Tracy John A. Accounting for Dummies
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generally accepted accounting principles (GAAP): The authoritative stan-
dards and approved accounting methods that should be used by businesses
domiciled in the United States and private nonprofit organizations to mea-
sure and report their revenue and expenses; to present their assets, liabili-
ties, and owners’ equity; and to report their cash flows in their financial
statements. GAAP are not a straitjacket; these official standards are loose
enough to permit alternative interpretations by accountants.
goodwill: In the broad business sense, this term generally refers to brand
name recognition or to the well-known and respected reputation of a com-
pany. Goodwill in this usage means the business has an important asset that
is not reported in its balance sheet. In the accounting context, however,
goodwill has a more restricted meaning. To be recorded and appear in the
balance sheet of a business, goodwill must actually be purchased, such as
by buying an established brand name or buying a company with an excellent
reputation. Only purchased goodwill is reported as an asset in the balance
sheet. The cost of (purchased) goodwill may or may not be amortized
(charged off to expense over the years).
gross margin (profit): Equals sales revenue less cost of goods sold for the
period. Making adequate gross margin is the starting point for making a
bottom-line profit.
income smoothing: Manipulating the timing of when sales revenue and/or
expenses are recorded in order to produce a smoother profit trend with
narrower fluctuations from year to year. Also called massaging the numbers,
the implementation of profit-smoothing procedures needs the implicit or
explicit approval of top-level managers, because these techniques require
the override of normal accounting procedures for recording sales revenue
and expenses. CPA auditors generally tolerate a reasonable amount of profit
smoothing — which is also called earnings management.
income statement: This financial statement summarizes sales revenue (and
income) and expenses (and losses) for a period and reports one or more
profit lines. Also, any extraordinary gains and losses are reported in this
financial statement. The income statement is one of the three primary finan-
cial statements of a business included in its financial report and is also called
the earnings statement, the operating statement, or other similar titles.
internal (accounting) controls: Forms, procedures, and precautions that are
established primarily to prevent and minimize errors and fraud (beyond the
forms and procedures that are needed for record keeping). Common internal
control are: requiring the signature of two managers to approve transactions
over a certain amount; restricting entry and exit routes of employees; using
surveillance cameras; forcing employees to take their vacations; separating
duties; and conducting surprise inventory counts and inspections.
International Accounting Standards Board (IASB): The authoritative finan-
cial reporting standards–setting body for businesses outside the United
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States (mainly European Union companies at the present time). The IASB
issues broad, general-language standards (a “principles-based approach”),
in contrast to the technically detailed pronouncements of the Financial
Accounting Standards Board (FASB). The two are working together toward the
harmonization of accounting and financial reporting practices in the United
States and the member nations of the EU.
investing activities: One of three classes of cash flows reported in the
statement of cash flows. Mainly, these outlays are the major investments
in long-term operating assets. A business may dispose of some of its fixed
assets during the year, and proceeds from these disposals are reported in
this section of the statement of cash flows.
last-in, first-out (LIFO): A widely used accounting method by which costs of
products when they are sold are charged to cost of goods sold expense in
reverse chronological order. One result is that the ending inventory cost
value consists of the costs of the earliest goods purchased or manufactured.
The actual physical flow of products seldom follows a LIFO sequence. The
method is justified on the grounds that the cost of goods sold expense
should reflect the cost of replacing the products sold, and the best approxi-
mations are the most recent acquisition costs.
lower of cost or market (LCM): A special accounting test applied to inven-
tory that can result in a write-down and charge to expense for the loss in
value of products held for sale. The recorded costs of products in inventory
are compared with their current replacement costs (market price) and with
net realizable value if normal sales prices have been reduced. If either value
is lower, then recorded cost is written down to this lower value.
management (managerial) accounting: The branch of accounting that pre-
pares internal financial statements and other accounting reports and analy-
ses to help managers carry out their planning, decision-making, and control
functions. Most of the detailed information in these reports is confidential
and is not circulated outside the business. Internal profit reports focus on
margin and sales volume, and they should separate variable expenses from
fixed expenses. Management accounting includes budgeting, developing and
using standard costs, and working closely with managers regarding how
costs are allocated.
manufacturing overhead costs: Refers to those costs that are indirect and
cannot be naturally matched or linked with manufacturing particular prod-
ucts, or even to a department or step in the production process. One exam-
ple is the annual property tax on the buildings in which all the company’s
manufacturing activities are carried out. Many overhead costs are fixed and
cannot be decreased over the short run — such as payment for the general
liability insurance carried by a business. Production overhead costs are allo-
cated among the different products manufactured during the period in order
to account for the full cost of each product. In this way, the manufacturing
overhead costs are absorbed into product cost.
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margin: Equals sales revenue minus cost of goods sold expense and minus all
variable expenses. (In other words, margin is profit before fixed expenses are
deducted.) On a per-unit basis, margin equals sales price less product cost per
unit and less variable expenses per unit. Margin is an exceedingly important
measure for analyzing profit behavior and in making sales price decisions.
market cap: The total value of a business calculated by multiplying the cur-
rent market price of its capital stock times the total number of capital stock
shares issued by the business. This calculated amount is not money that has
been invested in the business, which is subject to the whims of the stock
market.
massaging the numbers: See income smoothing. It’s also called earnings
management or juggling the books, and it sometimes includes the practice
of window dressing.
net income: Equals sales revenue less all expenses for the period; also any
extraordinary gains and losses for the period are counted in the calculation
to get bottom-line net income. Bottom line means everything has been
deducted from sales revenue (and other income the business may have) so
that the last profit line in the income statement is the final amount of profit
for the period. Instead of net income, you may see terms such as net earnings,
earnings from operations, or just earnings. You do not see the term profit very
often.
operating activities: Generally this term refers to the profit-making activities
of a business — that is, the mainstream sales and expense transactions of a
business.
operating liabilities: Refers to the liabilities from making purchases on credit
for items and services needed in the normal, ongoing operating activities of
a business. The term also includes the liabilities for the accumulation, or
accrual, of unpaid expenses in order to record a full cost of the expenses for
the period (such as accumulated vacation pay earned by employees that will
not be taken until later).
owners’ equity: The ownership capital base of a business. Owners’ equity
derives from two sources: investment of capital in the business by the
owners (for which capital stock shares are issued by a corporation) and
profit that has been earned by the business but has not been distributed to
its owners (called retained earnings for a corporation).
pass-through tax entity: A type of legal organization that does not itself pay
income tax but instead serves as a conduit of its annual taxable income. The
business passes through its annual taxable income to its owners, who include
their respective shares of the amount in their individual income tax returns.
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Partnerships are pass-through tax entities by their very nature. Limited liabil-
ity companies (LLCs) and corporations with 100 or fewer stockholders
(called S corporations) can elect to be treated as pass-through tax entities.
preferred stock: A second type, or class, of capital stock that is issued by a
business corporation in addition to its common stock. Preferred stock derives
its name from the fact that it has certain preferences over the common stock:
It is paid cash dividends before dividends can be paid to common stockhold-
ers; and, in the event of liquidating the business, preferred stock shares must
be redeemed before any money is returned to the common stockholders.
Owners of preferred stock usually do not have voting rights, and the stock
may be callable by the corporation, which means that the business has to
right to redeem the shares for a certain price per share.
prepaid expenses: Expenses that have been paid in advance, or up front, for
future benefits. The amount of cash outlay is entered in the prepaid expenses
asset account. For example, a business writes a $60,000 check today for fire
insurance coverage over the following six months. The total cost is first
entered in the asset account; then, each month, $10,000 is taken out of the
asset and charged to expense. Prepaid expenses are usually much smaller
than a business’s inventory, accounts receivable, and cash assets.
price/earnings (P/E) ratio: The current market price of a capital stock
divided by its trailing 12 months’ diluted earnings per share (EPS) — or its
basic earnings per share if the business does not report diluted EPS.
product cost: Equals the purchase cost of goods that are bought and then
resold by retailers and wholesalers (distributors). In contrast, a manufacturer
combines different types of production costs to determine product cost:
direct (raw) materials, direct labor, and overhead costs.
profit: A very general term that is used with different meanings. It may mean
gains minus losses, or other kinds of increases minus decreases. In business,
the term means sales revenue (and other sources of income) minus expenses
(and losses) for a period of time, such as one year. In an income statement,
the final or bottom-line profit is most often called net income. For public com-
panies, net income is put on a per-share basis, called earnings per share.
profit and loss (P&L) report: A popular title for internal profit performance
reports to managers (that are not circulated outside the company). The term
has a certain ring to it that sounds good, but if you consider it closely, how
can a business have profit and loss at the same time?
property, plant, and equipment: The term generally used in balance sheets
instead of fixed assets.
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proxy statement: The annual solicitation from a corporation’s top executives
and board of directors to its stockholders that requests that they vote a cer-
tain way on matters that have to be put to a vote at the annual meeting of
stockholders. In larger public corporations, most stockholders cannot attend
the meeting in person, so they delegate a proxy (stand-in person) to vote
their shares yes or no on each proposal on the agenda.
Public Company Accounting Oversight Board (PCAOB): The regulatory
agency of the U.S. federal government created by the Sarbanes-Oxley Act of
2002, which was enacted in response to fallout from a number of high-profile
accounting fraud scandals that the CPA auditors of the businesses failed to
discover. This board has broad powers over auditors of public businesses
and the public businesses themselves.
quality of earnings: A pejorative term that raises questions about the relia-
bility of the net income reported by a business. The issue is whether the
profit accounting methods of a business are correct in the circumstances,
and it raises the possibility that reported profit may be overstated.
quick ratio: Calculated by dividing the total of cash, accounts receivable, and
marketable securities (if any) by total current liabilities. This ratio measures
the capability of a business to pay off its current short-term liabilities with its
cash and near-cash assets. Note that inventory and prepaid expenses, the
other two current assets, are excluded from assets in this ratio (which is also
called the acid-test ratio.)
retained earnings: One of two basic sources of the owners’ equity of a busi-
ness (the other being capital invested by the owners). Annual profit (net
income) increases this account, and distributions from profit to owners
decrease the account. The balance in the retained earnings account does
not refer to cash or any particular asset.
return on assets (ROA): Equals the ratio of some measure of profit divided
by some measure of assets, and is expressed as a percent. Caution: There
is no one measure of profit or total assets for calculating this ratio. Different
ROA ratios have different uses. The main purpose of calculating ROA is to
test whether a business is using its assets so that it can pay its cost of capi-
tal, which includes interest on its debt and a satisfactory rate of return on
equity (ROE) for its owners.
return on equity (ROE): Equals net income (minus preferred stock dividends
if any) divided by the book value of owners’ equity (minus the amount of pre-
ferred stock) and is expressed as a percent. ROE is the basic measure of how
well a business is doing in generating earnings, or return on the owners’ capi-
tal investment in the business.
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return on investment (ROI): A very broad and general term that refers to the
income, profit, gain, or earnings on a capital investment, expressed as a per-
centage of the amount invested. Two relevant ROI ratios for a business are
return on assets (ROA) and return on equity (ROE).
Securities and Exchange Commission (SEC): The federal agency (established
by the federal Securities Exchange Act of 1934) that has jurisdiction and broad
powers over the public issuance and trading of securities (stocks and bonds)
by business corporations. Although it has the power to legislate accounting
standards, the SEC has largely deferred to the Financial Accounting Standards
Board (FASB). The SEC has authority over the Public Company Accounting
Oversight Board (PCAOB).
solvency: Refers to the ability of a business (or other entity) to pay its liabili-
ties on time. The current ratio and quick ratio are used to assess the short-
term solvency of a business.
statement of cash flows: One of the three primary financial statements of a
business, which summarizes its cash inflows and outflows during a period
according to a threefold classification: cash flow from operating activities,
investing activities, and financing activities.
statement of changes in owners’ (stockholders’) equity: More in the nature
of a supplementary schedule than a full-fledged financial statement in its own
right. Its purpose is to summarize the changes in the owners’ equity accounts
during the year, including distributing cash dividends, issuing additional
stock shares, buying some of its own capital stock shares, reporting special
types of technical gains and losses that are not reported in the income state-
ment, and who knows what else.
variable costs: Costs that are sensitive to changes in sales volume or sales
revenue. In contrast, fixed costs do not change over the short run in response
to changes in sales activity.
window dressing: An accounting trick or ruse that makes the liquidity and
short-term solvency of a business look better than it really was on the bal-
ance sheet date. The books are held open a few business days after the close
of the accounting year in order to record additional cash receipts (as if the
cash collections had occurred on the last day of the year). This term does
not refer to manipulating profit (see income smoothing). A reasonable amount
of window dressing is not viewed as accounting fraud.
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• Symbols and
Numerics •
( ) (parentheses) around numbers, 3
$ (dollar signs), in income statements, 3
- (minus signs), negative numbers, 3, 80
10-K form, 262, 275, 335
• A •
abandoning product lines, 93
ABC (activity-based costing),
235, 343
accelerated depreciation
definition, 145
financial statement differences, 145
fixed assets, 299–300
IRS rules, 155–156
accountability, 272
accountants. See also CPA (certified
public accountant)
careers in accounting, 27–29
CFO (chief financial officer), 29
CMA (certified management
accountant), 62–63
college degrees, 62–63
continuing education, 63
controllers, 28–29
education, 62–63
hiring guidelines, 62–63
insiders, 14–15
integrity, 63
outsiders, 15
related careers, 29
starting salaries, 29
stereotypes of, 15–16
accounting
actual costs versus economic, 227
versus bookkeeping, 54
definition, 343
methods, effects of changing, 93, 306
policies, choosing, 252, 326–327
range of uses, 17–18
software for, 72–74
in your personal life, 16–17
accounting department, 20–21
accounting equation, 25, 68, 69, 84, 97,
207, 343
accounting fraud. See also internal
(accounting) controls; tricks of the
trade
arm’s length bargaining, 71
controls, reviewing, 329–330
cooking the books, 72
definition, 343
discovery, recent failures, 318–319
embezzlement, 70–72
juggling accounts, 72
kickbacks, 70
losses, effects on profit, 306
money laundering, 71
related parties, 71
sales skimming, 70
shifting revenue and expenses, 71
in small businesses, 65
warning signs in reports, 340–341
Accounting Workbook For Dummies, 2
accounts. See also books
accumulated depreciation, 61
allowance for doubtful accounts, 61
balance sheet, 35–36, 61
balancing, 69–70
bookkeeping cycle, 56–57
chart of, 59–60
complete set. See general ledger
contra, 61
definition, 60
general ledger, 60
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accounts (continued)
income statement, 61
index of. See chart of accounts
juggling, 72. See also accounting fraud
negative, 61
required categories, 59–60
source documents, 61–62
standardized recording procedures,
61–62
types of, 61
accounts payable
cash flows, versus net income,
129–130
definition, 344
expenses, 111
managerial accounting, 300
profit-making activities, 89–90
accounts receivable
as assets, 86
balance, statement differences, 143
changes, effects on cash flow,
126–127
definition, 344
sales revenues, 109
status, 297
accrual-basis accounting
definition, 344
sales on credit, 86
window dressing cash flows, 147
accrued expenses payable
changes, effects on cash flow,
129–130
definition, 344
expenses, 111, 113
liability, 146
managerial accounting, 300–301
profit-making activities, 89–90
accumulated depreciation
balance sheets, 110–111
contra accounts, 61
definition, 344
financial statement differences,
145–146
fixed assets, 145–146, 299–300
acid-test ratio, 287–288, 344
active reading, 135–136. See also
reading reports
activities. See transactions
Activity-based costing (ABC), 235, 343
actual cost/actual output method, 239
actual costs, 224, 230
actual profits, versus smoothed,
260–261
adjusted trial balance, 58
adjusting entries, 65, 344
adjustments to net income, 124–125
adverse (negative) auditor opinion,
313
AICPA (American Institute of Certified
Public Accountants), 50, 319
aligning dollar amounts, 4
allied transactions, 91–92
allocated fixed operating expenses, 197
allowances, effects on profit, 305
allowances for doubtful accounts, 61
amortization, 112, 344
arm’s length bargaining, 71
Arthur Anderson & Company, 318–319
asset accounts, 86–89
asset impairment write-downs, 157
asset turnover ratio, 108, 303, 345
asset/liability ratio, 105
assets
amortization, 112
buying, 36
cash, 36
connection to sales revenues, 107
control benchmarks, 108
cost, versus depreciation, 110–111
fixed. See fixed assets
goodwill, 112
intangible, 112
inventory, 36
versus liabilities, 36
liquid, 287
long-term resources. See fixed assets
net operating assets, 288–289
net worth, 36
non-cash, 107
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property, plant, and equipment. See
fixed assets
quick, 287
and solvency, 104
turning over, 108
valuation, 226
writing down, 93, 95
assets, balance sheets
amortization, 112
cash, 36
connections to sales revenues, 107
control benchmarks, 108
fixed, 36
fixed, depreciation, 110–111
goodwill, 112
intangible, 112
inventory, 36
non-cash, 107
sources of, 24
turning over, 108
types of, 36
values, 24
assumptions of financial statements,
51
audit committees, 320
audit judgment failure, 319
audit trails, 66, 74
auditing firms, 315–316
auditing the auditors, 319–320
audits. See also internal (accounting)
controls
alternatives to, 313
Arthur Anderson & Company,
318–319
audit judgment failure, 319
auditing the auditors, 319–320
clean (unqualified) opinion, 313–314
cost of, 312–313
definition, 345
description, 313
disclosures, 256
Enron, 318–319
ethical duties, 316–317
federal requirements for, 312–313
field audits, IRS, 66
fraud controls, reviewing, 329–330
fraud discovery, recent failures,
318–319
going concern, reservations about,
315
need for, 312–313
negative (adverse) opinion, 313
professional skepticism, 316–317
qualified opinion, 314
responses to irregularities, 317
tips for reading, 291–292
average cost method, 152
avoiding income tax, versus evading,
302
• B •
bad debt, 143, 297, 345
balance, definition, 102
balance sheet accounts, 35–36, 61
balance sheets. See also financial
statements
accounting equation, 25
balance, 102
book value, 117–118. See also owners’
equity
budgeted, 208
contents, 35–37
definition, 345
disclosure, 251–256
double-entry bookkeeping, 25
due diligence, 249
example, 35–37, 101–102
external, 101–103
humor in, 256
importance of, 26–27
versus income statements, 102
internal, 103
liabilities, 24
management’s role, 248–249
market values, 117–118
multiyear statements, 105–106
net worth, 36
359
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