and short-term marketable securities if the business owns
any). These assets will be converted into cash during one operating cycle
or sooner, which determines the liquidity of a business.
current liabilities: Short-term liabilities, principally accounts payable,
accrued expenses payable, income tax payable, short-term notes payable,
and the portion of long-term debt that falls due within the coming year. This
group includes both non-interest-bearing and interest-bearing liabilities that
must be paid in the short term, usually defined to be one year or less.
current ratio: One test of a business’s short-term solvency (debt-paying
capability). Find the current ratio by dividing a business’s total current assets
by its total current liabilities.
debits and credits: Accounting jargon for decreases and increases recorded
in accounts for assets, liabilities, owners’ equity, revenue, and expenses
according to the centuries’ old method that is based on the accounting equa-
tion. In recording a transaction, the total of debits must equal the total of
credits. “The books are in balance” means that the sum of debit balance
accounts equals the sum of credit balance accounts. Even though the
accounts are in balance, there may be errors due to other reasons.
depreciation: Allocating a fixed asset’s cost over three or more years, based
on its estimated useful life to the business. Each year of the asset’s life is
charged with part of its total cost as the asset gradually wears out and
loses its economic value to the business. Either an accelerated depreciation
method or straight-line depreciation is used. An accelerated method allocates
more of the cost to the early years than the later years. The straight-line
method allocates an equal amount to every year.
dividend yield: Measures the cash income component of return on invest-
ment in stock shares of a corporation. The dividend yield equals the most
recent 12 months of cash dividends paid on a stock divided by the stock’s
current market price. If a stock is selling for $100 and over the last 12 months
paid $3 cash dividends, its dividend yield equals 3 percent.
double-entry accounting: Simply put, this term means that both sides of
an economic event or business transaction are recorded. For every action
recorded there is a reaction that is also recorded. The debits and credits
method is the means used to implement double-entry accounting.
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earnings before interest and income tax (EBIT): Sales revenue less cost
of goods sold and all operating expenses — but before deducting interest
expense and income tax expense (and usually, but not always, before extraor-
dinary gains and losses). This intermediate measure of profit also is called
operating earnings, operating profit, or something similar.
earnings per share (EPS): Equals net income for the most recent 12 months
reported, called the trailing 12 months, divided by the number of capital stock
shares. Dividing net income by the actual number of shares in the hands of
stockholders, called outstanding shares, gives basic EPS. Diluted EPS equals
the same net income figure divided by the sum of the actual number of
shares outstanding plus additional shares that will be issued under terms of
stock options awarded to managers and for the conversion of senior securi-
ties into common stock (if the company has issued convertible debt or pre-
ferred stock securities).
EDGAR: The first name of my father-in-law. Seriously, this is the acronym
for the database of financial reports and other required filings under federal
securities laws with the Securities and Exchange Commission (SEC). Go to
www.sec.gov and navigate to Filings & Forms (EDGAR).
extraordinary gains and losses: Unusual, nonrecurring gains and losses that
happen infrequently and that are aside from the normal, ordinary sales and
expenses of a business. These gains and losses, in theory, are one-time
events that come out of the blue. But in actual practice many businesses
record these gains and losses too frequently to be called nonrecurring. These
gains and losses (net of income tax effects) are reported separately in the
income statement. In this way, attention is directed to net income from the
normal continuing operations of the business — as if the special gains and
losses should be put out of mind.
Financial Accounting Standards Board (FASB): The highest authoritative,
private sector, standard-setting body of the accounting profession in the
United States. The FASB issues pronouncements that establish generally
accepted accounting principles (GAAP).
financial leverage: Generally refers to using debt capital on top of equity
capital. The strategy is to earn a rate of return on assets (ROA) higher than
the interest rate on borrowed money. A favorable spread between the two
rates generates financial leverage gain to the benefit of net income and
owners’ equity.
financial reports: The periodic financially oriented communications from a
business (and other types of organizations) to those entitled to know about
the financial performance and position of the entity. Financial reports of busi-
nesses include three primary financial statements (balance sheet, income
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statement, and statement of cash flows), as well as footnotes and other infor-
mation relevant to the owners of the business. Public companies must file
several types of financial reports and forms with the Securities and Exchange
Commission (SEC), which are open to the public. The financial reports of pri-
vate businesses are sent only to its owners and lenders.
financial statement: Generally refers to one of the three primary accounting
reports of a business: the balance sheet, statement of cash flows, or income
statement. Sometimes financial statements are called simply financials. Internal
financial statements and other accounting reports to managers contain consid-
erably more detail, which is needed for decision making and control.
financing activities: One of three basic types of cash flows reported in the
statement of cash flows. These are the dealings between a business and its
sources of debt and equity capital — such as borrowing and repaying debt,
issuing new stock shares, buying some of its own stock shares, and paying
dividends to shareowners.
first-in, first-out (FIFO): A widely used accounting method by which costs of
products when they are sold are charged to cost of goods sold expense in
chronological order. One result is that the most recent acquisition costs
remain in the inventory asset account at the end of the period. The reverse
order also is acceptable, which is called the last-in, first-out (LIFO) method.
fixed assets: The shorthand term for the long-life physical resources used
by a business in conducting its operations, which include land, buildings,
machinery, equipment, furnishings, tools, and vehicles. Please note that fixed
assets is an informal term; the more formal term used in a balance sheet is
property, plant, and equipment.
fixed costs: Those expenses or costs that remain unchanged over the short
run and do not vary with changes in sales volume or sales revenue. Common
examples are building rent under lease contracts, salaries of many employ-
ees, property taxes, and monthly utility bills. Fixed expenses provide the
capacity for carrying out operations and for making sales.
footnotes: Think of footnotes in a book. Footnotes are attached to the three
primary financial statements included in an external financial report, and
they present detailed information that cannot be put directly in the body of
one of the financial statements. Footnotes have the reputation of being diffi-
cult to read, poorly written, overly detailed, and too technical. Unfortunately,
these criticisms have a lot of truth behind them.
free cash flow: Be very cautious about this term because it has no uniform
meaning; different people use it to mean different things. Some people use it
to mean cash flow from operating activities — to emphasize that this source of
cash is free from the need to borrow money, issue capital stock shares, or sell
assets. But this is not the only meaning you see in practice.
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