Accounting
All-in-One
3rd Edition
by Michael Taillard
Accounting All-in-One For Dummies® 3rd Edition
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Library of Congress Control Number: 2022941592
ISBN 978-1-119-89766-8 (pbk); ISBN 978-1-119-89767-5 (ebk); ISBN 978-1-119-89768-2 (ebk)
Contents at a Glance
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Book 1: Accounting for Financial Systems . . . . . . . . . . . . . . . . . . . . . 5
CHAPTER 1:
CHAPTER 2:
CHAPTER 3:
CHAPTER 4:
CHAPTER 5:
Accounting for the Basics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Charting Your Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Using Journal Entries and Ledgers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Choosing an Accounting Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Setting the Standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Book 2: Recording Transactions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
CHAPTER 1:
CHAPTER 2:
CHAPTER 3:
CHAPTER 4:
CHAPTER 5:
Keeping the Books. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Tracking Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Tallying Your Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
Processing Employee Payroll and Benefits. . . . . . . . . . . . . . . . . . . . . . . . . 99
Taxing Payrolls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Book 3: Adjusting and Closing Entries . . . . . . . . . . . . . . . . . . . . . . .
129
Depreciating Your Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interesting Rates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Proving Out Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reconciling Accounts and Closing Journal Entries . . . . . . . . . . . . . . . . .
Checking Your Accuracy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Adjusting the Books. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
131
143
153
161
177
189
Book 4: Preparing Income Statements
and Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
201
Stating Your Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Balancing Your Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Digging for Debt in the Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . .
Explaining Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interpreting Income Statements and Balance Sheets. . . . . . . . . . . . . .
203
221
237
251
263
Book 5: Reporting Your Statements. . . . . . . . . . . . . . . . . . . . . . . . . .
277
Valuating Finances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Watching Cash Flow and Equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Analyzing Financial Statements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Explaining Disclosures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Sharing Public Reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
279
289
305
321
335
CHAPTER 1:
CHAPTER 2:
CHAPTER 3:
CHAPTER 4:
CHAPTER 5:
CHAPTER 6:
CHAPTER 1:
CHAPTER 2:
CHAPTER 3:
CHAPTER 4:
CHAPTER 5:
CHAPTER 1:
CHAPTER 2:
CHAPTER 3:
CHAPTER 4:
CHAPTER 5:
Book 6: Planning and Budgeting for Your Business . . . . . . .
347
Looking at the Legals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Incorporating Your Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Drawing Up a Business Plan. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Budgeting for a Better Bottom Line . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Mastering Budgeting Strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Planning for Long-Term Obligations. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
349
361
375
389
403
415
Book 7: Making Savvy Business Decisions . . . . . . . . . . . . . . . . . .
427
Costing Jobs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Costing by the ABCs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Contributing to the Margin. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounting for Change with Variance Analysis. . . . . . . . . . . . . . . . . . . .
Pricing Wisely . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Formulating Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
429
445
461
477
495
505
Book 8: Handling Cash and Making
Purchase Decisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
515
Matching Costs with Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Exploring Inventory Cost Flows. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Buying Wisely . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Financing with Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Managing Results. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Acquiring New Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
517
525
537
551
565
573
Book 9: Auditing for Financial Fraud. . . . . . . . . . . . . . . . . . . . . . . . .
591
Regulating Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Preventing Cash Losses from Embezzlement and Fraud. . . . . . . . . . .
Assessing Audit Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Discovering Audits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auditing Internal Controls. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Scheming Scams. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cooking the Books. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
593
607
621
645
663
685
695
Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
707
CHAPTER 1:
CHAPTER 2:
CHAPTER 3:
CHAPTER 4:
CHAPTER 5:
CHAPTER 6:
CHAPTER 1:
CHAPTER 2:
CHAPTER 3:
CHAPTER 4:
CHAPTER 5:
CHAPTER 6:
CHAPTER 1:
CHAPTER 2:
CHAPTER 3:
CHAPTER 4:
CHAPTER 5:
CHAPTER 6:
CHAPTER 1:
CHAPTER 2:
CHAPTER 3:
CHAPTER 4:
CHAPTER 5:
CHAPTER 6:
CHAPTER 7:
Table of Contents
INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
About This Book. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Foolish Assumptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Icons Used in This Book. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Beyond the Book. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Where to Go from Here . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1
2
3
3
4
BOOK 1: ACCOUNTING FOR FINANCIAL SYSTEMS. . . . . . . . . . . 5
CHAPTER 1:
Accounting for the Basics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Knowing What Bookkeeping and Accounting Are All About. . . . . . . . . . 8
Distinguishing between bookkeeping and accounting . . . . . . . . . . . 8
Taking a panoramic view of bookkeeping and accounting. . . . . . . . 9
Wrapping Your Brain around the Accounting Cycle. . . . . . . . . . . . . . . . 10
Working the Fundamental Accounting Equation . . . . . . . . . . . . . . . . . . 14
CHAPTER 2:
Charting Your Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Navigating the Chart of Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Setting Up Your Chart of Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Giving Credit (Or Is It Debit?). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Understanding Double-Entry Accounting . . . . . . . . . . . . . . . . . . . . . . . .
Conquering the balance sheet equation . . . . . . . . . . . . . . . . . . . . . .
Recording journal entries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Writing a complex journal entry . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
CHAPTER 3:
18
19
21
22
22
23
24
Using Journal Entries and Ledgers. . . . . . . . . . . . . . . . . . . . . 27
Keeping a Journal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28
Using journals to record cash transactions. . . . . . . . . . . . . . . . . . . . 28
Recording accrual transactions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Exploring other journals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Checking out examples of common journal entries . . . . . . . . . . . . 36
Bringing It All Together in the Ledger. . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Realizing what a ledger is. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Posting to the ledgers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Viewing an example of a general ledger . . . . . . . . . . . . . . . . . . . . . . 39
Recognizing the purpose of the trial balance . . . . . . . . . . . . . . . . . . 41
Putting Accounting Software to Work for You. . . . . . . . . . . . . . . . . . . . .42
Table of Contents
vii
CHAPTER 4:
Choosing an Accounting Method . . . . . . . . . . . . . . . . . . . . . . 45
Choosing Your Method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
The cash method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
The accrual method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
The hybrid method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Sorting through Standards for Other Types of Accounting. . . . . . . . . . 48
Financial accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Managerial and cost accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Not-for-profit accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Governmental accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
Forensic accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
Public accounting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52
CHAPTER 5:
Setting the Standards. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Exploring the Origins of Accounting Standards . . . . . . . . . . . . . . . . . . .
Recognizing the Role of the American Institute of Certified
Public Accountants. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tying together regulators for audits of publicly traded
companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Navigating ASB audit and attestation standards . . . . . . . . . . . . . . .
Observing the AICPA Code of Professional Conduct . . . . . . . . . . . .
Checking Out the U.S. Securities and Exchange Commission . . . . . . .
Getting to Know the Financial Accounting Standards Board . . . . . . . .
Understanding generally accepted accounting principles . . . . . . .
Looking online for FASB standards. . . . . . . . . . . . . . . . . . . . . . . . . . .
Picking a standard: Domestic or international . . . . . . . . . . . . . . . . .
Grasping Accounting Standards Around the Globe. . . . . . . . . . . . . . . .
54
55
55
56
57
59
59
60
61
61
62
BOOK 2: RECORDING TRANSACTIONS . . . . . . . . . . . . . . . . . . . . . . . . 63
CHAPTER 1:
Keeping the Books. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Analyzing the Effect of Business Transactions . . . . . . . . . . . . . . . . . . . .
Approaching the fundamental accounting equation. . . . . . . . . . . .
Getting familiar with accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Defining debits and credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Knowing more about the transaction methodology . . . . . . . . . . . .
Managing Your Bookkeeping and Accounting System . . . . . . . . . . . . .
Categorizing your financial information: The chart
of accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Standardizing source document forms and processing
procedures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Hiring competent personnel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Enforcing strong internal controls . . . . . . . . . . . . . . . . . . . . . . . . . . .
Wrapping Up with End-of-Period Procedures. . . . . . . . . . . . . . . . . . . . .
Tidying up the books. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
viii
Accounting All-in-One For Dummies
65
66
66
67
67
68
68
70
70
72
73
73
Leaving good audit trails . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Staying alert for unusual events and developments . . . . . . . . . . . . 75
Designing truly useful reports for managers . . . . . . . . . . . . . . . . . . 75
CHAPTER 2:
Tracking Purchases. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Keeping Track of Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Entering initial cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Managing inventory and its value. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Buying Supplies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Handling Billing and Payables. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
CHAPTER 3:
Tallying Your Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
Collecting on Cash Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Discovering the value of sales receipts . . . . . . . . . . . . . . . . . . . . . . .
Recording cash transactions in the books. . . . . . . . . . . . . . . . . . . . .
Selling on Credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Deciding whether to offer store credit. . . . . . . . . . . . . . . . . . . . . . . .
Recording store credit transactions in the books. . . . . . . . . . . . . . .
Proving Out the Cash Register. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tracking Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Recording Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Monitoring Accounts Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accepting Your Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
CHAPTER 4:
77
79
81
85
86
87
88
90
90
91
91
93
94
95
97
98
Processing Employee Payroll and Benefits . . . . . . . . . . 99
Staffing Your Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Completing government forms. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Picking pay periods. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
Determining wage and salary types. . . . . . . . . . . . . . . . . . . . . . . . . 105
Collecting Employee Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Sorting out Social Security tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Making sense of Medicare tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Figuring out federal withholding tax. . . . . . . . . . . . . . . . . . . . . . . . .107
Settling up state and local withholding taxes . . . . . . . . . . . . . . . . . 108
Determining Net Pay. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Surveying Your Benefits Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Tax-exempt benefits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
Taxable benefits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .110
Cafeteria plans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
Preparing Payroll and Posting It in the Books. . . . . . . . . . . . . . . . . . . . 111
Calculating payroll for hourly employees . . . . . . . . . . . . . . . . . . . . 111
Doling out funds to salaried employees . . . . . . . . . . . . . . . . . . . . . 112
Totaling up for commission checks . . . . . . . . . . . . . . . . . . . . . . . . . 112
Putting it together to prepare payroll. . . . . . . . . . . . . . . . . . . . . . . .114
Depositing Employee Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
Table of Contents
ix
Taxing Payrolls. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
119
Paying Employer Taxes on Social Security and Medicare. . . . . . . . . .
Filing Form 941 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Knowing how often to file . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Completing Unemployment Reports and Paying
Unemployment Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Figuring out how states calculate the FUTA tax rate . . . . . . . . . . .
Calculating FUTA tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Filing and paying unemployment taxes to state governments. . . .
Carrying Workers’ Compensation Insurance. . . . . . . . . . . . . . . . . . . . .
Maintaining Employee Records. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
119
120
121
BOOK 3: ADJUSTING AND CLOSING ENTRIES. . . . . . . . . . . . . .
129
Depreciating Your Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
131
CHAPTER 5:
CHAPTER 1:
121
122
122
124
125
126
Appreciating Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Knowing what you can and can’t depreciate. . . . . . . . . . . . . . . . . . 132
Figuring out the useful life of a fixed asset . . . . . . . . . . . . . . . . . . . 133
Delving into cost basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
Comparing Depreciation Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
Walking through the straight-line method . . . . . . . . . . . . . . . . . . . 136
Accelerating by using declining balance. . . . . . . . . . . . . . . . . . . . . .136
Calculating sum-of-the-years’-digits. . . . . . . . . . . . . . . . . . . . . . . . . 137
Using the units-of-production method . . . . . . . . . . . . . . . . . . . . . . 138
Seeing how the methods compare. . . . . . . . . . . . . . . . . . . . . . . . . . 139
Figuring partial year depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . 139
Tackling Taxes and Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .141
Section 179. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
MACRS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
CHAPTER 2:
CHAPTER 3:
Interesting Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
143
Deciphering Types of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Simple interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Compound interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Hybrid interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Handling Interest Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Delving into Loans and Interest Expenses. . . . . . . . . . . . . . . . . . . . . . .
Short-term debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
143
144
144
145
146
147
147
149
Proving Out Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
153
Making Sure That Ending Cash Is Right . . . . . . . . . . . . . . . . . . . . . . . . . 153
Closing the Cash Journals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
x
Accounting All-in-One For Dummies
Finalizing cash receipts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
Finalizing cash outlays . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Using a Temporary Posting Journal . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
CHAPTER 4:
Reconciling Accounts and Closing
Journal Entries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
161
Reconciling Bank Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Tracking down reconciling items. . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
Using a computerized system. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Posting Adjustments and Corrections . . . . . . . . . . . . . . . . . . . . . . . 165
Prepping to Close: Checking for Accuracy and Tallying
Things Up. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Paying attention to initial transaction details . . . . . . . . . . . . . . . . . 166
Summarizing journal entries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
Analyzing summary results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
Planning for cash flow. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .172
Posting to the General Ledger. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Checking Out Computerized Journal Records. . . . . . . . . . . . . . . . . . . . 173
CHAPTER 5:
Checking Your Accuracy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
177
Working with a Trial Balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Conducting your trial balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dealing with trial balance errors. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Testing Your Balance by Using Computerized
Accounting Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Developing a Financial Statement Worksheet . . . . . . . . . . . . . . . . . . .
Replacing Worksheets with Computerized Reports. . . . . . . . . . . . . . .
177
178
180
182
183
185
Adjusting the Books. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
189
Adjusting All the Right Areas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciating assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Allocating prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Counting inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Allowing for bad debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Recognizing unpaid salaries and wages. . . . . . . . . . . . . . . . . . . . . .
Testing an Adjusted Trial Balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
190
191
193
193
195
197
198
BOOK 4: PREPARING INCOME STATEMENTS
AND BALANCE SHEETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
201
Stating Your Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
203
CHAPTER 6:
CHAPTER 1:
Understanding the Nature of Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Choosing the Income-Statement Format. . . . . . . . . . . . . . . . . . . . . . . . 204
Table of Contents
xi
Deciding What to Disclose in the Income Statement. . . . . . . . . . . . . .
Considering expense disclosure. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Presenting the right amount of expense information. . . . . . . . . .
Examining How Sales and Expenses Change Assets
and Liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Sizing up a business’s financial condition . . . . . . . . . . . . . . . . . . . .
Noting how accounting transactions affect the income
statement and balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Considering the Diverse Financial Effects of Making a Profit. . . . . . .
Introducing T-accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Combining activity into one journal entry. . . . . . . . . . . . . . . . . . . .
Explaining additional transactions related to profit. . . . . . . . . . . .
Reporting Extraordinary Gains and Losses. . . . . . . . . . . . . . . . . . . . . .
Segregating the income statement. . . . . . . . . . . . . . . . . . . . . . . . . .
Considering business disruptions. . . . . . . . . . . . . . . . . . . . . . . . . . .
Questioning whether activity is truly unusual. . . . . . . . . . . . . . . . .
Correcting Common Misconceptions about Profit. . . . . . . . . . . . . . . .
Clearing up profit misconceptions . . . . . . . . . . . . . . . . . . . . . . . . . .
Comparing with industry standards. . . . . . . . . . . . . . . . . . . . . . . . .
Waving the red flag when you see revenue and credit
sales increase. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
CHAPTER 2:
CHAPTER 3:
xii
206
206
207
207
208
208
210
211
212
212
213
213
214
216
217
217
218
218
Balancing Your Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
221
Homing in on Historic Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Discovering What Makes an Asset Current. . . . . . . . . . . . . . . . . . . . . .
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Meeting the tangibles: Property, plant, and equipment . . . . . . . .
Investigating intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Exploring the Asset Section of the Balance Sheet . . . . . . . . . . . . . . . .
221
222
223
224
225
227
228
230
232
234
Digging for Debt in the Balance Sheet. . . . . . . . . . . . . .
237
Seeing How Businesses Account for Liabilities. . . . . . . . . . . . . . . . . . .
Keeping Current Liabilities under Control. . . . . . . . . . . . . . . . . . . . . . .
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Payroll and taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unearned revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other short-term liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Planning for Long-Term Obligations. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Financing asset purchases with debt versus equity. . . . . . . . . . . .
238
239
240
241
241
242
244
244
Accounting All-in-One For Dummies
Managing long-term debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
Anticipating contingent liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 246
Accounting for Bond Issuances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
Mulling over bond basics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
Examining sample bond transactions . . . . . . . . . . . . . . . . . . . . . . . 248
Journaling bond transactions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .249
CHAPTER 4:
CHAPTER 5:
Explaining Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
251
Understanding How Owner Equity Varies among
Business Entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Sole proprietorship. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Partnership. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Distinguishing between Two Types of Capital Stock . . . . . . . . . . . . . .
Looking into preferred stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Considering common stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Recording stock transactions on the balance sheet. . . . . . . . . . . .
Defining Paid-In Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Recording Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Spotting Reductions to Stockholders’ Equity. . . . . . . . . . . . . . . . . . . . .
Paying dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Buying back shares: Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . .
Exploring Stock Splits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Computing Earnings per Share. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Simple capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Complex capital structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
251
252
252
253
253
254
254
254
255
256
256
257
259
259
260
260
261
Interpreting Income Statements and
Balance Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
263
Rejoining the Income Statement and Balance Sheet. . . . . . . . . . . . . .
Seeing connections between accounts . . . . . . . . . . . . . . . . . . . . . .
Using transactions to explain the connections. . . . . . . . . . . . . . . .
Introducing Operating Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Comparing expected with actual operating ratios. . . . . . . . . . . . .
Generating balance sheet amounts by using ratios. . . . . . . . . . . .
Adding Fixed Assets, Depreciation, and Owners’ Equity. . . . . . . . . . .
Dealing with fixed assets and depreciation. . . . . . . . . . . . . . . . . . .
Tacking on owners’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Completing the Balance Sheet with Debt . . . . . . . . . . . . . . . . . . . . . . .
Going over the debt section of the balance sheet . . . . . . . . . . . . .
Tying in the new equity section. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
264
264
266
268
268
269
272
272
274
274
275
275
Table of Contents
xiii
BOOK 5: REPORTING YOUR STATEMENTS. . . . . . . . . . . . . . . . . .
CHAPTER 1:
CHAPTER 2:
CHAPTER 3:
xiv
277
Valuating Finances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
279
Clarifying the Values of Assets in Balance Sheets. . . . . . . . . . . . . . . . .
Considering options for balance sheet valuation. . . . . . . . . . . . . .
Comparing two balance sheet valuations . . . . . . . . . . . . . . . . . . . .
Introducing Business Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Grasping the practical applications of business valuations . . . . .
Getting CVA-certified. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Comparing Business Valuation Methods. . . . . . . . . . . . . . . . . . . . . . . .
Replacing values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Using future earnings and cash flow . . . . . . . . . . . . . . . . . . . . . . . .
280
280
282
283
283
284
285
286
286
Watching Cash Flow and Equity. . . . . . . . . . . . . . . . . . . . . .
289
Understanding the Difference between Cash and Profit . . . . . . . . . .
Seeing how noncash transactions affect profit. . . . . . . . . . . . . . . .
Distinguishing costs from expenses. . . . . . . . . . . . . . . . . . . . . . . . .
Flowing Through Cash Transactions. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Navigating the Three Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Figuring cash operating results. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Showing cash investing transactions . . . . . . . . . . . . . . . . . . . . . . . .
Accounting for financing activities . . . . . . . . . . . . . . . . . . . . . . . . . .
Preparing the Statement of Cash Flows. . . . . . . . . . . . . . . . . . . . . . . . .
Using the direct method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Starting indirectly with net income. . . . . . . . . . . . . . . . . . . . . . . . . .
Interpreting the Statement of Cash Flows. . . . . . . . . . . . . . . . . . . . . . .
Stating Changes in Stockholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . .
290
290
291
291
292
293
295
297
298
298
300
301
302
Analyzing Financial Statements . . . . . . . . . . . . . . . . . . . . .
305
Judging Solvency and Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Understanding the risks of late payments. . . . . . . . . . . . . . . . . . . .
Recognizing current assets and liabilities . . . . . . . . . . . . . . . . . . . .
Brushing up on current and quick ratios. . . . . . . . . . . . . . . . . . . . .
Driving the Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Analyzing three types of balance sheet transactions. . . . . . . . . . .
Reviewing changes in balance sheet accounts. . . . . . . . . . . . . . . .
Measuring Profitability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Understanding trend analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Focusing on return on investment . . . . . . . . . . . . . . . . . . . . . . . . . .
Homing in on return on equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Exploring Activity Measures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
306
306
306
307
310
310
311
313
313
314
315
315
316
317
Accounting All-in-One For Dummies
Comparing Horizontal and Vertical Analysis. . . . . . . . . . . . . . . . . . . . . 317
Using horizontal analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
Implementing vertical analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
Using Common Size Financial Statements. . . . . . . . . . . . . . . . . . . . . . .320
CHAPTER 4:
Explaining Disclosures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
321
Questioning Self-Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
Identifying Corporate Characteristics. . . . . . . . . . . . . . . . . . . . . . . . . . . 322
Reviewing Common Explanatory Notes. . . . . . . . . . . . . . . . . . . . . . . . . 324
Leveling the playing field among financial statements . . . . . . . . . 324
Explaining significant accounting policies . . . . . . . . . . . . . . . . . . . . 325
Looking for important-event disclosures. . . . . . . . . . . . . . . . . . . . . 328
Putting the Onus on the Preparer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .333
CHAPTER 5:
Sharing Public Reports. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
335
Differentiating between Private and Public Companies . . . . . . . . . . . 336
Finding Purpose in Reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
Meeting regulatory requirements. . . . . . . . . . . . . . . . . . . . . . . . . . . 337
Stating financial performance and goals. . . . . . . . . . . . . . . . . . . . . 337
Marketing and PR messages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
Reading the Annual Report to Shareholders. . . . . . . . . . . . . . . . . . . . . 338
Meeting the chair of the board of directors . . . . . . . . . . . . . . . . . . 338
Highlighting key financial data. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
Touting company achievements. . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
Looking into the future. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
Meeting management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .341
Walking through Form 10-K. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
Facing page: Identifying the affected company . . . . . . . . . . . . . . . 342
Part I: Finding out more about the registrant. . . . . . . . . . . . . . . . . 343
Part II: Revealing the company’s financial performance . . . . . . . . 343
Part III: Identifying management and corporate governance. . . . 345
Part IV: Exhibiting evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346
BOOK 6: PLANNING AND BUDGETING
FOR YOUR BUSINESS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
347
Looking at the Legals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
349
CHAPTER 1:
Surveying Structures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
Partnering up. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
Looking at the LLC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
Limiting liability: Professional corporations and LLPs. . . . . . . . . . 351
Understanding how partnerships and LLCs distribute profits. . . . 352
Going It Alone: Sole Proprietorships. . . . . . . . . . . . . . . . . . . . . . . . . . . .353
Describing a sole proprietorship. . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
Understanding liability and financial reporting . . . . . . . . . . . . . . . 353
Table of Contents
xv
Choosing the Right Legal Structure for Income Tax. . . . . . . . . . . . . . . 354
C corporations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
S corporations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356
Partnerships and LLCs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
The legal structure issue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .358
CHAPTER 2:
CHAPTER 3:
CHAPTER 4:
xvi
Incorporating Your Business . . . . . . . . . . . . . . . . . . . . . . . . .
361
Securing Capital: Starting with Owners . . . . . . . . . . . . . . . . . . . . . . . . .
Contrasting two sources of equity . . . . . . . . . . . . . . . . . . . . . . . . . .
Leveraging equity capital with debt . . . . . . . . . . . . . . . . . . . . . . . . .
Recognizing Legal Roots. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Incorporating a Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Issuing stock shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Offering different classes of stock shares. . . . . . . . . . . . . . . . . . . .
Determining the market value of stock shares. . . . . . . . . . . . . . . .
Keeping alert for dilution of share value. . . . . . . . . . . . . . . . . . . . .
Recognizing conflicts between stockholders and managers . . . .
362
362
364
365
366
367
368
370
371
372
Drawing Up a Business Plan. . . . . . . . . . . . . . . . . . . . . . . . . .
375
Outlining the Basic Business Plan. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The executive summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The market assessment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The operational overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The financial summary: Performance and required capital. . . . .
Developing a Business Plan. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Recognizing the evolution of business plans: BOTE, WAG,
and SWAG. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Taking a problem-solving approach. . . . . . . . . . . . . . . . . . . . . . . . .
Getting the process going . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Analyzing and streamlining information with SWOT and KISS. . .
Incorporating Third-Party Information into Your Plan. . . . . . . . . . . . .
Gathering the info. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Riding the CART concept: Complete, accurate, reliable,
and timely. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
376
376
377
378
379
379
379
381
382
384
386
386
387
Budgeting for a Better Bottom Line. . . . . . . . . . . . . . . . .
389
Brushing Up on Budgeting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Meeting the master budget. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Understanding key budgeting concepts . . . . . . . . . . . . . . . . . . . . .
Planning strategically . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Recognizing Factors That Affect Your Budgeting Process. . . . . . . . . .
Experience counts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Timing is everything . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
People get you headed in the right direction . . . . . . . . . . . . . . . . .
Sales projections pay off . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
389
390
390
391
391
392
392
393
393
Accounting All-in-One For Dummies
Understanding Budgeting Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Sourcing funds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Using the balance sheet. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Working with the income statement . . . . . . . . . . . . . . . . . . . . . . . .
Analyzing the statement of cash flows. . . . . . . . . . . . . . . . . . . . . . .
Reviewing Revenue and Production Budgets. . . . . . . . . . . . . . . . . . . .
Applying the revenue formula. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Using the inventory formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Assessing cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
395
395
396
396
397
398
399
399
400
Mastering Budgeting Strategies . . . . . . . . . . . . . . . . . . . . .
403
Budgeting with Cash or Accrual Accounting . . . . . . . . . . . . . . . . . . . . .
Accounting for cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accruing experience . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Budgeting to Produce the Income Statement and Balance Sheet. . .
Well-balanced sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The incredible income statement. . . . . . . . . . . . . . . . . . . . . . . . . . .
Flexing Your Budget: When Plans Change. . . . . . . . . . . . . . . . . . . . . . .
Controlling your business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dealing with budget variances . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Implementing a flexible budget . . . . . . . . . . . . . . . . . . . . . . . . . . . .
404
404
406
407
407
408
408
409
409
410
Planning for Long-Term Obligations . . . . . . . . . . . . . . . .
415
Managing Long-Term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The many faces of notes payable. . . . . . . . . . . . . . . . . . . . . . . . . . .
Treasury bonds defined. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The dark side of debt-free . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounting for Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Valuing bonds payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Figuring out the present value of a bond. . . . . . . . . . . . . . . . . . . . .
Issuing at face value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
415
416
421
422
423
423
424
425
BOOK 7: MAKING SAVVY BUSINESS DECISIONS. . . . . . . . . . .
427
CHAPTER 5:
CHAPTER 6:
CHAPTER 1:
Costing Jobs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
429
Understanding How Job Costing Works. . . . . . . . . . . . . . . . . . . . . . . . .
Objecting to costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Charging customers for direct and indirect costs. . . . . . . . . . . . . .
Implementing job costing in manufacturing. . . . . . . . . . . . . . . . . .
Taking a Closer Look at Indirect Costs by Using Normal Costing. . . .
Budgeting for indirect costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Following a normal job costing system . . . . . . . . . . . . . . . . . . . . . .
Following the Flow of Costs through a Manufacturing System . . . . .
Managing costs with control accounts. . . . . . . . . . . . . . . . . . . . . . .
Applying the methodology to other control accounts. . . . . . . . . .
429
430
431
433
436
437
438
439
440
443
Table of Contents
xvii
CHAPTER 2:
CHAPTER 3:
CHAPTER 4:
xviii
Costing by the ABCs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
445
Avoiding the Slippery Slope of Peanut Butter Costing. . . . . . . . . . . . .
Recognizing a single indirect cost allocation. . . . . . . . . . . . . . . . . .
Finding a fly in the peanut butter: Dealing with different
levels of client activity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Undercosting and overcosting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Designing an Activity-Based Costing System. . . . . . . . . . . . . . . . . . . . .
Refining your approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Grouping costs by using a cost hierarchy . . . . . . . . . . . . . . . . . . . .
Testing your ABC design. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Using Activity-Based Costing to Compute Total Cost,
Profit, and Sale Price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Allocating indirect costs evenly by product. . . . . . . . . . . . . . . . . . .
Analyzing and reallocating cost activities. . . . . . . . . . . . . . . . . . . . .
Changing allocations to cost pools. . . . . . . . . . . . . . . . . . . . . . . . . .
Changing prices after ABC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
445
446
447
448
450
450
451
452
455
456
457
458
459
Contributing to the Margin. . . . . . . . . . . . . . . . . . . . . . . . . . .
461
Computing Contribution Margin. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Figuring total contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . .
Calculating contribution margin per unit. . . . . . . . . . . . . . . . . . . . .
Working out contribution margin ratio . . . . . . . . . . . . . . . . . . . . . .
Preparing a Cost-Volume-Profit Analysis. . . . . . . . . . . . . . . . . . . . . . . .
Drafting a cost-volume-profit graph. . . . . . . . . . . . . . . . . . . . . . . . .
Trying out the total contribution margin formula . . . . . . . . . . . . .
Practicing the contribution margin per unit formula. . . . . . . . . . .
Eyeing the contribution margin ratio formula . . . . . . . . . . . . . . . .
Generating a Break-Even Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Plotting the break-even point . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Using the formula approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Shooting for Target Profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Setting a Margin of Safety . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Using a graph to depict margin of safety. . . . . . . . . . . . . . . . . . . . .
Calculating the margin of safety. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Measuring Operating Leverage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Graphing operating leverage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Looking at the operating leverage formula. . . . . . . . . . . . . . . . . . .
462
462
464
465
465
466
467
468
468
469
469
470
471
472
473
473
474
474
474
Accounting for Change with Variance Analysis . . .
477
Setting Up Standard Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Establishing direct materials standards. . . . . . . . . . . . . . . . . . . . . .
Determining direct labor standards. . . . . . . . . . . . . . . . . . . . . . . . .
Calculating the overhead rate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Adding up standard cost per unit. . . . . . . . . . . . . . . . . . . . . . . . . . .
478
479
480
480
481
Accounting All-in-One For Dummies
Understanding Variances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Computing direct materials variances. . . . . . . . . . . . . . . . . . . . . . .
Calculating direct labor variances. . . . . . . . . . . . . . . . . . . . . . . . . . .
Computing overhead variances . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Teasing Out Variances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interpreting variances in action. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Focusing on the big numbers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tracing little numbers back to big problems. . . . . . . . . . . . . . . . . .
482
483
486
489
490
491
492
492
Pricing Wisely. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
495
Differentiating Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Taking All Costs into Account with Absorption Costing. . . . . . . . . . . .
Pricing at Cost Plus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Computing fixed markups. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Setting a cost-plus percentage . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Considering problems with cost-plus pricing . . . . . . . . . . . . . . . . .
Accounting Extremes: Trying Variable-Cost Pricing . . . . . . . . . . . . . . .
Working out variable-cost pricing. . . . . . . . . . . . . . . . . . . . . . . . . . .
Spotting the hazards of variable-cost pricing . . . . . . . . . . . . . . . . .
Hitting the Bull’s-Eye (Your Target Cost). . . . . . . . . . . . . . . . . . . . . . . . .
Calculating your target cost. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Transferring price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Outsourcing decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
495
496
497
497
498
498
499
499
500
501
501
503
504
Formulating Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
505
Analyzing Profitability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Using Assets Effectively . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Evaluating Firm Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Monitoring your checkbook. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liquidating assets to collect cash . . . . . . . . . . . . . . . . . . . . . . . . . . .
Checking on Company Solvency. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Managing Projects and Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
505
507
509
510
511
511
512
BOOK 8: HANDLING CASH AND MAKING
PURCHASE DECISIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
515
CHAPTER 5:
CHAPTER 6:
CHAPTER 1:
Matching Costs with Revenue. . . . . . . . . . . . . . . . . . . . . . . .
517
Defining Costs and Expenses in the Business World. . . . . . . . . . . . . .
Satisfying the matching principle . . . . . . . . . . . . . . . . . . . . . . . . . . .
Identifying product and period costs. . . . . . . . . . . . . . . . . . . . . . . .
Discovering Which Costs Are Depreciated. . . . . . . . . . . . . . . . . . . . . . .
Handling real property depreciation . . . . . . . . . . . . . . . . . . . . . . . .
Allocating costs between land and buildings . . . . . . . . . . . . . . . . .
Expensing repairs and maintenance . . . . . . . . . . . . . . . . . . . . . . . .
518
518
519
519
520
520
521
Table of Contents
xix
Preparing a Depreciation Schedule . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521
Deciding When to Recognize Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . 523
Going over the revenue recognition principle. . . . . . . . . . . . . . . . .523
Recognizing revenue and cash flow. . . . . . . . . . . . . . . . . . . . . . . . . 524
CHAPTER 2:
CHAPTER 3:
CHAPTER 4:
xx
Exploring Inventory Cost Flows . . . . . . . . . . . . . . . . . . . . . .
525
Stating Inventory Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Comparing merchandising and manufacturing companies. . . . .
Translating inventory into revenue. . . . . . . . . . . . . . . . . . . . . . . . . .
Logging Inventory for Service Companies. . . . . . . . . . . . . . . . . . . . . . .
Classifying Inventory Types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounting for merchandising company inventory. . . . . . . . . . . .
Accounting for manufacturing company inventory. . . . . . . . . . . .
Knowing Inventory Valuation Methods . . . . . . . . . . . . . . . . . . . . . . . . .
Understanding guidelines used for all methods. . . . . . . . . . . . . . .
Comparing inventory cost-flow assumptions. . . . . . . . . . . . . . . . .
Preparing an Inventory Worksheet. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
526
526
526
527
527
527
530
531
532
532
534
Buying Wisely . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
537
Identifying Incremental and Opportunity Costs. . . . . . . . . . . . . . . . . .
Keeping Things Simple: The Cash Payback Method. . . . . . . . . . . . . . .
Using the cash payback method with equal annual
net cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Applying the cash payback method when annual net
cash flows change each year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Netting Present Value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Calculating time value of money with one payment for
one year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finding time value of money with one payment held for
two periods or more. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Calculating net present value with a series of future
cash flows. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Measuring Internal Rate of Return. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Considering Qualitative Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
538
538
539
540
541
542
543
544
547
548
Financing with Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
551
Understanding the Basics of Debt Capital. . . . . . . . . . . . . . . . . . . . . . .
Debt maturity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Debt security . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other debt attributes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Determining When Debt Is Most Appropriate . . . . . . . . . . . . . . . . . . .
When you can offer security or collateral . . . . . . . . . . . . . . . . . . . .
When business is stable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
When you have financial strength . . . . . . . . . . . . . . . . . . . . . . . . . .
551
552
552
554
554
555
555
556
Accounting All-in-One For Dummies
CHAPTER 5:
CHAPTER 6:
Using Loans, Leases, and Other Sources of Debt. . . . . . . . . . . . . . . . .
Borrowing from banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Making friends with asset-based lenders . . . . . . . . . . . . . . . . . . . .
Leasing as a source of capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tapping government programs . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Using other sources of debt-based capital . . . . . . . . . . . . . . . . . . .
Getting Creative with Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Generating internal cash flow. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Leveraging unsecured creditors . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Going after government aid, gifts, and grants . . . . . . . . . . . . . . . .
Partnering up. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Crowdfunding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
556
556
558
559
561
561
562
562
562
563
563
564
Managing Results. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
565
Approaching Financial Reports. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reviewing Profit and Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Judging profit performance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Testing earnings per share against change in bottom line. . . . . .
Judging the Company’s Cash Position . . . . . . . . . . . . . . . . . . . . . . . . . .
Comparing net income to cash flow. . . . . . . . . . . . . . . . . . . . . . . . .
Considering solvency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tackling Extraordinary Gains and Losses . . . . . . . . . . . . . . . . . . . . . . .
Recognizing the Risks of Restatement. . . . . . . . . . . . . . . . . . . . . . . . . .
566
566
567
567
569
569
569
570
571
Acquiring New Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
573
Maximizing Business Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Attending to financial and nonfinancial factors . . . . . . . . . . . . . . .
Evaluating business operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reviewing products, services, and training. . . . . . . . . . . . . . . . . . .
Attending to issues that can sink the sale. . . . . . . . . . . . . . . . . . . .
Becoming a Team Player . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Funding a Business Purchase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Working through Due Diligence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Mulling over your accounting system. . . . . . . . . . . . . . . . . . . . . . . .
Having your accounting system audited . . . . . . . . . . . . . . . . . . . . .
Having an attorney review contracts and other agreements. . . .
Coming to Terms with a Sale Price. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Comparing an asset purchase with an equity purchase. . . . . . . .
Normalizing the financial statements. . . . . . . . . . . . . . . . . . . . . . . .
Factoring in industry and economic conditions . . . . . . . . . . . . . . .
Securing a win–win sale price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
574
574
578
579
580
582
583
584
585
585
587
587
587
588
589
590
Table of Contents
xxi
BOOK 9: AUDITING FOR FINANCIAL FRAUD. . . . . . . . . . . . . . .
CHAPTER 1:
CHAPTER 2:
CHAPTER 3:
xxii
591
Regulating Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
593
Early Securities Laws. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Securities Act of 1933: Arming investors with information . . .
The Securities Exchange Act of 1934: Establishing the SEC. . . . . .
Other securities laws. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Scope of SOX: Securities and Issuers . . . . . . . . . . . . . . . . . . . . . . .
Determining what a security is . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Defining an issuer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Figuring out how stock exchanges work . . . . . . . . . . . . . . . . . . . . .
Unveiling the SOX surprise. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some universal SOX provisions. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Post-SOX Paper Trail . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Form 10-K. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Form 10-Q. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Form 8-K. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
594
594
595
598
599
599
600
601
602
604
604
605
605
605
Preventing Cash Losses from Embezzlement
and Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
607
Preventing Loss with Internal Controls . . . . . . . . . . . . . . . . . . . . . . . . .
Weighting internal control costs and benefits . . . . . . . . . . . . . . . .
Understanding collusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Recognizing the dual purpose of internal accounting controls . . .
Segregating duties to prevent theft . . . . . . . . . . . . . . . . . . . . . . . . .
Struggling with fraud committed by the business . . . . . . . . . . . . .
Considering fraud committed by the business. . . . . . . . . . . . . . . .
Considering external auditors and detecting fraud. . . . . . . . . . . .
Putting Internal Controls to Work. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Going down the internal controls checklist. . . . . . . . . . . . . . . . . . .
Considering some important details of internal control. . . . . . . .
Recognizing Limitations of Internal Controls . . . . . . . . . . . . . . . . . . . .
Keeping internal controls under control . . . . . . . . . . . . . . . . . . . . .
Finding fraud that slips through the net . . . . . . . . . . . . . . . . . . . . .
608
608
609
609
610
610
611
611
612
612
617
619
619
619
Assessing Audit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
621
Introducing Audit Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Recognizing the Nature of a Client’s Business: Inherent Risk. . . . . . .
Environment and external factors . . . . . . . . . . . . . . . . . . . . . . . . . .
Previous-period misstatements . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Susceptibility to theft or fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Assessing a Client’s Ability to Detect and Correct Problems:
Control Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Figuring Your Chances of Overlooking Inaccuracies:
Detection Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
622
623
623
624
625
Accounting All-in-One For Dummies
626
627
Changing the audit risk model formula. . . . . . . . . . . . . . . . . . . . . . 627
Considering detection risk and sampling. . . . . . . . . . . . . . . . . . . . .627
Going over elements of detection risk. . . . . . . . . . . . . . . . . . . . . . . 628
Following Risk Assessment Procedures. . . . . . . . . . . . . . . . . . . . . . . . . 629
Recognizing the nature of the company . . . . . . . . . . . . . . . . . . . . . 629
Examining the quality of company management. . . . . . . . . . . . . . 630
Asking employees for information. . . . . . . . . . . . . . . . . . . . . . . . . . 631
Analyzing processes and paperwork . . . . . . . . . . . . . . . . . . . . . . . . 632
Observing the client at work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 633
Figuring Out What’s Material and What Isn’t. . . . . . . . . . . . . . . . . . . . . 634
Distinguishing errors from fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . 635
Explaining the triangle of fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 637
Evaluating Your Audit Risk Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 641
Tailoring the audit to a low-risk situation . . . . . . . . . . . . . . . . . . . . 641
Responding to a high-risk assessment. . . . . . . . . . . . . . . . . . . . . . . 642
Documenting audit risk results. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 643
CHAPTER 4:
CHAPTER 5:
Discovering Audits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
645
Management Assertions: Assessing the Information
a Client Gives You . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Defining financial statement presentation and disclosure. . . . . .
Monitoring classes of transactions. . . . . . . . . . . . . . . . . . . . . . . . . .
Analyzing account balances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Eyeing the Four Concepts of Audit Evidence. . . . . . . . . . . . . . . . . . . . .
The nature of the audit evidence . . . . . . . . . . . . . . . . . . . . . . . . . . .
The competence of the audit evidence . . . . . . . . . . . . . . . . . . . . . .
The sufficiency of the audit evidence. . . . . . . . . . . . . . . . . . . . . . . .
The evaluation of the audit evidence. . . . . . . . . . . . . . . . . . . . . . . .
Applying Professional Judgment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Exercising skepticism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Brainstorming with audit team members. . . . . . . . . . . . . . . . . . . .
Using Your Audit Program to Request the Right Evidence . . . . . . . . .
Documenting the Audit Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Types of documentation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ownership and retention of the audit documentation. . . . . . . . .
646
646
647
649
650
650
651
652
653
654
655
656
658
659
659
662
Auditing Internal Controls. . . . . . . . . . . . . . . . . . . . . . . . . . . .
663
Defining Internal Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Identifying the Five Components of Internal Controls. . . . . . . . . . . . .
Determining When You Need to Audit Internal Controls . . . . . . . . . .
Defining substantive strategy and control testing strategy . . . . .
Figuring out which strategy is best. . . . . . . . . . . . . . . . . . . . . . . . . .
Testing a Client’s Reliability: Assessing Internal Control Procedures . . .
Considering external factors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Evaluating how management assesses its controls. . . . . . . . . . . .
664
665
667
667
668
669
669
670
Table of Contents
xxiii
CHAPTER 6:
Using questionnaires to evaluate internal controls. . . . . . . . . . . .
Designing your tests of controls. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Using sampling to test internal controls . . . . . . . . . . . . . . . . . . . . .
Knowing when internal controls are sound or flawed. . . . . . . . . .
Documenting your conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Limiting Audit Procedures When Controls Are Strong. . . . . . . . . . . . .
Tailoring Tests to Internal Control Weaknesses. . . . . . . . . . . . . . . . . .
Timing a Client’s Control Procedures. . . . . . . . . . . . . . . . . . . . . . . . . . .
Setting a timeline for the client. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Conducting interim versus year-end audits . . . . . . . . . . . . . . . . . .
672
673
674
677
679
679
680
681
682
683
Scheming Scams. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
685
Frauds Committed by Businesses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 685
Preying on vulnerable populations. . . . . . . . . . . . . . . . . . . . . . . . . . 686
Picking investors’ pockets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687
Doing business with bribes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687
Laundering money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687
Perpetrating construction fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . 688
Dealing in subprime and predatory lending. . . . . . . . . . . . . . . . . . 689
Taking advantage of employees . . . . . . . . . . . . . . . . . . . . . . . . . . . . 689
Frauds Committed against Businesses . . . . . . . . . . . . . . . . . . . . . . . . . 691
Employee theft. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 691
Vendor and customer fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .691
Insurance fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 692
Real estate and mortgage fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . 692
Cooking the Books. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
695
Exploring the Financial Statement Fraud Triangle . . . . . . . . . . . . . . . .
Understanding the incentive behind financial statement fraud. . . .
Seeing the fraud opportunity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Coming up with a rationalization for the fraud. . . . . . . . . . . . . . . .
Spotting the Common Methods of Fraud . . . . . . . . . . . . . . . . . . . . . . .
Hidden liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cookie jar reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Off-balance-sheet transactions. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notes no one can comprehend. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Uncovering Financial Statement Fraud . . . . . . . . . . . . . . . . . . . . . . . . .
Comparative techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ratio analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Beneish model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Data mining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
696
697
697
698
698
699
700
700
701
702
702
703
704
705
INDEX. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
707
CHAPTER 7:
xxiv
Accounting All-in-One For Dummies
Introduction
T
he process of accounting is often somewhat mysterious to the general public.
Mentioning it may conjure thoughts of Bob Cratchit (from Charles Dickens’
A Christmas Carol) scribbling away in books, or perhaps something more
exciting like the forensic accounting detectives featured in movies such as The
Untouchables. Odds are good, though, that a person’s exposure to actual accountants has been something a bit more commonplace, such as getting taxes done or
sitting through treasury reports at council meetings. In any of these cases, people
are given just enough information to understand that accounting is something
that they should probably learn more about while simultaneously being obscure
and quantitative enough to discourage them from trying.
Accounting is much more than just keeping the books and completing tax returns.
Sure, those tasks are a large part of the job, but in the business world, accounting
also includes setting up an accounting system, preparing financial statements and
reports, analyzing financial statements, planning and budgeting for a business,
attracting and managing investment capital, securing loans, analyzing and managing costs, making purchase decisions, providing financial insight and advice to
business owners and management, and preventing and detecting fraud.
Although no single book can help you master everything there is to know about all
fields of accounting, this book provides the information you need to get started in
the most common areas.
About This Book
Accounting All-In-One For Dummies, 3rd Edition, expands your understanding of
what accounting is and provides you the information and guidance to master the
skills you need in various areas of accounting. This book, which is nine books in
one, covers everything from setting up an accounting system to preventing and
detecting fraud:
»» Book 1: Accounting for Financial Systems
»» Book 2: Recording Transactions
Introduction
1
»» Book 3: Adjusting and Closing Entries
»» Book 4: Preparing Income Statements and Balance Sheets
»» Book 5: Reporting Your Statements
»» Book 6: Planning and Budgeting for Your Business
»» Book 7: Making Savvy Business Decisions
»» Book 8: Handling Cash and Making Purchase Decisions
»» Book 9: Auditing for Financial Fraud
Foolish Assumptions
To narrow the scope of this book and present information and guidance that’s
most useful for you, the reader, we had to make a few foolish assumptions about
who you are:
»» You’re an accountant, accountant wannabe, a businessperson who
needs to know about some aspect of business accounting, or an investor
who needs to know how to make sense of financial statements. This
book doesn’t cover how to budget for groceries or complete your 1040 tax
return. In other words, this book is strictly business. Some chapters are
geared more toward accountants; others primarily address business owners
and managers.
»» You’re compelled to or genuinely want to find out more about account-
ing. If you’re not motivated by a need or desire to acquire the knowledge and
skills required to perform fundamental accounting tasks, you probably need
to hire an accountant instead trying to do this stuff on your own.
»» You can do the math. You don’t need to know trigonometry or calculus, but
you do need to be able to crunch numbers by using addition, subtraction,
multiplication, and division. As for that higher-level math, that’s why we have
accounting software.
2
Accounting All-in-One For Dummies
Icons Used in This Book
Throughout this book, icons in the margins cue you in on different types of information that call out for your attention. Here are the icons you’ll see and a brief
description of each.
These items are your “walking-away points” — the things you really should keep
in your brain.
Tips provide insider insight. When you’re looking for a better, faster way to do
something, check out these tips.
There are real consequences to making decisions with money. The Warning icon
lets you know that you may want to get a professional opinion on something
before you put your money where your mouth is.
Technical Stuff items are things you don’t necessarily need to know if you’re an
average business student, but they add context for those who will be managing
money.
Beyond the Book
In addition to the abundance of information and guidance on accounting that’s
provided in this book, you’re entitled to some online material:
»» Quizzes: Each of the nine books that comprise this book has an online quiz
you can use to self-evaluate the knowledge and skills you acquired or at least
see how much of the information you can recall. After completing each book,
test your knowledge with the corresponding quiz.
To gain access to the quizzes and videos, all you have to do is register. Just
follow these simple steps:
1. Go to www.dummies.com/go/getaccess to register your book.
2. Choose your product from the drop-down list on that page.
3. Follow the prompts to validate your product.
4. Check your email for a confirmation message that includes your
personal identification number (PIN) and instructions for logging in.
Introduction
3
If you don’t receive this email within two hours, please check your spam folder
before contacting us through http://support.wiley.com or by phone at
(877) 762-2974.
Now you’re ready to go! You can come back to the practice material as often
as you want; simply log on with the username and password you created
during your initial login. You don’t need to enter the access code a second
time. Your registration is good for one year from the day you activate
your PIN.
»» Video presentations: Ken Boyd, former CPA, current online accounting
trainer, and one of the many authors who contributed to this mini accounting
library, has contributed several videos on various accounting topics covered in
this book. To view these engaging and educational videos, go to http://www.
dummies.com/go/accountingaiovids3e.
You can also access a free Cheat Sheet at www.dummies.com (enter Accounting
All-in-One For Dummies Cheat Sheet in the search box). The Cheat Sheet features key accounting terms, tips for controlling cash, essential formulas for cost
accounting, and definitions of key financial accounting terms. It also explains the
relationship between cash flow and profit.
Where to Go from Here
Although you’re certainly welcome to read Accounting All-In-One For Dummies,
3rd Edition, from start to finish (probably not at a single sitting), feel free to skip
and dip, focusing on whichever area of accounting and whichever topic is most
relevant to your current needs and interests. If you’re getting started, books 1 to
3 may be just what you’re looking for. If you’re facing the daunting challenge of
preparing financial statements for a business, consult books 4 and 5. If you own or
manage a business, check out books 6 to 8 for information and guidance on managerial accounting. And if you’re in charge of preventing and detecting incidents
of fraud, or if you just want to know more about accounting fraud so that you can
do your part to prevent it, check out the chapters in Book 9.
Wherever you go, you’ll find the information and guidance you need in an engaging, easily accessible format.
4
Accounting All-in-One For Dummies
1
Accounting
for Financial
Systems
Contents at a Glance
CHAPTER 1:
Accounting for the Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Knowing What Bookkeeping and Accounting Are All About. . . . . . . . 8
Wrapping Your Brain around the Accounting Cycle. . . . . . . . . . . . . . 10
Working the Fundamental Accounting Equation . . . . . . . . . . . . . . . . 14
CHAPTER 2:
Charting Your Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Navigating the Chart of Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Setting Up Your Chart of Accounts. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Giving Credit (Or Is It Debit?). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Understanding Double-Entry Accounting . . . . . . . . . . . . . . . . . . . . . .
CHAPTER 3:
18
19
21
22
Using Journal Entries and Ledgers . . . . . . . . . . . . . . . . . 27
Keeping a Journal. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Bringing It All Together in the Ledger. . . . . . . . . . . . . . . . . . . . . . . . . . 38
Putting Accounting Software
to Work for You. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
CHAPTER 4:
Choosing an Accounting Method. . . . . . . . . . . . . . . . . . . 45
Choosing Your Method. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Sorting through Standards for Other Types of Accounting. . . . . . . . 48
CHAPTER 5:
Setting the Standards. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Exploring the Origins of Accounting Standards . . . . . . . . . . . . . . . . .
Recognizing the Role of the American Institute
of Certified Public Accountants. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Checking Out the U.S. Securities and Exchange Commission . . . . .
Getting to Know the Financial Accounting Standards Board . . . . . .
Grasping Accounting Standards Around the Globe. . . . . . . . . . . . . .
54
55
59
59
62
IN THIS CHAPTER
»» Examining the differences between
bookkeeping and accounting
»» Getting to know the accounting cycle
»» Maintaining balance with the
fundamental accounting equation
Chapter
1
Accounting for the Basics
I
ndividuals can get along quite well without much bookkeeping — but the
exact opposite is true for a business. A business needs a good bookkeeping and
accounting system to operate day to day, and a business needs accurate and
timely data to operate effectively.
In addition to facilitating day-to-day operations, a company’s bookkeeping and
accounting system serves as the source of information for preparing its periodic financial statements, tax returns, and reports to managers. The accuracy of
these reports is critical to the business’s survival because managers use financial
reports to make decisions, and if the reports aren’t accurate, managers can’t make
intelligent decisions.
Obviously, then, a business manager must be sure that the company’s bookkeeping and accounting system is dependable and up to snuff.
This chapter shows you what bookkeepers and accountants do so that you have
a clear idea of what it takes to ensure that the information coming out of the
accounting system is complete, accurate, and timely. This chapter also offers a
brief survey of bookkeeping and accounting, which you may find helpful before
moving on to the more hands-on financial and management topics.
CHAPTER 1 Accounting for the Basics
7
Knowing What Bookkeeping
and Accounting Are All About
In a nutshell, accountants “keep the books” of a business (or a not-for-profit
organization or government entity) by following systematic methods to record all
the financial activities and prepare summaries. This summary information is used
to create financial statements.
Financial statements are sent to stakeholders — people who have a stake in the
company’s success or failure. Here are some examples of stakeholders:
»» Stockholders: If you own stock in General Electric, for example, you receive
regular financial reports. Stockholders are owners of the business; they need
to know the financial condition of the business they own.
»» Creditors: Entities that loan money to your business are creditors. They need
to review financial statements to determine whether your business still has
the ability to repay principal and make interest payments on the loan.
»» Regulators: Most businesses have to answer to some type of regulator. If you
produce food, for example, you send financial reports to the U.S. Food and
Drug Administration. Reviewing financial statements is one responsibility of a
regulator.
The following sections help you embark on your journey to develop a better
understanding of bookkeeping and accounting. Here, you discover the differences
between the two and get a bird’s-eye view of how they interact.
Distinguishing between bookkeeping
and accounting
Distinguishing between bookkeeping and accounting is important because they’re
not completely interchangeable.
Bookkeeping refers mainly to the record-keeping aspects of accounting — the
process (some would say the drudgery) of recording all the detailed information
regarding the transactions and other activities of a business (or other organization, venture, or project).
The term accounting is much broader because it enters the realm of designing the
bookkeeping system, establishing controls to make sure that the system is working well, and analyzing and verifying the recorded information. Accountants give
orders; bookkeepers follow them.
8
BOOK 1 Accounting for Financial Systems
You can think of accounting as what goes on before and after bookkeeping.
Accountants design the bookkeeping and accounting system (before) and use
the information that the bookkeepers enter to create financial statements, tax
returns, and various internal-use reports for managers (after).
Taking a panoramic view of bookkeeping
and accounting
Figure 1-1 presents a panoramic view of bookkeeping and accounting for businesses and other entities that carry on business activities. This brief overview
can’t do justice to all the details of bookkeeping and accounting, of course, but it
serves to clarify important differences between bookkeeping and accounting.
FIGURE 1-1:
Panoramic view
of bookkeeping
and accounting.
© John Wiley & Sons, Inc.
Bookkeeping has two main jobs: recording the financial effects and other rele­
vant details of the wide variety of transactions and other activities of the entity,
and generating a constant stream of documents and electronic outputs to keep the
business operating every day.
Accounting, on the other hand, focuses on the periodic preparation of three main
types of output: reports to managers, tax returns (income tax, sales tax, payroll
tax, and so on), and financial statements and reports. These outputs are completed according to certain schedules. Financial statements, for example, are usually prepared every month and at the end of the year (12 months).
CHAPTER 1 Accounting for the Basics
9
Accounting for the
Basics
Bookkeepers spend more time with the record-keeping process and dealing with
the problems that inevitably arise in recording so much information. Accountants,
on the other hand, have a different focus.
This book is concerned primarily with financial and management accounting.
Financial accounting refers to the periodic preparation of general-purpose financial
statements (see books 4 and 5). General purpose means that the financial statements are prepared according to standards established for financial reporting to
stakeholders.
These financial statements are useful to managers as well, but managers need more
information than is reported in the external financial statements of a business. Much
of this management information is confidential and not for circulation outside the
business. Management accounting refers to the preparation of internal accounting
reports for business managers. Management accounting is used for planning business activity (Book 6) and to make informed business decisions (Book 7).
Wrapping Your Brain around the
Accounting Cycle
You must take certain steps to appropriately complete the accounting cycle.
Figure 1-2 presents an overview of this process. These basic steps, which apply
to virtually every bookkeeping and accounting system, are done in the order presented in the figure, although the methods of performing the steps vary from
business to business. The details of a sale might be entered by scanning bar codes
in a grocery store, for example, or they may require an in-depth legal interpretation for a complex order from a customer for an expensive piece of equipment.
Following is a more detailed description of the steps:
1.
Prepare source documents for all transactions, operations, and other
events of the business.
Source documents are the starting point in the bookkeeping process. When
buying products, a business gets an invoice from the supplier. When borrowing
money from the bank, a business signs a note payable, a copy of which the
business keeps. When preparing payroll checks, a business depends on salary
rosters and time cards. All these key business forms serve as sources of
information entered into the bookkeeping system — in other words, information the bookkeeper uses to record the financial effects of the activities of the
business.
10
BOOK 1 Accounting for Financial Systems
Accounting for the
Basics
FIGURE 1-2:
Basic steps of the
accounting cycle.
©John Wiley & Sons, Inc.
2.
Determine the financial effects of the transactions, operations, and other
events of the business.
The activities of the business have financial effects that must be recorded,
because the business is better off, worse off, or otherwise affected in some
way as the result of its transactions. Examples of typical business transactions
include paying employees, making sales to customers, borrowing money from
the bank, and buying products that will be sold to customers. The bookkeeping
process begins by determining the relevant information about each transaction. The chief accountant of the business establishes the rules and methods
for measuring the financial effects of transactions. The bookkeeper should
comply with these rules and methods, of course.
3.
Make original entries of financial effects in journals, with appropriate
references to source documents.
Using the source documents, the bookkeeper makes the first, or original, entry
for every transaction in a journal; this information is later posted in accounts
(see Step 4). A journal is a chronological record of transactions in the order in
which they occur — like a very detailed personal diary.
CHAPTER 1 Accounting for the Basics
11
Here’s a simple example that illustrates recording a transaction in a journal.
Expecting a big demand from its customers, a retail bookstore purchases, on
credit, 100 copies of The Beekeeper Book from its publisher, Animal World. The
books are received, a few are placed on the shelves, and the rest are stored.
The bookstore now owns the books and owes Animal World $2,000, which is
the cost of the 100 copies. This example focuses solely on recording the
purchase of the books, not recording subsequent sales of the books and
payment to Animal World.
The bookstore has established a specific inventory asset account called
Inventory – Trade Paperbacks for books like this one. The liability to the
publisher should be entered in the account Accounts Payable – Publishers.
Therefore, the original journal entry for this purchase records an increase in
the inventory asset account of $2,000 and an increase in the accounts payable
account of $2,000. Notice the balance in the two sides of the transaction. An
asset increases $2,000 on the one side, and a liability increases $2,000 on the
other side. All is well (assuming that no mistakes were made).
4.
Post the financial effects of transactions to accounts, with references and
tie-ins to original journal entries.
As Step 3 explains, the pair of changes for the bookstore’s purchase of 100
copies of this book is first recorded in an original journal entry. Sometime later,
the financial effects are posted, or recorded in the separate accounts — one as
an asset and the others a liability. Only the official, established chart or list of
accounts should be used in recording transactions. An account is a separate
record, or page, for each asset, each liability, and so on. One transaction affects
two or more accounts. The journal entry records the whole transaction in one
place; then each piece is recorded in the accounts affected by the transaction.
After the bookkeeper posts all transactions, they generate a trial balance. This
document lists all the accounts and their balances as of a certain date.
The importance of entering transaction data correctly and in a timely manner
can’t be stressed enough. The prevalence of data-entry errors is one important
reason why most retailers use cash registers that read bar-coded information
on products, which more accurately capture the necessary information and
speed data entry.
5.
Perform end-of-period procedures — the critical steps for getting the
accounting records up to date and ready for the preparation of management accounting reports, tax returns, and financial statements.
A period is a stretch of time — from one day (or even one hour) to one month
to one quarter (three months) to one year — determined by the needs of the
business. Most businesses need accounting reports and financial statements
at the end of each quarter, and many need monthly financial statements.
12
BOOK 1 Accounting for Financial Systems
Accounting for the
Basics
Before the accounting reports can be prepared at the end of the period (refer
to Figure 1-1), the bookkeeper needs to bring the accounts up to date and
complete the bookkeeping process. One such end-of-period requirement, for
example, is recording the depreciation expense for the period. (See Book 3,
Chapter 1 for more on depreciation.)
The accountant needs to be heavily involved in end-of-period procedures and
check for errors in the business’s accounts. Data-entry clerks and bookkeepers
may not fully understand the unusual nature of some business transactions
and may have entered transactions incorrectly. One reason for establishing
internal controls (see Book 2, Chapter 1) is to keep errors to an absolute
minimum. Ideally, accounts should contain no errors at the end of the period,
but the accountant can’t assume anything and should perform a final check for
any errors.
6.
Compile the adjusted trial balance for the accountant, which is the basis
for preparing management reports, tax returns, and financial
statements.
In Step 4, you see that a trial balance is generated after you post the accounting activity. After all the end-of-period procedures have been completed, the
bookkeeper compiles a comprehensive list of all accounts, which is called the
adjusted trial balance. Businesses of modest size maintain hundreds of
accounts for their various assets, liabilities, owners’ equity, revenue, and
expenses. Larger businesses keep thousands of accounts.
The accountant takes the adjusted trial balance and combines similar accounts
into one summary amount that is reported in a financial report or tax return. A
business might keep hundreds of separate inventory accounts, every one of
which is listed in the adjusted trial balance. The accountant collapses all these
accounts into one summary inventory account presented in the balance sheet
of the business. In grouping the accounts, the accountant should comply with
established financial reporting standards and income tax requirements.
7.
Close the books — bring the bookkeeping for the fiscal year just ended to
a close and get things ready to begin the bookkeeping process for the
coming fiscal year.
Books is the common term for a business’s complete set of accounts along with
journal entries. A business’s transactions are a constant stream of activities
that don’t end tidily on the last day of the year, which can make preparing
financial statements and tax returns challenging. The business has to draw a
clear line of demarcation between activities for the year ended and the year to
come by closing the books for one year and starting with fresh books for the
next year.
CHAPTER 1 Accounting for the Basics
13
Most medium-size and larger businesses have an accounting manual that spells
out in great detail the specific accounts and procedures for recording transactions.
A business should review its chart of accounts and accounting rules and policies regularly and make any necessary revisions. Companies don’t take this task
lightly; discontinuities in the accounting system can be major shocks and have to
be carefully thought out. The remaining chapters in Book 1 lead you through the
process of developing an accounting system. See Book 3 for details on adjusting
and closing entries.
Working the Fundamental
Accounting Equation
The fundamental accounting equation (also known as the accounting equation or
the balance sheet equation) helps explain the concept that all transactions must
balance:
Assets = Liabilities + Owners’ equity
Net assets equals assets minus liabilities. If you do some algebra and subtract liabilities from both sides of the previous equation, you get
Assets – Liabilities = Owners’ equity
or
Net assets = Owners’ equity
Before going any further, acquaint yourself with the cast of characters in the
equation:
»» Assets are resources a company owns. Book 4, Chapter 3 discusses all the
typical types of business assets. Some examples are cash, equipment, and
cars. You use assets to make money in your business. In other words, the
resources are used over time to generate sales and profits.
»» Liabilities are debts the company owes to others — people other than
owners of the business. See Book 4, Chapter 4 for the scoop on liabilities. The
biggies are accounts payable and notes payable.
14
BOOK 1 Accounting for Financial Systems
Accounting for the
Basics
»» Owners’ equity (or simply equity) is what’s left over in the business at the end
of the day. If you sold all your assets for cash and then paid off all your
liabilities, any cash remaining would be equity. Many accounting textbooks
define equity as the owners’ claim to the company’s net assets. Book 4,
Chapter 5 discusses the different components of equity.
Don’t confuse capital and equity. Capital is cash and other assets used to run
the business, whereas equity is assets minus liabilities. A firm can raise capital
in two ways: by issuing stock or by taking on debt (borrowing money). It can
increase equity in several ways, including generating net income (profit),
reducing employee costs, lowering manufacturing costs, closing an office, or
issuing stock to shareholders to raise capital. Check out Book 6, Chapter 1 for
more about capital.
You may read the explanation of owners’ equity and think, “That’s just another
way to say net worth.” But you can’t use the term net worth interchangeably
with owners’ equity in an accounting setting. Generally accepted accounting
principles (GAAP) don’t allow accountants to restate all assets to their fair
market value, which would be required to calculate a company’s net worth.
Here’s a simple example of the fundamental accounting equation at work:
Assets = Liabilities + Equity
$100 = $40 + $60 After subtracting liabilities from each side of the equation, you get
Assets – Liabilities = Equity
$100 – $40 = $60
Finally, you can restate assets less liabilities and net assets:
Net assets = Owners’ equity
$60 = $60
These simple record-keeping concepts may seem simple, but they are the foundations for a wealth of accounting processes and tools that are available.
CHAPTER 1 Accounting for the Basics
15
IN THIS CHAPTER
»» Warming up with balance sheet and
chart of accounts
»» Creating your own chart of accounts
»» Grasping the basics of debits and
credits
»» Getting schooled in double-entry
accounting
Chapter
2
Charting Your Accounts
A
ccessing your chart of accounts in easier than ever with the advent of
online banking. Most banks provide you with quick and convenient access
to your full transaction history made by card, check, or direct transfers.
Some even have tools to let you categorize, analyze, and graphically represent
trends and patters in your transactions. If you don’t have online banking, then
you’ll be managing your own chart of accounts and transaction history as you
keep a written record of these for yourself.
Keeping the books of a business can be a lot more difficult than maintaining a
personal checkbook. You have to record each business transaction carefully to
make sure that it goes into the right account. This careful bookkeeping gives you
an effective tool for figuring out how well the business is doing financially. You
need a road map — a chart of accounts — to determine where to record all those
transactions.
This chapter introduces you to the chart of accounts and explains how to set up
your chart of accounts. It also spells out the differences between debits and credits, and orients you to the fine art of double-entry accounting.
CHAPTER 2 Charting Your Accounts
17
Navigating the Chart of Accounts
The chart of accounts is the road map that a business creates to organize its financial transactions. After all, you can’t record a transaction until you know where to
put it! Essentially, this chart is a list of all the accounts a business has, organized
in a specific order; each account has a description that includes the type of account
and the types of transactions that should be entered into that account. Every business creates its own chart of accounts based on the nature of the business and its
operations, so you’re unlikely to find two businesses with exactly the same chart.
Some basic organizational and structural characteristics are common to all charts
of accounts. The organization and structure are designed around two key financial
reports:
»» The balance sheet shows what your business owns (assets) and who has
claims on those assets (liabilities and equity).
»» The income statement shows how much money your business took in from
sales and how much money it spent to generate those sales.
You can find out more about income statements and balance sheets in books 4
and 5. The following lists present a common order for these accounts within each
of their groups, based on how they appear on the financial statements.
The chart of accounts starts with the balance sheet accounts, which include
»» Current assets: Accounts that track what the company owns and expects to
use in the next 12 months, such as cash, accounts receivable (money collected
from customers), and inventory
»» Long-term assets: Accounts that track what assets the company owns that
have a life span of more than 12 months, such as buildings, furniture, and
equipment
»» Current liabilities: Accounts that track debts the company must pay over the
next 12 months, such as accounts payable (bills from vendors, contractors, and
consultants), interest payable, and credit cards payable
»» Long-term liabilities: Accounts that track debts the company must pay over a
period of time longer than the next 12 months, such as mortgages payable
and bonds payable
»» Equity: Accounts that track the owners’ claims against the company’s net
assets, which includes any money invested in the company, any money taken
out of the company, and any earnings that have been reinvested in the
company
18
BOOK 1 Accounting for Financial Systems
The rest of the chart is filled with income statement accounts, which include
»» Revenue: Accounts that track sales of goods and services as well as revenue
generated for the company by other means
»» Cost of goods sold: Accounts that track the direct costs involved in selling the
company’s goods or services
»» Expenses: Accounts that track expenses related to running the business that
aren’t directly tied to the sale of individual products or services
This chapter introduces the key account types found in most businesses, but this
list isn’t cast in stone. You should develop an account list that makes the most
sense for the way you’re operating your business and the financial information
you want to track.
The chart of accounts is a management tool that helps you make smart business decisions. You’ll probably tweak the accounts in your chart annually and, if
necessary, add accounts during the year if you find something that requires more
detailed tracking. You can add accounts during the year, but it’s best not to delete
accounts until the end of a 12-month reporting period.
Setting Up Your Chart of Accounts
Cooking up a useful chart of accounts doesn’t require any secret sauce. All you
need to do is list all the accounts that apply to your business. A good brainstorming session usually does the trick.
When you’re setting up your chart of accounts, don’t panic if you can’t think
of every type of account you may need for your business. Adding to the chart of
accounts at any time is very easy. Just add the account to the list and distribute the
revised list to any employees who use the chart of accounts for entering transactions into the system. (Even employees who aren’t involved in bookkeeping need
a copy of your chart of accounts if they code invoices or other transactions, or
indicate the accounts in which those transactions should be recorded.) Accounting
software makes it easy to add or delete accounts in the chart of accounts.
CHAPTER 2 Charting Your Accounts
19
Charting Your Accounts
When developing the chart of accounts, you start by listing all asset, liability,
equity, revenue, and expense accounts. All these accounts come from two places:
the balance sheet and the income statement.
The chart of accounts usually includes at least three columns:
»» Account: Lists the account names
»» Type: Lists the type of account, such as asset, liability, equity, revenue, cost of
goods sold, or expense
»» Description: Contains a description of the type of transaction that should be
recorded in the account
Nearly all companies also assign numbers to the accounts, to be used for coding
charges. If your company is using a computerized system, the computer automatically assigns the account number. Otherwise, you need to develop your own
numbering system. The most common number system is
»» Asset accounts: 1000 to 1999
»» Liability accounts: 2000 to 2999
»» Equity accounts: 3000 to 3999
»» Revenue accounts: 4000 to 4999
»» Cost of goods sold accounts: 5000 to 5999
»» Expense accounts: 6000 to 6999
This numbering system matches the one used by computerized accounting systems, making it easy for a company to transition to automated books at some
future time.
Most companies create an accumulated depreciation account and match it with
each unique fixed asset account. So if you have a fixed asset account called
Delivery Trucks, you likely have an account called Accumulated Depreciation –
Delivery Trucks. Book value is defined in Book 3, Chapter 1 as cost less accumulated
depreciation. This chart-of-accounts approach allows management to view each
asset’s original cost and the asset’s accumulated depreciation together, and then
calculate book value.
If you choose a computerized accounting system, one major advantage is that
several types of charts of accounts have been developed for various types of businesses. When you get your computerized system, all you need to do is review its
list of chart options for the type of business you run, delete any accounts you don’t
want, and add any new accounts that fit your business plan.
20
BOOK 1 Accounting for Financial Systems
If you’re setting up your chart of accounts manually, be sure to leave a lot of room
between accounts to add new accounts. You might number your cash in checking account 1000 and your accounts receivable account 1100, for example. That
approach leaves you plenty of room to add other accounts to track cash.
Using this strategy allows you to track all revenue and expenses by department
and generate financial reports to track the profitability of each department.
Design your chart-of-accounts numbering system to make better-informed business decisions.
Giving Credit (Or Is It Debit?)
In this section, you discover the mechanism of journal entries, which you use to
enter financial information into the company’s accounting software. To post
journal entries properly, you need to understand debits and credits.
Writing journal entries is a major area of confusion for anyone who’s getting
started in accounting because they involve debits and credits that are often counterintuitive. If you’re starting in accounting, consider reading this section more
than once. Then start posting some journal entries; you’ll get the hang of it.
These rules regarding debits and credit are always true:
»» Debits are always on the left. In journal entries, debits appear to the left
of credits.
»» Credits are always on the right. In journal entries, credits appear to the right of
debits.
See “Understanding Double-Entry Accounting” later in this chapter for examples
of journal entries.
CHAPTER 2 Charting Your Accounts
21
Charting Your Accounts
You can set up your chart of accounts to track the profitability of a company, a
division, or specific products. Suppose that you manage a sporting goods store
with three departments: equipment, uniforms, and shoes. If the company revenue account is 5000, you can create revenue subaccounts for each department.
Revenue – Equipment can be account 5100, Revenue – Uniforms can be account
5200, and Revenue – Shoes can be account 5300. You can use the same process for
all your expense accounts.
The following rules are also true, but with a few exceptions:
»» Assets and expenses are debited to add to them and credited to subtract
from them. In other words, for assets and expenses, a debit increases the
account, and a credit decreases it.
»» Liability, revenue, and equity accounts are just the opposite: These accounts
are credited to add to them and debited to subtract from them. In other
words, for liability, revenue, and equity accounts, a debit decreases the
account, and a credit increases it, as you’d expect.
This book covers three exceptions to these two rules. Treasury stock (covered in
Book 4, Chapter 5), allowance for doubtful accounts (see Book 4, Chapter 3), and
accumulated depreciation (Book 3, Chapter 1) are contra-accounts, which offset the
balance of a related account. Other than these exceptions, these two rules hold
true.
Understanding Double-Entry Accounting
All businesses, whether they use the cash-basis or accrual accounting method use
double-entry accounting — a practice that helps minimize errors and increase the
chance that your books balance. Double-entry accounting doesn’t mean you enter
all transactions twice; it means that you enter both sides of the transaction, debiting one account and crediting another.
Conquering the balance sheet equation
In double-entry accounting, the balance sheet equation plays a major role. To
change the balance of any accounts, you use a combination of debits and credits.
In some cases, you debit and credit multiple accounts to record the same transaction. Regardless of how many accounts are affected, these additional rules hold
true:
»» The total dollar amount debited equals the total amount credited.
»» The total dollar change in the asset accounts (increase or decrease) equals the
change in the total dollar amount of liabilities and equity. This concept is
consistent with the balance sheet equation: Assets on the left must equal
liabilities and equity on the right.
22
BOOK 1 Accounting for Financial Systems
Recording journal entries
All accounting transactions for a business must be recorded as journal entries,
following a specific three-column format followed by a transaction description:
»» Account titles in the left column
»» Debit dollar amounts in the middle column
»» Credit dollar amounts in the right column
»» Transaction description below the journal entry (to indicate the nature and
Charting Your Accounts
purpose of the transaction for future reference)
Here’s an example:
Account
Debit
Inventory
$3,000
Accounts payable
Credit
$3,000
To purchase sprockets for sale to customers
The following sections present some typical journal entries — entries that many
companies frequently post in their accounting records.
Posting entries to one side of the
balance sheet equation
Suppose that you purchase a new $1,500 desk for your office. This transaction
has two parts, because you spend an asset — cash — to buy another asset —
furniture. So you must adjust two accounts in your company’s books: the cash
account and the furniture account. Here’s what the transaction looks like in
double-entry accounting:
Account
Debit
Furniture
$1,500
Cash
Credit
$1,500
To purchase a new desk for the office
CHAPTER 2 Charting Your Accounts
23
In this transaction, the debit increases the value of the furniture account, and
the credit decreases the value of the cash account. Both accounts affected are
asset accounts, so the transaction affects only the assets side of the balance sheet
equation:
Assets + $1,500 furniture – $1,500 cash = Liabilities (no change) + Equity (no
change)
In this case, the books stay in balance because the exact dollar amount that
increases the value of the furniture account decreases the value of the cash account.
Using both sides of the equation
To see how you record a transaction that affects both sides of the balance sheet
equation, consider an example that records the purchase of inventory. Suppose
that you purchase $5,000 worth of widgets on credit. These new widgets increase
both inventory (an asset account) and accounts payable (a liability) accounts.
Here’s what the transaction looks like in double-entry accounting:
Account
Debit
Inventory
$5,000
Accounts payable
Credit
$5,000
To purchase widgets for sale to customers
In this case, the books stay in balance because both sides of the equation (assets
on the left and liabilities on the right) increase by $5,000:
Inventory + $5,000 = Accounts payable + $5,000 + Equity (no change)
You can see from the two example transactions in this section how double-entry
accounting helps you keep your books in balance — as long as each entry into the
books is balanced. Balancing your entries may look simple here, but entries sometimes get complex when more than two accounts are affected by the transaction.
Writing a complex journal entry
To take the subject of journal entries one step further, take a look at a more complex journal entry. Suppose that you sell a company truck. You bought the truck
for $30,000. As of the date of sale, you’ve recognized $25,000 of accumulated
depreciation. You receive $6,000 for the sale. The transaction is complex because
more than one debit and credit are required.
24
BOOK 1 Accounting for Financial Systems
Starting with cash
As an accountant, you have several issues to resolve. First, consider which
accounts in the chart of accounts are affected. Second, the total debits must equal
total credits.
Accountants figure out journal entries every day. If you’re not sure where to start,
think about whether or not cash should be part of the journal entry. In this case,
the answer is yes. Because cash increased, you need to debit the asset account cash
for $6,000.
Getting to a balanced entry
In Book 3, Chapter 1, you discover that accumulated depreciation represents all
depreciation taken on an asset since the purchase date. You also see that accumulated depreciation carries a credit balance. When you sell the truck, you remove
the accumulated depreciation by debiting the account for $25,000.
Now comes the hardest part. So far, you’ve debited cash $6,000 and debited
accumulated depreciation for $25,000. On the credit side, you credited the truck
account for $30,000. In total, you have $31,000 in debits ($6,000 + $25,000) and
$30,000 in credits. To balance this entry, you need an additional $1,000 credit.
Think about which account you should use.
If you sell an asset, accounting standards require that you record a gain or loss on
sale. Because you need a credit entry, you record a gain. Here’s how your complex
journal entry looks:
Account
Debit
Cash
$6,000
Accumulated depreciation
$25,000
Credit
Truck
$30,000
Gain on sale of truck
$1,000
To record the sale of a truck for a gain
CHAPTER 2 Charting Your Accounts
25
Charting Your Accounts
Now go over the other “knowns” for this transaction. You sold someone the truck
(an asset). In the “Giving Credit (Or Is It Debit?)” section earlier in this chapter,
you see that you post a credit to reduce assets. The truck account should be credited for $30,000.
The combination for the cash received and depreciation removed ($31,000) was
more than the original cost of the truck sold ($30,000). The result is a gain of
$1,000.
This thought process is what accountants use to post complex journal entries
Complex? Maybe. But don’t worry — you’ll be balancing your entries in no time!
26
BOOK 1 Accounting for Financial Systems
IN THIS CHAPTER
»» Becoming familiar with journals
»» Understanding ledgers
»» Saving time and reducing errors with
accounting software
Chapter
3
Using Journal Entries
and Ledgers
A
ccounting involves a great deal of record keeping or booking — the process
of recording accounting transactions. Some booking tasks involve basic
data entry done by clerks. Junior accountants or bookkeepers may perform
other booking tasks, such as preparing journal entries — the accountant’s way to
enter transactions into the accounting system. (The accountant records any bank
charges shown on the company’s monthly bank statement, for example.)
Whether you’ll need to book journal entries during your accounting career depends
on a couple of factors. If you work for a small company in a one- or two-person
accounting department, you could very well be the controller (the chief accounting
officer for the business) and be doing the journal entries yourself. If, instead, you
work for a large accounting firm that provides services to many clients, chances
are that you won’t book journal entries yourself. But you’ll most certainly review
journal entries while providing your services, such as when you audit a company’s
financial statements, and you may propose journal entries for your client to book
if you find errors.
CHAPTER 3 Using Journal Entries and Ledgers
27
In this chapter, you’ll navigate booking, a critical aspect of your accounting
career. You’ll find out what booking involves, such as journal entries and ledgers.
This chapter ends with some insights about software that can help you keep your
records in order.
Keeping a Journal
Accounting journals, like diaries, keep a record of events. But accounting journals
record business transactions taking place within a company’s accounting department. Accountants call journals the books of original entry because no transactions
get into the accounting records without being entered into a journal first.
A business can have many types of journals. In this section, you find out about
the most common journals, which are tailored to handle cash, accrual, and special
transactions.
When accountants put together the financial statements, they spend a lot of time
reviewing journals, so create a system that allows the accounting staff to find
journals quickly. To work more efficiently, your business should move away from
paper files and operate by using cloud computing. Working in the cloud enables
your accounting staff to find documents faster, share documents easily, and generate the company financial statements with fewer delays.
Using journals to record cash
transactions
All transactions that affect cash go into the cash receipts or cash disbursements
journal. Some accountants and accounting software programs refer to the record
of cash disbursements as the cash payments journal. No worries — both terms
mean the same thing.
When accountants use the word cash, it doesn’t mean just paper money and
coinage; it includes checks and credit card transactions. In accounting, cash is a
generic term for any payment method that’s assumed to be automatic. See Book 4,
Chapter 3 for balance sheet details.
When you sign a check and give it to the clerk behind the store counter, part of
your implicit understanding is that the funds are immediately available to clear
28
BOOK 1 Accounting for Financial Systems
the check. The same is true of paying with a credit card, which represents an
immediate satisfaction of your debit with the vendor.
Cash receipts journal
The cash receipts journal keeps a record of all payments a business receives in cash
or by check, debit card, or credit card. Book 2, Chapter 3 discusses cash activity
related to sales to customers. This discussion of cash covers a variety of transactions. Here are examples of some cash events that require posting to the cash
receipts journal:
»» Customer sales made for paper money and coinage: Many types of
businesses still have booming cash sales involving the exchange of paper
money and coins. Some examples are convenience stores, retail shops, and
service providers such as hair salons.
»» Customers making payments on their accounts: If a business lets its
Using Journal Entries
and Ledgers
customers buy now and pay later, any payments due are entered into
accounts receivable, which is money customers owe the business. (See
“Recording accrual transactions” later in this chapter for details.) Any payments a customer makes toward those amounts owed are recorded in the
cash receipts journal.
»» Interest or dividend income: When a bank or investment account pays a
business for the use of its money in the form of interest or dividends, the
payment is considered to be a cash receipt. Many businesses record interest
income reported on their monthly bank statements in the general journal,
discussed a little later in this section.
Interest and dividend income is also known as portfolio income and may be
considered to be passive income because the recipient doesn’t have to work
to receive the portfolio income (as you do for your paycheck).
»» Asset sales: Selling a business asset, such as a car or office furniture, can also
result in a cash transaction. Suppose that a company is outfitting its executive
office space with new deluxe leather chairs and selling all the old leather
chairs to a furniture liquidator. The two parties exchange cash to complete the
sale.
Keep in mind that this list isn’t comprehensive; these are just a few of the many
instances that may necessitate recording a transaction in the cash receipts
journal.
CHAPTER 3 Using Journal Entries and Ledgers
29
Cash receipts may receive different treatment on a company’s income statement.
Cash sales to customers are treated one way, for example, and cash received
for the sale of a building — a transaction that’s not part of normal business
activity — is treated differently. The details are explained in Book 4, Chapter 2.
Setting up the cash receipts journal
The cash receipts journal normally has two columns for debits and four columns
for credits:
»» Debit columns: Because all transactions in the cash receipts journal involve
the receipt of cash, one of the debit columns is always for cash. The other
column is for sales discounts, which reflect any discount the business gives a
good customer who pays early. A customer’s invoice might be due within 30
days, but if the customer pays early, it gets a 2 percent discount.
»» Credit columns: To balance the debits, a cash receipts journal contains four
credit columns:
•
•
•
Sales
•
Miscellaneous, which is a catchall column in which you record all other cash
receipts, such as interest and dividends
Accounts receivable
Sales tax payable, which is the amount of sales tax the business collects on
a transaction (and doesn’t apply to every transaction)
Not all sales are subject to sales tax. Your state department of revenue determines
which sales transactions are taxable. In many states, fees for accounting or legal
services aren’t subject to sales tax, for example.
In addition to the debit and credit columns, a cash receipts journal contains at
least two columns that don’t have anything to do with debits or credits:
»» The date on which the transaction occurs
»» The name of the account affected by the transaction
Depending on the company or accounting system, additional columns may be
used as well.
Figure 3-1 shows an example of a portion of a cash receipts journal.
30
BOOK 1 Accounting for Financial Systems
FIGURE 3-1:
A partial cash
receipts journal.
©John Wiley & Sons, Inc.
Cash disbursements journal
On the flip side, any payment the business makes by using a form of cash gets
recorded in the cash disbursements (or payments) journal. Here are a few examples of transactions that appear in a cash disbursements journal:
»» Merchandise purchases: When a merchandiser (a company that sells goods
to the public) pays cash for the goods it buys for resale (inventory), the
transaction goes in the cash disbursement journal. A retail store is considered
to be a merchandiser.
»» Payments the company is making on outstanding accounts: This category
Using Journal Entries
and Ledgers
includes all cash disbursements a company makes to pay for goods or
services it obtained from another business and didn’t pay for when the
original transaction took place.
»» Payments for operating expenses: These transactions include checks or
bank transfers a business uses to pay utility or telephone invoices. Operating
expenses are incurred to manage your day-to-day business, in addition to
your cost of sales.
The cash disbursements journal normally has two columns for debits and two for
credits:
»» Credit columns: Because all transactions in the cash disbursements journal
involve the payment of cash, one of your credit columns is for cash. The other
column is for purchase discounts, which are reductions in the amount a
company has to pay vendors for any purchases on account. A business might
offer vendors a certain discount amount if they pay their bills within a certain
number of days — the same process that’s explained in the earlier section
“Setting up the cash receipts journal.” In this case, the company pays less due
to a discount. With cash receipts, a discount means that the company may
receive less.
CHAPTER 3 Using Journal Entries and Ledgers
31
»» Debit columns: To balance these credits, the debit columns in a cash
disbursements journal are accounts payable and miscellaneous (a catchall
column in which you record all other cash payments for transactions, such as
payment of operating expenses).
A cash disbursements journal also contains at least three other columns that don’t
have anything to do with debiting or crediting:
»» The date on which the transaction occurs
»» The name of the account affected by the transaction
»» The pay-to entity (to whom the payment is made)
Depending on the company or accounting system, more columns could be used as
well. Figure 3-2 shows an example of a partial cash disbursements journal.
FIGURE 3-2:
A partial cash
disbursements
journal.
©John Wiley & Sons, Inc.
Recording accrual transactions
Accrual transactions take place whenever cash doesn’t change hands. A customer
might a purchase with a promise to pay within 30 days, for example. Using accruals and recording business transactions with the accrual method are the backbones of accounting. Unfortunately, figuring out accruals, understanding how
accrual transactions interact with cash transactions, and knowing when to record
an accrual transaction can be quite a challenge.
Never fear. The following sections introduce the two accrual workhorse journals (the sales and purchases journals), walk you through the accrual transactions
you’re likely to encounter, and provide a sample of typical accrual transactions.
32
BOOK 1 Accounting for Financial Systems
Book 1, Chapter 4 defines accrual accounting, and Book 3, Chapter 6 explains
many types of accrual journal entries in detail.
Sales journal
The sales journal records all sales that a business makes to customers on account,
which means that no money changes hands between the company and its customer at the time of the sale. A sales journal affects two different accounts:
accounts receivable and sales. In the sales journal, accounts receivable and sales
are always affected by the same dollar amount.
Figure 3-3 presents an example of a sales journal.
FIGURE 3-3:
A partial sales
journal.
©John Wiley & Sons, Inc.
Use the sales journal only for recording sales on account. Sales returns, which
reflect all products customers return to the company after the sales are done,
aren’t recorded in the sales journal. Instead, you record them in the general journal, discussed later in this chapter.
Purchases journal
Any time a business buys products or services by using credit (on account), it
records the transaction in its purchases journal. The purchases journal typically
has a column for date, number, and amount. It also has the following columns:
»» Accounts payable: Because the company is purchasing on account, the
current liability account, called accounts/trade payable, is always affected.
»» Terms: This column shows any discount terms the company may have with
the vendor. The entry 2/10, n/30 means the company gets a 2 percent
discount if it pays within 10 days; otherwise, the full amount is due in 30 days.
(The n in this shorthand stands for net.)
CHAPTER 3 Using Journal Entries and Ledgers
33
Using Journal Entries
and Ledgers
When you record credit sales in your sales journal, you follow up by posting the
transactions to each customer’s listing in the accounts receivable ledger. (See
“Bringing It All Together in the Ledger” later in this chapter.)
»» Name: The company records the name of the vendor from which the
purchase is made.
»» Account: This column references which accounts are affected. The example
in Figure 3-4 shows two accounts: accounts payable (A/P) and purchases.
Because no other accounts (such as sales tax) are affected, A/P and purchases
are for the same dollar amount. If the company collects sales tax too, a
column is added to report this amount as well.
FIGURE 3-4:
A partial
purchases
journal.
©John Wiley & Sons, Inc.
Exploring other journals
The discussion of journals wouldn’t be complete without a brief rundown of other
special journals you’ll see during your foray into accounting, as well as the general
journal. The following sections cover both topics.
Special journals
Here are three additional journals you’ll encounter:
»» Payroll journal: This journal records all payroll transactions, including gross
wages, taxes withheld, and other deductions (such as health insurance paid
by the employee), leading to net pay, which is the amount shown on the
employee’s check. Head over to Book 2, chapters 4 and 5 for more on payroll
accounting.
»» Purchases return and allowances journal: This journal shows all subtractions from gross purchases because of products a company returns to a
vendor or discounts given to the company by the vendor.
»» Sales returns and allowances journal: This journal shows all subtractions
from gross sales as a result of products that customers return or discounts
given to customers.
34
BOOK 1 Accounting for Financial Systems
This list isn’t all-inclusive; some companies have other journals, and some
smaller companies may not use all of these. If you understand the basic methodology of all the journals discussed in this chapter, however, you’ll be well prepared
to tackle journal entries.
General journal
The general journal is a catchall type of journal in which transactions that don’t
appropriately belong in any other journal show up. Many companies record interest income and dividends in the general journal.
This journal is also used for adjusting and closing journal entries:
»» Adjusting journal entries: One key reason to adjust journal entries is to
make sure that the accounting books are recorded by using the accrual
method. On April 30, for example, employees have earned but not yet been
paid $5,000 in gross wages. (The next payroll date is May 2.) So to make sure
that your company’s revenue and expenses match, you book an adjusting
journal entry debiting wages expense account for $5,000 and crediting wages
payable (or accrued wages) for $5,000.
Using Journal Entries
and Ledgers
You also adjust journal entries to reclassify transactions. Reclassifying occurs
when the original transaction is correct but circumstances change after the
fact and the transaction needs to be adjusted. Suppose that your company
buys $1,000 of supplies on April 1, and the transaction is originally booked as
supplies inventory. On April 30, an inventory of the supplies is taken. Only
$800 of the supplies remain, so you have to debit your supplies expense
account for $200 and credit supplies inventory for $200.
»» Closing journal entries: You use this type of entry to zero out all temporary
accounts. These accounts don’t make it into the financial statements. Revenue
and expense accounts are temporary accounts because their balances are
adjusted to zero at the end of each accounting period (month or year). Then
you transfer the net amounts (net income or a net loss) to the balance sheet.
(See Book 4, Chapter 2 for information about the income statement.) There
are four closing journal entries:
•
You debit all revenue accounts and credit income summary for the same
amount. Income summary is a temporary holding account you use only
when closing out a period.
•
You credit all expenses and debit income summary for the same amount.
CHAPTER 3 Using Journal Entries and Ledgers
35
•
You either debit or credit income summary to reduce it to zero and take
the same figure to retained earnings, which represent cumulative net
income less all dividends (distributions of profit) paid to owners since the
company was formed.
Here’s an example: If in step one you credit income summary for $5,000,
and in step two you debit income summary for $3,000, you have a credit
balance of $2,000 in income summary. So to reduce income summary to
zero, you debit it for $2,000 and credit retained earnings for the same
amount.
•
Finally, if the owners have paid themselves any dividends during the
period, you credit cash and debit retained earnings.
Honestly, you’ll likely never have to prepare the first three closing entries yourself, because all accounting software systems perform this task for you automatically. But you do need to understand what goes on with the debits and credits
when the books close. You have to do the fourth closing entry yourself because
automated accounting systems require a manual journal entry for the dollar
amount of the dividend.
You clear out only temporary accounts with closing journal entries. Balance sheet
accounts are permanent accounts. Until you cease using the account (such as when
you close a bank account), no balance sheet accounts are zeroed out at closing.
Checking out examples of common
journal entries
It’s time for you to review a few journal entries so that the concepts related to
them really come to life. First, keep in mind the general format of a journal entry,
which is shown in Figure 3-5:
»» The date of the entry is in the left column.
»» The accounts debited and credited are in the middle column.
»» The amounts are shown in the two right columns.
Proper journal entries always list debits first, followed by credits. See Book 2,
Chapter 2 for an explanation of debits and credits.
36
BOOK 1 Accounting for Financial Systems
FIGURE 3-5:
The standard
journal entry
format.
©John Wiley & Sons, Inc.
Journal entries can have more than one debit and more than one credit, and the
number of accounts debited and credited doesn’t have to be the same. You can
have five accounts debited and one account credited, for example, but the dollar
amounts of the debits and credits has to match.
Consider an example of a journal entry for service income, which records cash and
accrual income. You provide a service to your client, Mr. Jones, on May 15, giving
him invoice #200 in the amount of $700 for services rendered. Before he leaves
your office, he pays you $200 in cash, with a promise to pay the balance of $500
next week. The journal entry to record this transaction is shown in Figure 3-6.
Using Journal Entries
and Ledgers
FIGURE 3-6:
Recording service
income.
©John Wiley & Sons, Inc.
Under the accrual method of accounting (see Book 1, Chapter 4), both the cash
receipts and the promise to pay the remaining balance have to be reported at the
time the transaction takes place, because the service has been rendered and the
income has been earned.
Every journal entry should have a brief description. This description doesn’t have
to be a paragraph, but it should be long enough that you or anyone else who
reviews the journal entry can figure out why you made it. A common mistake is
to make the description just a little too brief, forcing you to go back through the
transaction to figure out why you made the journal entry. The description for
the journal entry in Figure 3-6 (“To record invoice #200”) is brief but totally
understandable.
CHAPTER 3 Using Journal Entries and Ledgers
37
Take a look at one more journal entry before moving on. Suppose that you borrow
$5,000 from your bank on July 1. Your arrangement calls for you to pay $200 interest on July 31 and pay back the loan in full, plus $200 in interest, on August 30.
Figure 3-7 shows how your journal entries look from soup to nuts.
FIGURE 3-7:
Journalizing a
loan transaction.
©John Wiley & Sons, Inc.
Bringing It All Together in the Ledger
At this point, you may be thinking “Okay, the journals are the books of original entry, but what happens then? How do entries into these journals turn into
financial statements?” That’s the topic of this section. The accounts and amounts
debited or credited affect the company’s ledgers.
Realizing what a ledger is
A ledger records applicable transactions that take place in a company during a particular accounting cycle. Picture a big book. Every page of the book has a title that
corresponds with an account from the chart of accounts. Page 1 might be titled
“1001 Cash in Bank.” On this page, you’d list the total of the funds you deposited
in your company checking account, as well as the total of all the withdrawals for
a given period — for, say, a month.
38
BOOK 1 Accounting for Financial Systems
A business has one big-dog ledger: the general ledger, which lists all transactions
that take place in all the accounts during the specified accounting period. You
may also see subsidiary ledgers that list in detail transactions that happen only
under specific accounting circumstances. The payroll subsidiary ledger lists all payroll transactions, for example, and the accounts receivable subsidiary ledger lists all
customers that owe your company money and the amount of their current outstanding balances.
Posting to the ledgers
When you post to the ledgers, you take accounts and numbers from transactions
entered in the journals and record them in the correct ledger. If a subsidiary ledger is the first point of recording, the transaction eventually flows through the
subsidiary ledger to the general ledger. A customer sale on account, for example,
first posts to the sales journal and is reported in the accounts receivable subsidiary
ledger under the customer’s name.
Until modern accounting software arrived, posting to the ledgers was a laborious process, requiring the use of ledger paper with 14 columns. Fortunately, this
practice has become a thing of the past because accounting software has become
so affordable and easy to use.
Most accounting software programs require no formal procedure to post to the
ledgers. Every time you enter a transaction in a journal, the software automatically posts to the correct ledger. Proprietary accounting software (software that a
business has the exclusive right to use), however, may require the user to select
the posting command.
Viewing an example of a general ledger
General ledgers vary according to the nature of the business, a company’s preferences, and the software used. Figure 3-8 shows a very simple partial general
CHAPTER 3 Using Journal Entries and Ledgers
39
Using Journal Entries
and Ledgers
Then that amount flows from the accounts receivable subsidiary ledger to the
accounts receivable listing in the general ledger, combining with all other customers owing the business money to show a grand total of accounts receivable.
Then the combined total of all the transactions in the sales journal also posts to
the sales listing in the general ledger.
ledger for a small services company. The ledger starts with a revenue account,
Consulting Fees, and ends with an operating expense account, Bank Charge.
FIGURE 3-8:
A partial general
ledger.
©John Wiley & Sons, Inc.
Columns similar to the debit, credit, and balance columns in Figure 3-8 are
used in earlier figures in this chapter. Here’s what some of the other columns
mean:
»» Type: The original nature of the transaction.
»» Date: The day on which the transaction took place.
»» No.: The identifying number from the journal of original entry. 1008 is the
company check number used to pay James Fine, for example.
»» Name: Whatever name you put in the journal of original entry.
»» Memo: Any explanation for the transaction that you put in the original entry.
Using this section is important. If your journal entry involves four accounts,
each account has this same memo information when it’s posted to general
ledger. The memo notes make it much easier to understand why the entry
was posted.
40
BOOK 1 Accounting for Financial Systems
Recognizing the purpose of the
trial balance
The trial balance is a listing of all the accounts in the general ledger and the balance of each account as of a certain date. The trial balance checks to make sure
that all debits equal credits. Any imbalance indicates the presence of an error that
must be identified and corrected. Accountants also use the trial balance as a frontline tool to review the accuracy of the financial statements.
To find out more about running trial balances, see Book 3, Chapter 5. This chapter
provides a short explanation and an example trial balance.
Suppose that you run a trial balance, scan it, and see that an expense account
carries a balance that seems too high based on your professional judgment and
knowledge of the company. You check the general ledger and see that a rent payment of $5,000 was posted to postage expense by mistake. You can correct the
error before producing any financial statements.
Figure 3-9 shows an example of a partial trial balance.
Using Journal Entries
and Ledgers
FIGURE 3-9:
A partial trial
balance.
©John Wiley & Sons, Inc.
CHAPTER 3 Using Journal Entries and Ledgers
41
Accounting software shouldn’t allow a user to enter a transaction that’s out of
balance. (Out of balance means that the total dollar amount of debits doesn’t equal
credits.) If an out-of-balance transaction occurs, the software has a serious bug
that you need to report to the developer.
Putting Accounting Software
to Work for You
A bewildering array of accounting software is available today for small and
medium-size businesses. (Larger corporations tend to develop their own
computer-based accounting systems or hire a programmer to develop specialized
software.)
Today, a business can choose among a wide array of accounting software
packages. Two popular choices for small businesses are QuickBooks and Sage 50
Accounting. A quick Internet search for “accounting software” can help you track
down additional options. Unless your company has its own custom accounting
software and information technology (IT) staff, consider seeking the advice and
assistance of a consultant in choosing, implementing, upgrading, and replacing
accounting software.
If you don’t have the funds to hire a consultant, here’s some free advice:
»» Choose your accounting software very carefully. Switching to a different
accounting program later is a major headache, so choose software that serves
your current needs and provides room to grow.
»» In evaluating accounting software, you and your accountant should consider
three main factors: ease of use, features and functionality, and vendor
stability (the likelihood that the vendor will continue in business and be
around to update and make improvements to the software).
»» Make sure that your accounting software leaves good audit trails, which you
need for management control, for your certified pubic accountant who audits
your financial statements, and for the Internal Revenue Service when it
decides to audit your income tax returns. The lack of good audit trails looks
very suspicious to the IRS. See Book 9 for a discussion of audits.
42
BOOK 1 Accounting for Financial Systems
»» Pay attention to security features and best practices. You need very tight
controls of all aspects of using the accounting software and who is authorized
to make changes in any of the modules.
Online accounting systems that permit remote input and access over the
Internet or a local-area network with multiple users present special security
problems. Think twice before putting any part of your accounting system
online (and if you do, institute airtight controls).
More and more businesses seem to be switching to the cloud to do more and
more of their accounting tasks. The cloud consists of a network of offsite computer servers that users connect with over the Internet. You can choose to do
your accounting in the cloud or use the cloud simply as the backup storage
location for your accounting records. Cloud providers offer a wide variety of
accounting and business software and services that are too numerous to discuss
here. Cloud servers have a reputation for being very secure, but you still need
very strong controls over the transmission of accounting information to and
from the cloud.
Using Journal Entries
and Ledgers
CHAPTER 3 Using Journal Entries and Ledgers
43
IN THIS CHAPTER
»» Getting clear on the cash and accrual
methods of accounting
»» Walking through other types of
accounting
»» Finding out about FASB’s conceptual
framework
Chapter
4
Choosing an Accounting
Method
Y
ou can approach accounting in several ways, depending on the nature
of your business and the audience that reads your financial statements.
Businesses use accounting to track transactions and keep investors
informed, for example, whereas their managers use accounting to make better
decisions. Not-for-profit organizations use accounting primarily to help with
budgeting and grant proposals. Accountants serving government agencies must
also focus on budgeting while providing citizens and government agencies and
officials the information they need.
This chapter explains the differences between cash- and accrual-basis accounting,
describes the various ways accounting is used, and introduces you to the Financial
Accounting Standards Board’s Statements of Financial Accounting Concepts. This
chapter also explores many of the specialized fields of accounting which are available as an extension.
CHAPTER 4 Choosing an Accounting Method
45
Choosing Your Method
You can’t keep books unless you know how you want to go about doing so. The two
basic accounting methods are cash-basis accounting and accrual-basis accounting.
The key difference between these two accounting methods is the point at which
you record revenue and expenses in your books. If you choose cash-basis accounting, you record transactions only when cash changes hands. If you use accrualbasis accounting, you record revenue when it’s earned and expenses when they’re
incurred, regardless of when cash changes hands. If neither of these approaches
works on their own, then selecting a clear and coherent combination of the two
can be possible using a hybrid-basis.
The accrual method of accounting allows you to apply the matching principle to
your transactions. This principle states that revenue should be matched with the
expenses incurred to produce the revenue, regardless of when cash changes hands.
Suppose that your company buys products to sell from a vendor but doesn’t pay
for those products for 30 days. If you’re using cash-basis accounting, you don’t
record the purchase until you lay out the cash to the vendor. If you’re using
accrual-basis accounting, you record the purchase when you receive the products,
and you also record the debt you owe in an account called accounts payable. The
following sections describe each method in greater detail, discussing their pros
and cons.
The cash method
Cash-basis accounting couldn’t be easier: You record revenue when the company
receives payments, and you record expenses when the company pays for something. In this type of accounting, you essentially post accounting transactions
by using your checkbook. Your checkbook deposits for March represent March
revenue, and your checks and debits for March are your expenses for that month.
The ease of using the cash method is more than offset by the fact that the method
fails to match revenue with the expenses that the company incurs to earn that
revenue. Because the matching principle isn’t applied, cash-basis financial statements usually don’t present as accurate a picture of how the business is performing as accrual-method financial statements do.
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BOOK 1 Accounting for Financial Systems
SWITCHING UP YOUR METHODS
Some small businesses use the cash method because they have little activity in the way of
accounts receivable or payable. But the vast majority of businesses use the accrual basis.
Because of the issues companies encounter with the cash method, most companies
eventually switch to the accrual method. Often, a financial-statement user insists on the
change. Maybe you’re applying for a company bank loan. Your banker believes that the
accrual method provides a more accurate view of your profit and loss each period, so
the banker asks to see previous-year financials that use the accrual period.
As you can imagine, adjusting your accounting records from the cash to accrual method
may take a lot of work. You must review every revenue and expense transaction and
then determine whether the accounting needs to be changed.
Consider an example. Suppose that say ABC Corp. has revenue of $40,000 and
expenses totaling $15,000 associated with that revenue in April. Of the revenue,
$20,000 was received in cash, and the rest is on account. ABC Corp. paid cash for
the entire $15,000 of expenses. Under the cash method, ABC Corp.’s net income for
April is $5,000 ($20,000 cash revenue less $15,000 cash expenses). But that $5,000
of net income grossly underrepresents the volume of activity the company had during the month. The figures could be just as wildly inaccurate if the company didn’t
pay any of its expenses and had cash sales of $30,000 — or in any other scenario
involving the use of cash changing hands as criteria for recording net income.
The accrual method
Typically, revenue is considered to be earned when the vendor delivers the goods
or services. Realizable means that the company has good reason to believe it will
receive payment, such as when the customer swipes their debit card and enters
their personal identification number.
A company can choose the criteria it uses to recognize revenue in the accounting
records. The timing of revenue recognition depends on the company’s industry,
as well as the firm’s history of receiving payments. A company may recognize
revenue when it sends an invoice or when it ships the goods. Even if the revenue
is realizable, the point at which the revenue is considered to be earned can vary.
CHAPTER 4 Choosing an Accounting Method
47
Choosing an Accounting
Method
Under the accrual method of accounting, you record revenue when it’s earned and
realizable, and you record expenses when they’re incurred, regardless of whether
or when money changes hands. Are you wondering what the criteria are for revenue to be earned and realizable? The earned criterion is satisfied when the vendor
performs satisfactorily on its contract with the customer.
The accrual method takes cash out of the equation, because money changing hands
doesn’t determine whether you recognize a transaction. As a result, a company
that uses the accrual method has accounts receivable, showing how much money
customers owe to the business, and accounts payable, showing all the money a
company owes to its vendors.
The statement of cash flows (discussed briefly in the “Financial accounting”
section and explained in detail in Book 5, Chapter 2) is the accountant’s bridge
between the cash and accrual methods of accounting. That’s because the statement of cash flows shows cash sources and uses — an aspect missing from the
accrual method. Therefore, it gives users of financial statements a chance to look
beyond and through the accrual-based numbers.
The hybrid method
As the name suggests, hybrid accounting methods use elements of both accrualbased and cash-based accounting, giving companies a greater degree of flexibility in how to represent income and expenses, as well as how to manage assets.
The best way to approach this is to pick either a cash-based or accrual-based
approach, whichever one meets your needs the closest, and then replace the elements that create misleading information with the opposite method. The key to
using a hybrid-basis is to ensure that the information being collected and shared
accurately represents the state of the organization in a coherent manner.
Sorting through Standards for Other
Types of Accounting
Financial accounting is the process of compiling accounting transactions to create
financial statements. Here are some other types of accounting that accountants
may perform:
»» Managerial accounting: Creating internal accounting reports that company
managers use to make decisions.
»» Not-for-profit accounting: Generating financial statements for not-for-profit
entities, using a different set of financial reports. Not-for-profit firms raise
money from donations, grants, and other sources; they don’t produce
revenue primarily from selling a product or service. As a result, their financial
reports are different.
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BOOK 1 Accounting for Financial Systems
»» Governmental accounting: Like not-for-profits, governments (federal, state,
and local) have a unique method for creating financial statements.
»» International accounting: The global accounting industry is attempting to
create a single set of accounting standards for international commerce. At this
point, countries outside the United States maintain at least some accounting
rules that are different. As a result, rules for foreign entities may differ from
U.S. accounting rules.
If you work in an accounting field other than financial accounting, you must
follow standards different from (or in addition to) those discussed in Book 4,
Chapter 1. Other organizations besides the financial accounting standard-setters
give official guidance on how to prepare financial statements and reports. Instead
of following generally accepted accounting principles (GAAP), for example, governmental entities follow procedures set up by the Governmental Accounting
Standards Board (GASB). The next few sections give you the lowdown on other
types of accounting and note who provides guidance to accountants in these fields.
Financial accounting
The purpose of financial accounting is to provide useful information that allows
financial-statement users to make informed decisions. Financial accounting
requires accountants to classify and record all accounting events that take place
in the course of a company’s business, including earning revenue, paying bills,
bringing in gains, and incurring losses.
The results of all these events are posted to the correct financial statement (the
balance sheet, income statement, and/or statement of cash flows) and reported to
the external users of the financial statements. External users include investors,
creditors, banks, and regulatory agencies such as the Internal Revenue Service
(IRS) and the U.S. Securities and Exchange Commission (SEC).
»» Understandability: The information on the financial statement has to be
understandable to people who aren’t privy to the internal workings of the
business. The financial information must be laid out in such a fashion that
users who have reasonable understanding of the business world (and
willingness to research specific topics as needed) can ferret out all important
accounting facts about the business.
CHAPTER 4 Choosing an Accounting Method
49
Choosing an Accounting
Method
Besides organizing accounting events into financial statements, financial accountants serve the needs of external users by delivering the information they need in
a format that they understand. To achieve this goal, accountants must produce
financial reports that exhibit the following characteristics:
»» Relevance: This characteristic means that the financial statements give the
users enough info to form opinions about the final outcome of past events,
and how any present or future events are likely to shake out. Also, the
financial statements should give the users enough info to make informed
opinions reached about future events.
»» Reliability: Financial statements aren’t worth the paper they’re printed on
unless the information they present is verifiable, neutral, and materially
correct. If the income statement (see Book 4, Chapter 2) shows $10 million of
sales, for example, that $10 million should represent sales that actually took
place, not projections (or what company management wants users to think
occurred).
»» Comparability: Comparability means that the quality of the information
allows users to identify differences between and similarities among companies they’re evaluating, or among different financial periods for the same
company. Users need to know what method(s) companies use to depreciate
assets, for example. Without this knowledge, they can’t accurately evaluate
the relative worth of one company compared with the other. (Head over to
Book 3, Chapter 1 for more information on depreciation.)
»» Consistency: Consistency means that the company uses the same accounting
treatment for the same type of accounting transactions — both within a
certain financial period and among various financial periods. This characteristic lets users know that the financial accountant isn’t doing the accounting
equivalent of comparing apples and oranges.
Managerial and cost accounting
Managerial accountants provide economic and financial information to the internal users of financial statements, such as a company’s department heads, shift
leaders, and human resources department. Human resources personnel, for
example, use managerial accounting reports to make sure that they have the right
mix of employees to maintain a smooth-running operation. Additionally, managerial accounting reports measure quality and performance, and gauge how close
each department or business unit came to meeting its goals. Finally, these reports
measure managerial effectiveness and efficiency. To be useful, managerial reports
are issued frequently — sometimes daily. There’s no messing around! At other
times, the accounting staff prepares and distributes the reports the day after a
reporting period ends. For internal reporting to management, the rules are similar
to those you follow when playing horseshoes: Close is good enough.
Because managerial reports are used only internally, no regulatory bodies or other
outside agencies mandate how managerial accountants do their job. Instead,
50
BOOK 1 Accounting for Financial Systems
managerial accountants look to the Institute of Management Accountants (IMA)
for guidance on carrying out their accounting duties. The managerial accountant code of ethics is contained in the Standards of Ethical Conduct for Management
Accountants. For more information, check out the IMA website at www.imanet.org.
To find out more about managerial accounting, see Corporate Finance For Dummies,
by Michael Taillard, PhD (John Wiley & Sons, Inc.).
Not-for-profit accounting
Not-for-profit businesses are run for the public good, not driven by any profit
motive. You may consider these entities to be “mission-driven.” Every notfor-profit organization has a particular mission that it has defined for itself.
These types of organizations include hospitals, schools, religious organizations,
and charitable agencies.
Most of the net income generated by an exempt organization isn’t taxed federally. To qualify for exempt status in the United States, an organization fills out
an application package that must be approved by the IRS. After the application
is approved, which can take months, the organization is exempt from paying the
normal taxes levied on a for-profit business by the federal government.
The not-for-profit accountant’s job involves two important components (in addition to typical accounting duties): preparing budgets and preparing the financial
information for grant applications. Budgets are crucial because the organization
needs to be able to predict what amount of money it must obtain through grants,
donations, and fundraising efforts to serve the organization’s purpose.
Are you wondering whether not-for-profits also have to report by using accrualbasis accounting (according to FASB and GAAP standards)? As explained in
Book 4, Chapter 1, the FASB Accounting Standards Codification is the source of
authoritative GAAP to be applied by all nongovernmental entities. So the answer
is yes, a not-for-profit follows FASB and GAAP unless an FASB pronouncement
specifically excludes not-for-profits.
One difference between keeping the books for profit-seeking entities and keeping
them for not-for-profit organizations is that not-for-profits use fund accounting,
which groups accounting transactions into funds or accounts that have a similar
CHAPTER 4 Choosing an Accounting Method
51
Choosing an Accounting
Method
Not-for-profits apply for grants awarded by government entities and private
foundations. The purpose of the grant should fit the organization’s mission. If
your organization promotes trails for hiking and biking, you might apply for a
grant to encourage kids to walk or ride bikes to school. The entity awarding the
grant requests financial information in the grant application and insists that the
not-for-profit report periodically on how the funds are used.
purpose. This way, the organization has a better idea of the resources it has available for each function.
Governmental accounting
Government accountants work for city, county, state, and federal government
agencies. Their job is similar to the not-for-profit accountant’s job because they
deal with budgets and government agencies that have no profit motive. Budgeting
is important because budgets serve as the primary tool in allocating governmental
cash sources to urban, suburban, and rural parts of the communities served.
At the city, county, or state level, the cash comes in from sources such as ad valorem (property) taxes; funds from the federal government for schools, streets, and
roads; interdepartmental governmental transfers; fines and forfeitures; sales and
use taxes; licenses and permits; and municipal bond issuances. Funds are appropriated to cover costs. The appropriations are approved or disapproved during the
setting of the budget. Finally, disbursements are made throughout the fiscal year
for approved budget items.
Governmental accountants also prepare financial statements that are open to the
general public. The financial statements must show accountability to citizens
while pursuing the goals of efficiency and effectiveness. External users also use
these financial statements to decide whether to invest in a municipality’s bond
issuances. The regulatory authority for governmental accountants is GASB. You
can find more information at www.gasb.org.
Forensic accounting
Forensic accounting uses auditing methods to perform examinations of the ways
in which people and businesses manage their resources. This type of accounting
is done primarily for legal reasons and was greatly popularized by cases such as
the investigation of Al Capone, or movies like The Fugitive. Forensic accounting
consists of a thorough audit of accounting records in order to looks for clues or
evidence associated with criminal acts.
Public accounting
Public accountants perform reporting and analyses intended for the public rather
than for people within the organization they work for. Because this information
isn’t being used strictly for internal management reasons, it’s vital that the users
of this information feel secure in the belief that they’re not being misled. As a
result, public accounting is subject to a great degree of regulation and scrutiny.
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BOOK 1 Accounting for Financial Systems
IN THIS CHAPTER
»» Looking back at the origins of
financial accounting standards
»» Introducing the accountant’s code of
conduct
»» Reviewing rules set by the Financial
Accounting Standards Board
»» Finding out about generally accepted
accounting principles
»» Shifting to a global focus with
International Accounting Standards
Chapter
5
Setting the Standards
A
lthough accountants often ply their trade as freelancers, accounting isn’t
a free-for-all. Accountants are expected to operate according to a professional code of conduct and to practice generally accepted accounting principles (GAAP) — best practices for accounting in the United States.
In this chapter, we take you on a whirlwind tour through the history of accounting
that highlights the origins of accounting standards. Following this brief historical
account is an overview of the financial accounting code of professional conduct,
which is set by the American Institute of Certified Public Accountants (AICPA).
These standards give you a road map to follow when you’re trying to figure out
how to interact with your clients or employer. The standards also explain how to
handle various accounting transactions that take place during day-to-day business operations.
Finally, you meet the financial accounting standard-setting bodies. You find out
why publicly owned companies (those whose stock shares are traded on a public
stock exchange) abide by a different set of standards from those followed by privately owned companies.
CHAPTER 5 Setting the Standards
53
Exploring the Origins of
Accounting Standards
Although accounting dates back to prehistoric times, the birth of accounting standards is fairly recent. Here’s a brief timeline that traces the history of accounting
up to the present:
»» Human ancestors probably traded whatever they had or produced to acquire
food and other basic necessities. These trades required some equitable
method of measuring the relative value of goods, thus originating the concept
of keeping track of — or accounting for — items.
»» Later in history, formal accounting records were kept to make sure that
people paid the required amount of taxes.
»» The Industrial Revolution in the 18th and 19th centuries ushered in the mass
production of manufactured goods. Mass production required a more
sophisticated approach to recording the movement of goods, services, and
money. As a result, the accounting field had to operate with a higher level of
professionalism and expertise. Many owners needed more people to manage
the business properly. Mass production resulted in the separation of ownership from management.
»» Accountants plied their trade in a mostly unmonitored and unregulated
environment until the stock-market crash of 1929. After this horrific event, the
American Institute of Accountants, which is now the American Institute of
Certified Public Accountants, partnered with the New York Stock Exchange to
agree on five principles of accounting.
»» Fast-forwarding to the present, these five principles have expanded into
hundreds of principles covering every accounting topic imaginable, from how
to prepare financial statements to how to keep the books for different types
of businesses.
If you’re just getting started in accounting, you may be wondering why you have
to record financial events in such a nitpicky fashion. You may also wonder who the
head nitpickers are and where they get their authority. Well, read on! This chapter
answers both questions and gives you a good foundation for understanding why
accountants perform certain tasks the way they do.
Sometimes, accountants handle transactions in a certain way simply because
that’s the way it’s done. Instead of trying to understand the logic or lack thereof,
develop a general understanding of the regulatory system, as explained in this
chapter, and then go with the flow. As you spend more time working in accounting, the standards will make more sense to you.
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BOOK 1 Accounting for Financial Systems
The American Institute of Certified Public Accountants (AICPA) is the national
professional organization for all certified public accountants (CPAs). Through its
senior technical committee, called the Auditing Standards Board (ASB), the AICPA
is responsible for establishing auditing and attestation standards for companies in
the United States. To understand what that entails, you need to know the meaning
of three key terms:
»» Auditing: The purpose of auditing is to gather evidence about a company’s
financial statements and to use that evidence to determine whether the
statements are free of material (significant) misstatements. The company
creates the financial statements; the auditor is an independent entity who
issues an opinion on the company’s financials.
»» Attestation: Accountants create other reports on financial statements that
don’t provide an opinion. Those reports are considered to be attestation
services. A company might hire you to calculate the rate of return on its
investments (see Book 8, Chapter 3), for example, making sure that your
figures match the company’s report on the same topic.
»» Nonpublic: Nonpublic companies are privately owned; their stock isn’t traded
on any open-to-the-public stock exchange. Holders of nonpublic stock may
choose to have an initial public offering in which shares are sold publicly in
order to increase the pool of potential investors, but it’s not a requirement
that all corporations go public.
Tying together regulators for audits
of publicly traded companies
Shares of publicly traded companies are available for purchase on stock exchanges,
such as the New York Stock Exchange, or over-the-counter markets, such as
Nasdaq. To issue securities to the public, companies must register their securities
with the U.S. Securities and Exchange Commission (SEC).
The Public Company Accounting Oversight Board (PCAOB) oversees audits of publicly traded companies. The SEC has oversight over the PCAOB, approving its rules,
standards, and budget.
The AICPA also enforces a code of professional conduct for its members, which
governs how accountants perform their duties. Those duties include performing
CHAPTER 5 Setting the Standards
55
Setting the Standards
Recognizing the Role of the American
Institute of Certified Public Accountants
audits and attestation services. The ASB (a senior committee within the AICPA)
sets audit and attestation standards.
When the company involved is publicly traded, the PCAOB and the SEC have oversight. As a result, auditing standards created by the ASB are adopted by the PCAOB
and approved by the SEC. If you look through the standards listed on the PCAOB
website (https://pcaobus.org/), you’ll see a list of auditing standards from
the ASB.
Establishing and adhering to accounting standards ensure that financial reports
have accurate information so that investors and others can make well-informed
decisions. As an accountant, you’re responsible for serving at least two masters:
the organization that hires you to produce the financial reports and investors who
use that information to make investment decisions. Accounting standards help
ensure that everyone is making decisions by using timely and accurate financial
information.
You don’t have to be a CPA or a member of the AICPA to perform your job ethically or to get work as an accountant. But membership in the AICPA has many
benefits, including automatic accounting standards updates, research tools, and
educational resources.
Navigating ASB audit and attestation
standards
The ASB issues the standards and procedures that accountants must follow when
conducting attestation and audit services for nonpublic companies. As explained
in the preceding section, the ASB is also involved with accounting work on publicly traded companies.
The ASB sets quality-control standards to use in conducting peer reviews, which
occur when one CPA firm evaluates the operations of another CPA firm. Most ASB
members work for public accounting firms), are university professors or government accountants, or practice in some other accounting field.
Are you curious about these mysterious ASB standards? They’re called Statements
on Auditing Standards (SAS). Here are a couple of the standards so that you have
some idea of what they cover:
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BOOK 1 Accounting for Financial Systems
Setting the Standards
»» SAS No. 1 Section 410 establishes that the auditor must state whether the
financial statements are presented in accordance with GAAP.
»» SAS No. 85 defines the responsibilities that management of a company has
for the preparation of the financial statements. Management also must
provide written representations about financial-statement preparation to the
auditors.
More information about the ASB standards and procedures is available free of
charge on the AICPA website at www.aicpa.org. On the home page, select Research
and then Standards. You can access all sorts of good financial accounting info on
the topics of audit, attest, compilation, and review standards.
A compilation occurs when an accountant prepares financial statements for a company by using only data received from company management. A review occurs
when the accountant gives limited assurance that no material modifications need
to be made to financial statements prepared by company management.
Observing the AICPA Code of
Professional Conduct
The AICPA’s Code of Professional Conduct contains six principles of professional
conduct by which its members must abide: responsibilities, serving the public
interest, integrity, objectivity and independence, taking due care, and the scope
and nature of services.
Following are brief definitions of the six principles:
»» Responsibilities: As an accountant, you hold yourself to high moral and
ethical standards to maintain the public’s confidence in your financial
reporting. Accountants have the responsibility to participate in selfgovernance, for example, by performing peer reviews of other CPA/financial
accounting firms’ work to check for accuracy and consistency among the
profession.
»» Serving the public interest: An accountant’s public interest is the company
for whom they are preparing the financial statements, as well as the users of
the financial statements (such as people who are thinking about purchasing
shares of the company stock).
CHAPTER 5 Setting the Standards
57
The public interest also includes banks and other businesses that are
considering granting credit to the company, government agencies such as the
Internal Revenue Service (which measures the company’s compliance with the
tax code), current and prospective investors, and other members of the
business and financial community who rely on the objectivity and integrity of
CPAs.
»» Integrity: Having this characteristic means that you’re honest when dealing
with others. In the world of accounting, integrity means that you serve the
company for which you’re preparing the financial statements to the best of
your ability. Keep in mind that integrity may not be the same as completely
agreeing with the way the company wants its financial statements to be
prepared. You can’t be worried that the company’s management is going to
be mad at you or fire you if you disagree with them.
»» Objectivity and independence: When you’re objective, you’re neutral and
unbiased in all decision-making processes. You base your opinions only on
facts, not on any preconceived notions you may have. You interpret rules and
policies, such as GAAP, in a truthful and sincere manner, staying true to both
the form and spirit of the particular principle or regulatory issue.
Accountants who provide auditing and other attestation services must be
independent in both fact and appearance. Being independent means that you
have no special relationship to or financial interest with the company that
would cause you to disregard evidence and facts when evaluating the
company. Preparing the financial statements for a business owned by a close
relative, for example, would justifiably cause those who read your report to
doubt your objectivity.
»» Taking due care: In a nutshell, this principle means that you have the
education and experience to perform the work at hand. You must be both
competent and diligent. In addition, due care means that you plan and
adequately supervise any professional activity for which you’re responsible.
»» Scope and nature of services: All the principles in this list lead up to this final
one. Accountants consider all the preceding principles when determining
whether they can provide specific services in individual circumstances.
For more about these six principles, search online for “AICPA Code of Professional
Conduct.”
If being a member of the AICPA isn’t required to get a job as an accountant, you
may wonder why its code of conduct is such a big deal. Well, if you want to be
an accountant who practices as a CPA, you must be licensed by your state, which
recognizes the authority of the AICPA. State and federal courts consistently hold
that all practicing CPAs, regardless of membership status, must follow the professional ethical standards contained in the AICPA’s Code of Professional Conduct.
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In addition to the AICPA, other organizations give accountants official guidance
on preparing financial statements. Public and nonpublic corporations have different agencies that monitor their activities. Perhaps the best-known of the regulating agencies is the SEC. The earlier section “Tying together regulators for audits
of publicly traded companies” tells you that the SEC has oversight over auditors
of public companies.
In response to the stock-market crash of 1929 and the ensuing Great Depression,
Congress passed the Securities Exchange Act of 1934, which led to the formation
of the SEC. The SEC’s mission is to ensure that publicly traded companies tell the
truth about their businesses and treat investors in a fair fashion by putting the
needs of investors before the needs of the company.
The president of the United States appoints five commissioners to five-year terms
to run the SEC. Their terms are staggered, and no more than three commissioners
can be from the same political party at the same time. These commissioners ride
herd over the SEC’s power to license and regulate stock exchanges, the companies
whose securities are traded on the exchanges, and the brokers and dealers who
conduct the trading and sell securities to investors.
The enforcement authority given by Congress allows the SEC to bring civil enforcement actions against people or companies alleged to have committed accounting
fraud, provided false information, or engaged in insider trading or other violations of the securities law. The SEC also works with criminal law enforcement
agencies to prosecute individuals and companies alike for offenses that include
criminal violations.
As an accountant, your exposure to the regulatory authority of the SEC will be
limited unless you work for a company whose shares of stock are publicly traded
or you work for a CPA firm that conducts financial statement audits for publicly
traded companies.
Getting to Know the Financial Accounting
Standards Board
The Financial Accounting Foundation (FAF) was established as a not-for-profit
corporation in June 1972 in response to congressional criticism of the standardsetting work being done by AICPA.
CHAPTER 5 Setting the Standards
59
Setting the Standards
Checking Out the U.S. Securities and
Exchange Commission
The FAF in turn established the Financial Accounting Standards Board (FASB),
which is the private-sector body establishing GAAP for all nongovernment entities. FAF also established the Governmental Accounting Standards Board (GASB).
Governmental entities follow GASB procedures.
The FASB has five full-time members, who are selected by FAF. All are required
to have knowledge of accounting, finance, and business. For more info about
the FASB, accounting standards, and FAF, check out the FASB website at www.
fasb.org.
In 1984, the FASB formed the Emerging Issues Task Force to help identify
accounting issues in need of standardization. This group is composed of accounting professionals who meet regularly to mull over current economic, business,
and industrial developments.
Understanding generally accepted
accounting principles
Generally accepted accounting principles define the acceptable practices in the
preparation of financial statements in the United States. Specifically, GAAP tells
accountants exactly how financial data must be presented on the income statement, balance sheet, and statement of cash flows. GAAP states, for example, that
assets, liabilities, and equity must be posted on the balance sheet, not on the
income statement. GAAP is also pretty darn picky as to how these accounts are
arranged on the balance sheet. (You can find out more about the balance sheet
starting in Book 1, Chapter 3.) In addition, GAAP gives specific rules for separating
operating revenue (which is related to the business purpose) from nonoperating
revenue (non-business-related revenue, such as profit from selling a company
asset), as explained in Book 1, Chapter 3. Some of this detail is also explained in
the footnotes of the financial statements. Check out Book 5, Chapter 4 for more
on footnotes.
Like most rules, the rule that all businesses must follow GAAP has exceptions.
Some businesses — including airlines, franchisors, and health-care entities —
can deviate from GAAP, but these companies are required to justify their deviation
in their financial statements.
Is GAAP the same for public and nonpublic companies? For now, yes. The SEC has
the statutory authority to set accounting standards for publicly held companies,
but historically, it has relied on private-sector bodies to set those standards.
As explained earlier in this chapter, the SEC oversees the PCAOB in regard to
audits. Nearly all of the auditing standards listed by the PCAOB, however, are
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BOOK 1 Accounting for Financial Systems
Hold on to your hat! How accountants view GAAP changed with the adoption of
FASB Accounting Standards Codification. FASB Accounting Standards Codification (ASC) became the single source of authoritative GAAP in the United States.
Before you panic, keep in mind that the ASC doesn’t change GAAP; the FASB
didn’t rewrite all the accounting rules. Instead, the ASC organizes GAAP in a more
user-friendly fashion and (mercifully) uses a consistent format across the board
for all GAAP topics.
Looking online for FASB standards
The FASB allows free, limited access to the Accounting Standards Codification. To
check it out, visit https://asc.fasb.org. After you complete the login procedure,
you can browse the topics to see how to apply GAAP to accounting topics such as
revenue, assets, liabilities and equity, and presentation. Each topic allows you to
drill down to more detailed information. If you select Equity, for example, you can
further select Treasury Stock to find out how to account for treasury stock under
GAAP.
For better search functions that allow for a fully functional view of the codification, you can upgrade to ASC’s professional version for an annual subscription
cost. If you’re still in school, ask your accounting instructor whether your school
has academic access.
Picking a standard: Domestic or
international
For many years, the size of a company — and whether it was public or private —
wasn’t considered to be relevant to the accounting and financial reporting standards that should be used by a business. The business world in the United States
was under the dominion of one set of accounting and financial reporting standards: GAAP, which applied to all businesses. GAAP was considered to be the gold
standard and good for the rest of the world as well.
In recent years, the movement toward adopting international standards gained
momentum. Now companies that follow the U.S. GAAP may also be affected
by international financial reporting standards (IFRS). If you do business outside
the United States, ask your accounting firm whether any IFRS rules affect your
business.
CHAPTER 5 Setting the Standards
61
Setting the Standards
written by the AICPA’s Auditing entity. The AIPCA is the private-sector body that
sets standards, and the SEC relies on those standards.
Serious efforts have arisen to simplify accounting and financial reporting for private businesses. The Private Company Council, established by FAF, is tasked with
making recommendations to the FASB for modifying and making exceptions to
GAAP to alleviate the burden on private companies in complying with complex
GAAP standards.
Grasping Accounting Standards
Around the Globe
International accountants work for multinational businesses, performing financial and managerial accounting, tax return preparation, and auditing. (Auditing is
the process of investigating financial information prepared by someone else to see
whether it’s stated fairly. Check out Book 9 for additional details.) They should be
familiar with the legal regulations and standards of the countries in which their
employers conduct business.
International accountants have to deal with foreign-currency translations, such
as how many U.S. dollars equal how many euros. They also manage two special
risks:
»» Expropriation: The seizure of company assets by the host government
»» Blocked funds: When the host government doesn’t allow any company funds
to be repatriated to the United States
An important organization for international accountants is the International
Accounting Standards Board (IASB). The IASB is currently working in tandem with
the FASB to provide comparability between the accounting standards — in other
words, to bring U.S. and international GAAP together. This process is referred to
as harmonization, and the purpose is to develop a single set of global accounting
standards that will provide high-quality, transparent, and comparable financial
statement reporting.
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2
Recording
Transactions
Contents at a Glance
CHAPTER 1:
Keeping the Books . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Analyzing the Effect of Business Transactions . . . . . . . . . . . . . . . . . . 65
Managing Your Bookkeeping and Accounting System . . . . . . . . . . . 68
Wrapping Up with End-of-Period Procedures. . . . . . . . . . . . . . . . . . . 73
CHAPTER 2:
Tracking Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Keeping Track of Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Buying Supplies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Handling Billing and Payables. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86
CHAPTER 3:
Tallying Your Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
Collecting on Cash Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Selling on Credit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Proving Out the Cash Register. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tracking Sales Discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Recording Returns and Allowances . . . . . . . . . . . . . . . . . . . . . . . . . . .
Monitoring Accounts Receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accepting Your Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
CHAPTER 4:
87
90
93
94
95
97
98
Processing Employee Payroll and Benefits . . . . . . . 99
Staffing Your Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Collecting Employee Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Determining Net Pay. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Surveying Your Benefits Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Preparing Payroll and Posting It in the Books. . . . . . . . . . . . . . . . . . 111
Depositing Employee Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
CHAPTER 5:
Taxing Payrolls. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Paying Employer Taxes on Social Security and Medicare. . . . . . . . 119
Completing Unemployment Reports and
Paying Unemployment Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
Carrying Workers’ Compensation Insurance. . . . . . . . . . . . . . . . . . . 125
Maintaining Employee Records. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
IN THIS CHAPTER
»» Getting a bird’s-eye view of accounts
and transactions
»» Establishing your accounting system
»» Closing out at the end of a period
Chapter
1
Keeping the Books
I
ndividuals can get along quite well without much bookkeeping, but the exact
opposite is true for a business. In addition to facilitating day-to-day operations, a company’s bookkeeping system serves as the source of information
for preparing its periodic financial statements, tax returns, and reports to managers. The accuracy of these reports is critical to the business’s survival. As a
result, business managers have to be sure that their company’s bookkeeping and
accounting system is dependable and up to snuff.
In this chapter, you’ll see what bookkeepers and accountants do, mainly so that
you have a clear idea of what it takes to be sure that the information coming out
of the accounting system is complete, timely, and accurate.
Analyzing the Effect of Business
Transactions
This section walks you through the basics of bookkeeping, including the rule
of debits and credits and why proper debiting and crediting keeps the financial
statements in balance. You also discover the five steps for entering transactions
into the accounting records.
CHAPTER 1 Keeping the Books
65
Modern financial accounting is a double-entry system: For every entry into the
company accounting records, there has to be an opposite and equal entry. In other
words, debits must always equal credits. Technology gives you a hand here: No
accounting software package worth its salt will let you enter an unbalanced transaction into the accounting books. For more about double-entry accounting, see
Book 1, Chapter 2.
Approaching the fundamental
accounting equation
The fundamental accounting equation (also known as the accounting equation or the
balance sheet equation) requires that all transactions balance when they’re posted
to the equation. It demands that
Assets = Liabilities + Owners’ equity
A truncated version of this equation states
Net assets = Owners’ equity
This version of the equation just moves liabilities over to the other side of the
equal sign; net assets are all assets minus all liabilities. Before you can begin to
set up your accounts and enter transactions, you must have a good grasp of this
fundamental accounting equation, which is discussed in Book 1, Chapter 1.
Getting familiar with accounts
As an accountant within a business, you summarize accounting transactions in
accounts that you use to create financial reports. Every account your company
uses is annotated in a list called the chart of accounts — a list of all accounts and
each account’s balance. The business uses that chart of accounts to record transactions in its general ledger. The general ledger is the record of all financial transactions within the company during a particular accounting cycle. You find out
more about the general ledger later in this chapter.
The chart of accounts isn’t a financial report; it’s merely a list of all accounts
you’ve set up to handle company transactions.
When you’re “doing the books,” as the saying goes, you record your normal
business transactions by using accounts that you set up in the chart of accounts.
Each account in the chart of accounts has a unique number. Regardless of what
accounting software package your company uses, the numbering sequence is
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BOOK 2 Recording Transactions
pretty much set in stone to ensure consistency among companies and among
their financial reports. For more information about creating and using a chart of
accounts, see “Categorizing your financial information: The chart of accounts”
later in this chapter.
Defining debits and credits
Writing journal entries is a major area of concern for small-business owners,
first-year accounting students, and students who are taking accounting only
because it’s required for a business degree. The logistics of presenting the journal
entry don’t cause the concern; the worry is how to figure out which account is
debited and which is credited.
Assets and expense accounts are increased with a debit and decreased with a credit.
Liability, revenue, and equity accounts are just the opposite: These accounts are
credited for increases and debited for decreases. There are occasional exceptions
to these rules. Book 3, Chapter 6 explains one of them: accumulated depreciation.
This account is a contra-asset, which is an asset account that’s increased by crediting. Accumulated depreciation is the only exception discussed in this book.
Knowing more about the transaction
methodology
Before you enter an event into a business accounting system, you have to consider the transaction methodology, a five-step process for deciding the correctness
of whatever entry you’re preparing. When you get into the financial accounting
rhythm, this process becomes automatic. Here are your five considerations:
»» What’s going on? This question addresses the precipitating event for the
entry. Did the company buy a new piece of business equipment or sell some
product to a customer, for example?
»» Which accounts does this event affect? Is the account an asset, liability,
owners’ equity, revenue, or expense? Assets would definitely be affected by
the purchase of business equipment, and revenue would be affected by a
customer sale. To get started, ask yourself whether the event affects cash.
Cash is often the most-used account in your chart of accounts.
CHAPTER 1 Keeping the Books
67
Keeping the Books
When you understand the basics of accounts and the chart of accounts (see the
previous sections), it’s time to find out about the mechanism of journal entries,
which you use to enter financial information into the company’s accounting
records.
»» How are the accounts affected — by a debit or credit? Looking back to
your rules of debits and credits, buying assets adds to the account, so it’s a
debit. Making a sale adds to a revenue account, so it’s a credit.
»» Do all debits for an entry equal all credits for the same entry? Think
about the fundamental accounting equation discussed earlier in this chapter.
Every debit requires an equal credit.
»» Does the entry make sense? Do the accounting actions you take match the
facts and circumstances of the business event? Although the net effect on the
books is the same, you can’t credit an expense to record revenue, for
example.
Each type of account in your chart of accounts has a normal balance: the balance
you expect to see in an account at any point in time. You debit cash (an asset balance) to increase it, for example. A normal balance for an asset account is a debit
balance. If you review account balances and notice a credit balance in cash, that
fact should be a red flag; it may mean that your cash account is overdrawn or
negative.
Managing Your Bookkeeping
and Accounting System
Too many business managers and owners ignore their bookkeeping and accounting systems or take them for granted — until something goes wrong. They
assume that if the books are in balance, everything is okay. Book 1, Chapter 2 covers exactly what having “books in balance” means; it does not necessarily mean
that everything is okay.
To determine whether your bookkeeping system is up to snuff, check out the following sections, which provide a checklist of the most important elements of a
good system.
Categorizing your financial
information: The chart of accounts
Suppose that you’re the accountant for a corporation, and you’re faced with the
daunting task of preparing the annual federal income tax return for the business.
The Internal Revenue Service (IRS) requires that you report the following kinds of
expenses (and this list contains just the minimum!):
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BOOK 2 Recording Transactions
Keeping the Books
»» Advertising
»» Bad debts
»» Charitable contributions
»» Compensation of officers
»» Cost of goods sold (COGS)
»» Depreciation
»» Employee benefit programs
»» Interest
»» Pensions and profit-sharing plans
»» Rents
»» Repairs and maintenance
»» Salaries and wages
»» Taxes and licenses
The cost-of-goods-sold expense, for example, is determined in a schedule that
also requires inventory cost at the beginning of the year, purchases during the
year, cost of labor during the year (for manufacturers), other costs, and inventory
cost at year-end.
Where do you start? For each category of information that you must report, you
need an account, which is a record of the activities in that category. An account is a
focused history of a particular dimension of a business. People can have accounts
too. Your checkbook is an account of the cash inflows and outflows and the balance of your checking account (assuming that you remember to record all activities and reconcile your checkbook against your bank statement). You probably
don’t keep a written account of the coins and currency in your purse, wallet, or
pockets, but a business needs to keep track of all its cash no matter where it is. An
account serves as the source of information for preparing financial statements,
tax returns, and reports to managers.
The formal index or list of all accounts is referred to as the chart of accounts.
The chart of accounts, even for a relatively small business, often contains
more than 100 accounts. Larger business organizations sometimes need ­thousands
of accounts. The larger the number, the more likely the accounts are to have
number codes according to some scheme, such as all assets in the 100 to 300 range
and all liabilities in the 400 to 500 range. To get the lowdown on how to set up
your chart of accounts, check out Book 1, Chapter 2.
CHAPTER 1 Keeping the Books
69
Standardizing source document forms
and processing procedures
Just as humans need a constant circulation of blood to live, businesses need a
constant flow of paperwork. Even in the age of the Internet, electronic communication, and computers, a business generates and depends on a lot of paperwork,
and much of this paperwork is used in the accounting process. Placing an order
to buy products, selling a product to a customer, determining the earnings of an
employee for the month — virtually every business transaction needs paperwork,
generally known as source documents.
Source documents serve as evidence of the terms and conditions agreed upon by
the business and the person or organization that it’s dealing with. Both parties
receive some kind of source document. For a sale at a cash register, for example,
the customer gets a sales receipt, and the business keeps a running record of all
the transactions in the register, which can be printed later if need be.
Clearly, an accounting system needs to standardize the forms and procedures for
processing and recording all normal, repetitive transactions and should control
the generation and handling of these source documents. From the bookkeeping
point of view, these business forms and documents are very important because
they provide the input information needed for recording transactions in the
business’s accounts. Sloppy paperwork leads to sloppy accounting records, which
won’t do when the time comes to prepare tax returns and financial statements.
If you’re the owner of a small business, you may want to check out an officesupply store to see the kinds of forms that you can buy right off the shelf. You
can find many basic forms and documents for executing and recording business
transactions. Also, computer accounting software packages include templates for
most business forms and source documents that a business needs.
Hiring competent personnel
A business shouldn’t be penny-wise and pound-foolish: What good is meticulously collecting source documents if the information on those documents isn’t
entered into your system correctly? You shouldn’t try to save a few bucks by hiring the lowest-paid people you can find. Bookkeepers and accountants, like all
other employees in a business, should have the skills and knowledge to perform
their functions properly. Here are some guidelines for choosing the right people to
enter and control the flow of your business’s data and for making sure that those
people remain the right people:
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BOOK 2 Recording Transactions
»» Education and experience: The ideal level of education and experience for
accounting employees can vary greatly. Many accountants in large business
organizations have a college degree with a major in accounting. The head of
accounting in a smaller company may have similar qualifications. As you move
down the pay scale in any accounting department, however, you find more
employees who don’t have a college degree and may not have taken any
courses in accounting; they learned bookkeeping methods and skills through
on-the-job training. Even without a degree or formal accounting coursework,
however, these employees can be very effective workers.
»» Certifications: When you’re hiring higher-level accountants in a business
Keeping the Books
organization, decide whether they should be certified public accountants
(CPAs). Larger businesses insist on this credential, along with a specific
number of years of experience in public accounting. Until recently, the other
main professional accounting credential was certified management accountant (CMA), sponsored by the Institute of Management Accountants (IMA). The
CMA credential is American-born and -bred. By contrast, the Chartered Global
Management Accountant (CGMA) designation is co-sponsored by the
American Institute of CPAs and the British Chartered Institute of Management
Accountants. Unlike the CPA license, the CMA and CGMA designations
recognize professional achievement and experience, but most governments
don’t regulate these credentials.
A business is prudent to require the CPA, CGMA, or CMA credential for its
chief accountant (who usually holds the title of controller). Alternatively, a
business could regularly consult a CPA in public practice for advice on its
accounting system and on any accounting problems that arise.
Note: For bookkeepers, the American Institute of Professional Bookkeepers
sponsors the Certified Bookkeeper designation. For more information, visit
https://aipb.org.
»» Continuing education: Bookkeepers and accountants need continuing
education to keep up with changes in income tax law and financial reporting
requirements, as well as changes in how the business operates. Ideally,
bookkeepers and accountants should be able to spot needed improvements
and implement these changes to make accounting reports to managers more
useful. Fortunately, many courses are available at reasonable costs to help
employees keep up on the latest accounting developments. Many continuing
education courses are available on the Internet, but be cautious: Check out
the standards of any Internet course. States generally require CPAs in public
practice to take 30 to 40 hours of continuing education per year to keep their
licenses.
CHAPTER 1 Keeping the Books
71
»» Integrity: Possibly the most important quality to look for is also the hardest to
judge. Bookkeepers and accountants need to be honest people because of
the control they have over your business’s financial records. Conduct a careful
background check when hiring new accounting personnel. Small-business
owners and managers have closer day-in and day-out contact with their
accountants and bookkeepers, which can be a real advantage; they get to
know their accountants and bookkeepers on a personal level. Even so, you
can find many cases in which a trusted bookkeeper embezzled thousands of
dollars over the years.
Enforcing strong internal controls
Any accounting system worth its salt should establish and vigorously enforce
effective internal controls — additional forms and procedures over and above
what’s strictly needed to move operations along. These additional procedures
serve to deter and detect errors (honest mistakes) and all forms of dishonesty by
employees, customers, suppliers, and even managers. Unfortunately, many businesses pay only lip service to internal controls; they don’t put good internal controls in place, or they don’t seriously enforce their internal controls, merely going
through the motions of enforcement.
Internal controls are like highway truck weigh stations, which make sure that a
truck’s load doesn’t exceed the limits and that the truck has a valid license plate.
You’re just checking that your staff is playing by the rules. To prevent or minimize shoplifting, for example, most retailers now have video surveillance and
security tags in or on their merchandise. Likewise, a business should implement
certain procedures and forms to prevent (as much as possible) theft, embezzlement, kickbacks, fraud, and simple mistakes by its own employees and managers.
The Sarbanes-Oxley Act of 2002 (see Book 4, Chapter 1) requires that public companies establish and enforce a special module of internal controls over their external financial reporting. Although the law applies only to public companies, some
accountants worry that the law’s requirements will have a trickle-down effect on
smaller private businesses. This scenario is unlikely, but it could come to pass.
Many small-business owners tend to think that they’re immune to insider
embezzlement and fraud, especially when the people who work for them are family members or friends. Yet in fact, many small businesses are hit very hard by
fraud and usually can least afford the consequences. To protect your business, you
should put checks and balances in place to discourage dishonest practices and to
uncover any fraud and theft as soon as possible.
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BOOK 2 Recording Transactions
Following are five common internal control procedures you can implement to
protect your business:
»» Require a second signature on cash disbursements over a certain dollar amount.
»» Match receiving reports based on actual counts and inspections of incoming
shipments with purchase orders before cutting checks for payment to
suppliers.
»» Require both a sales manager’s and another high-level manager’s approval for
Keeping the Books
write-offs of customers’ overdue receivable balances (that is, closing the
accounts on the assumption that they won’t be collected), including a checklist
of collection efforts that were undertaken.
»» Require auditors or employees who don’t work in the warehouse to take
surprise counts of products stored in the company’s warehouse and compare
the counts with inventory records.
»» Require mandatory vacations by every employee, particularly bookkeepers
and accountants, during which time someone else does that person’s job
(because a second person may notice irregularities or deviations from
company policies).
Wrapping Up with End-of-Period
Procedures
Suppose that all transactions during the year have been recorded correctly. Your
job’s done, right? Not so fast. Now you need to tidy up those books and prepare end-of-period reports for management. As you perform those tasks, you also
need to be sure to leave clear audit trails and keep an eye out for any out-of-theordinary events or developments. The following sections explain what you need to
do to wrap things up at the end of a period.
Tidying up the books
Before creating financial reports, you need to perform a couple of additional procedures at the end of the period to make sure that the accounts are correct and
CHAPTER 1 Keeping the Books
73
complete. When those steps are complete, you can prepare financial statements
and income tax returns for the year. You have two main at the end of the period:
»» Record routine adjusting entries. Depreciation expense isn’t a transaction
that’s recorded during the day-to-day bookkeeping process. (Book 4,
Chapter 2 explains depreciation expense.) You record depreciation expense at
the end of the accounting period (a month or a year). Accountants refer to
these transactions as adjusting entries. The purpose of adjusting entries is to
update and correct the revenue, income, expense, and loss accounts for the
year. Year-end adjusting entries are necessary to have correct balances for
determining profit for the period.
»» Review other business developments that may affect the accuracy of
the accounts. Assume that a company discontinued a product line during the
year. The product line’s remaining inventory may have to be removed from
the inventory asset account, with a corresponding loss recorded in the period.
Maybe the company settled a long-standing lawsuit, and the amount of
damages needs to be recorded. Layoffs and severance packages are other
examples of what the chief accountant needs to look for before preparing
financial reports.
End-of-period accounting procedures can stir up controversy of the heated-debate
variety. These procedures require the accountant to make decisions and judgment
calls that upper management may not agree with. The accountant might suggest
recording major losses that would put a big dent in profit for the year or cause the
business to report a loss, for example. The outside CPA auditor (assuming that the
business has an independent audit or review of its financial statements) often gets
in the middle of the argument. These kinds of debates are precisely why business
managers need to know some accounting.
Leaving good audit trails
Good accounting systems leave good audit trails. An audit trail is a clear-cut, wellmarked path of the sequence of events leading up to an entry in the accounts. The
trail starts with the source documents and follows through to the final posting in
the accounts. You create an audit trail so an auditor can “re-walk” the path. Even
if a business doesn’t have an outside CPA do an annual audit or review, the accountant has frequent occasion to go back to the source documents. An accountant may
need to verify certain information in the accounts or reconstruct the information
in a different manner. Suppose that a salesperson is claiming some suspiciouslooking travel expenses; the accountant would probably want to go through all this
person’s travel and entertainment reimbursements for the past year.
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BOOK 2 Recording Transactions
If the IRS comes in for a field audit of your income tax return, you’d better have
good audit trails to substantiate all your expense deductions and sales revenue for
the year. The IRS has rules about saving source documents for a reasonable period
of time and having a well-defined process for making bookkeeping entries and
keeping accounts. Think twice before throwing away source documents too soon.
Also, ask your accountant to demonstrate and lay out for your inspection the audit
trails for key transactions, such as cash collections, sales, cash disbursements,
and inventory purchases. Even computer-based accounting systems recognize the
importance of audit trails. Well-designed computer programs enable you to backtrack through the sequence of steps in recording specific transactions.
Business managers should encourage their accountants to stay alert to anything
out of the ordinary that may require attention. Suppose that the accounts receivable balance for a customer is increasing rapidly — that is, the customer is buying
more from your company on credit but isn’t paying for these purchases quickly.
Maybe the customer has switched more of their company’s purchases to your
business and is buying more from you only because they’re buying less from
other businesses. That’s a good thing. But maybe the customer is planning to stiff
your business. Or maybe the customer is planning to go into bankruptcy soon and
is stockpiling products before the company’s credit rating heads south — two
really bad things.
Don’t forget internal time bombs. A bookkeeper’s reluctance to take a vacation
could mean that they don’t want anyone else looking at the books.
To some extent, accountants have to act as the eyes and ears of the business. That
job is one of the main functions of a business manager as well, of course, but the
accounting staff can play an important role.
Designing truly useful reports for managers
End-of-period reports include the three biggies — income statement, balance
sheet, and cash flow statement — and any other financial statements management requires to do its job. End-of-period reports, when done well, serve several
purposes:
»» Fulfill government financial reporting requirements.
»» Keep investors and creditors posted on the financial state of the business.
CHAPTER 1 Keeping the Books
75
Keeping the Books
Staying alert for unusual events
and developments
»» Keep management posted on the financial state of the business.
»» Provide financial information to managers so that they can make better
business decisions.
To produce clear and useful reports, consult management to assess its needs.
Proactively study a manager’s decision-making responsibilities and provide the
information that is most useful to them, presented in the most easily digestible
manner.
In designing the chart of accounts, keep in mind the type of information needed
for management reports. To exercise control, managers need much more detail
than what’s reported in tax returns and external financial statements. Consider
regrouping expenses in different categories for management decision-making
analysis. A good chart of accounts looks to both external and internal (management) needs for information.
So what’s the answer for a manager who receives poorly formatted reports?
Demand a report format that suits your needs! Books 4 and 5 cover financial
reporting in detail.
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BOOK 2 Recording Transactions
IN THIS CHAPTER
»» Tracking inventory and monitoring
costs
»» Keeping your business supplied
»» Paying your bills
Chapter
2
Tracking Purchases
T
o make money, your business must have something to sell. Whether you sell
products or offer services, you have to deal with costs directly related to the
goods or services you sell. Those costs come primarily from the purchase or
manufacturing of the products you plan to sell or the items you need to provide
the services.
In addition to the costs to produce products or services, every business has expenses
associated with purchasing supplies needed to run the business. The bookkeeper
has primary responsibility for monitoring all these costs and expenses as invoices
are paid. Bookkeepers can alert company owners or managers when vendors
increase prices. This chapter covers how to track purchases and their costs, manage inventory, buy and manage supplies, and pay the bills for your purchases.
Keeping Track of Inventory
Products to be sold are called inventory. As a bookkeeper, you use two accounts to
track inventory:
»» Purchases: Where you record the actual purchase of goods to be sold. You
use this account to calculate the cost of goods sold, which is an item on the
income statement. (See Book 4, Chapter 2 for more on the income statement.)
CHAPTER 2 Tracking Purchases
77
»» Inventory: Where you track the value of inventory on hand. This value is
shown on the balance sheet as an asset in a line item called inventory. (See
Book 4, chapters 3–5 for more on the balance sheet.)
Companies track physical inventory on hand by using one of two methods:
»» Periodic inventory: Conducting a physical count of the inventory in the
stores and in the warehouse. This count can be done daily, monthly, yearly, or
for any other period that best matches your business needs. (Many stores
close for all or part of a day when they count inventory.)
»» Perpetual inventory: Adjusting inventory counts as each sale is made. To use
this method, you must manage your inventory by using a computerized
accounting system that’s tied into your points of sale (usually, cash registers).
Even if you use a perpetual inventory method, it’s a good idea to do a physical
count of inventory periodically to make sure those numbers match what’s in
your computer system. Because theft, damage, and loss of inventory aren’t
entered in your computer system automatically, the losses don’t show up until
you do a physical count of the inventory you have on hand.
When preparing your income statement at the end of an accounting period
(whether that period is a month, a quarter, or a year), you need to calculate the
cost of goods sold to determine your profit. To calculate the cost of goods sold,
you must first find out how many items of inventory were sold. You start with
the amount of inventory on hand at the beginning of the month (called beginning
inventory), as recorded in the inventory account, and add the amount of purchases,
as recorded in the purchases account, to find the goods available for sale. Then you
subtract the inventory on hand at the end of the month, which is determined by
counting remaining inventory.
Here’s how you calculate the number of goods sold:
Beginning inventory + Purchases = Goods available for sale – Ending inventory =
Items sold
After you determine the number of goods sold, you compare that number with the
actual number of items sold by the company during that accounting period, which
is based on sales figures collected through the month. If the numbers don’t match,
you have a problem. The mistake may be in the inventory count, or items may be
unaccounted for because they’ve been misplaced or damaged and discarded. In the
worst-case scenario, you may have a problem with theft by customers or employees. These differences are usually tracked within the accounting system in a line
item called inventory shrinkage.
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BOOK 2 Recording Transactions
Entering initial cost
When your company first receives inventory, you enter the initial cost of that
inventory into the bookkeeping system based on the shipment’s invoice. In some
cases, invoices are sent separately, and only a packing slip is included in the order.
If that’s the case, you should still record the receipt of the goods, because the
company incurs the cost from the day the goods are received and must be sure
it will have the money to pay for the goods when the invoice arrives and the bill
comes due. (You track outstanding bills in the accounts payable account.)
Entering the receipt of inventory is a relatively easy entry in the bookkeeping system. If your company buys $1,000 of inventory to be sold, you make the following
record in the books:
Debit
Purchases (Asset account)
Accounts payable
Credit
$1,000
$1,000
Cost of goods sold = Beginning inventory + Purchases – Ending inventory
When inventory enters your business, in addition to recording the actual costs,
you need more detail about what was bought, how much of each item was bought,
and what each item cost. You also need to track
»» How much inventory you have on hand
»» The value of the inventory you have on hand
»» When you need to order more inventory
Tracking these details for each type of product bought can be a nightmare, especially if you’re trying to keep the books for a retail store, because you need to set
up a special inventory journal with pages detailing purchase and sale information
for every item you carry. (See Book 1, Chapter 3 for the scoop on journals.)
CHAPTER 2 Tracking Purchases
79
Tracking Purchases
The purchases account increases by $1,000 to reflect the additional costs, and the
accounts payable account increases by the same amount to reflect the amount of
the bill that needs to be paid in the future. The purchases account is used to isolate inventory purchased during the period (month or year). Purchases are part
of the formula to calculate cost of goods sold (a formula explained in detail in
Book 2, Chapter 2):
Computerized accounting simplifies this process of tracking inventory. Details
about inventory can be entered initially into your computer accounting system
in several ways:
»» If you pay by check or credit card when you receive the inventory, you can
enter the details about each item on the check or credit card form.
»» If you use purchase orders, you can enter the detail about each item on the
purchase order, record receipt of the items when they arrive, and update the
information when you receive the bill.
»» If you don’t use purchase orders, you can enter the detail about the items
when you receive them and update the information when you receive the bill.
When you receive inventory with a bill, you can collect the data in a computerized
accounting software program. Similar information is collected on the software
program’s check, credit card, and purchase order forms.
In addition to recording the name of the vendor, date received, and payment
amount, you record details about the items bought, including the quantity and
cost. When you load each item into the computerized accounting system, you can
easily track cost detail over time.
After you receive the inventory, you set up an inventory item in the computerized
accounting system. Note that in addition to the item name, two descriptions are
added to the accounting system: an abbreviated version you can use on purchase
transactions (to save time), and a longer description that’s displayed on customer
invoices (sales transactions).
If you have a set contract purchase price or sale price on an inventory item, entering it in this form saves time because you don’t have to enter the price each time
you record a transaction. But if the prices change frequently, it’s best to leave
the space blank so you don’t forget to enter the updated price when you enter a
transaction.
Your accounting system should collect information about inventory on hand and
indicate when inventory needs to be reordered. To make sure that your store
shelves are never empty, you can enter a number that indicates the point at which
you want to reorder inventory. Accountants refer to this point as the reorder point.
When the number of units on hand declines to the reorder point, you order more
product.
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BOOK 2 Recording Transactions
After you complete and save the form that records the receipt of inventory, your
accounting software should do the following things automatically:
»» Adjust the quantity of inventory you have in stock.
»» Increase the asset account called inventory.
»» Lower the quantity of items on order (if you initially entered the information
as a purchase order).
»» Average the cost of inventory on hand.
»» Increase the accounts payable account.
Managing inventory and its value
After you record the receipt of inventory, you have the responsibility of managing
the inventory you have on hand. You also must know the value of that inventory.
You may think that as long as you know what you paid for the items, the value
isn’t difficult to calculate. There are four ways to value inventory:
Tracking Purchases
»» Last in, first out (LIFO): You assume that the last items put on the shelves
(the newest items) are the first items to be sold. Retail stores that sell nonperishable items, such as tools, are likely to use this type of system. When a
hardware store gets new hammers, for example, workers probably don’t
unload what’s on the shelves and put the newest items in the back. Instead,
the new tools are put in the front, so they’re likely to be sold first.
»» First in, first out (FIFO): You assume that the first items put on the shelves
(the oldest items) are sold first. Stores that sell perishable goods, such as food
stores, use this inventory valuation method most often. When new milk
arrives at a store, for example, the person stocking the shelves unloads the
older milk, puts the new milk at the back of the shelf, and puts the older milk
in front. Each carton of milk (or other perishable item) has a date indicating
the last day it can be sold, so food stores always try to sell the oldest stuff first,
while it’s still sellable.
»» Weighted average: You average the cost of goods received, so there’s no
reason to worry about which items are sold first or last. This method of
inventory is used most often in any retail or services environment in which
prices are fluctuating and the business owner finds that an average cost
works best for managing the cost of goods sold.
»» Specific identification: You maintain cost figures for each inventory item
individually. Retail outlets that sell big-ticket items (such as cars), which often
have a different set of extras on each item, use this type of inventoryvaluation method.
CHAPTER 2 Tracking Purchases
81
Accountants are big on consistency. After you choose an accounting method,
you should stick with it. If your accounting method is the same each year, your
financial results will be comparable year to year. A financial statement reader will
be able to compare your results and notice trends. If you decide to change the
method, you need to explain the reasons for the change in your financial statements. You also have to go back and show how the change in inventory method
affects your previous financial reporting.
Figuring out the best method for you
You may be wondering why it matters so much which inventory valuation method
you use. The keys to the choice are the impact on your bottom line and the
taxes your company will pay.
The total cost of your inventory and the number of units purchased and sold
are the same whether you choose the FIFO, LIFO, or weighted average method.
(See the previous section for explanations of these methods.) Also, if prices
rise over time, which is normally the case, your newer inventory items will be
more expensive. This analysis assumes that the three inventory methods use the
same sale prices per unit. After all your inventory items are sold, your total profit
will be the same for the three methods.
FIFO, because it assumes that the oldest (and, most likely, lowest-priced) items
are sold first, results in a low cost of goods sold number. Because cost of goods
sold is subtracted from sales to determine profit, a low cost of goods sold number
produces a high profit. For more on cost of goods sold, refer to “Keeping Track of
Inventory” earlier in this chapter.
The opposite is true for LIFO, which uses cost figures based on the last price paid
for the inventory (most likely, the highest price). When you use the LIFO method,
the cost of goods sold number is high, which means that a larger sum is subtracted from sales to determine profit. Thus, the profit margin is low. The good
news, however, is that the tax bill is low too.
Rather than dealing with the ups and downs of inventory costs, the weighted
average method smooths out the numbers used to calculate a business’s profits.
Cost of goods sold, taxes, and profit margins for this method fall between those of
LIFO and FIFO. If you’re operating a business in which inventory prices go up and
down, you should choose this method.
Comparing the methods
To show you how much of an impact inventory valuation can have on profit margin, this section compares three of the most common methods: FIFO, LIFO, and
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BOOK 2 Recording Transactions
weighted average. (Refer to the earlier section “Managing inventory and its value”
for details on each method.) For this example, assume that Company A bought the
inventory in question at different prices on three occasions. Beginning inventory
is valued at $500 (50 items at $10 each).
Here’s the calculation for determining the number of items sold:
Beginning inventory + Purchases = Goods available for sale – Ending inventory =
Items sold
50 + 500 = 550 – 75 = 475
Here’s what the company paid to purchase the inventory:
Date
Quantity
Unit Price
April 1
150
$10
April 15
150
$25
April 30
200
$30
Account
Units and Dollar Amounts
Total
Beginning inventory
50 units
$500
Purchases
150 units @ $10
$1,500
150 units @ $25
$3,750
200 units @ $30
$6,000
Total inventory
550 units
$11,750
Average inventory cost
$11,750 ÷ 550 units = $21.36
Cost of goods sold
475 units × $21.36 = $10,146
Ending inventory
75 units @ $21.36 = $1,602
As mentioned in “Keeping Track of Inventory,” earlier in this chapter, your goods
available for sale can end up in only two places: cost of goods sold or ending
inventory. The total inventory listed in the preceding table is also goods available
for sale. Your total inventory ($11,750) should equal the sum of cost of goods sold
and ending inventory ($10,146 + $1,602 = $11,748). The slight difference is due to
rounding the weighted average cost per unit. Use this formula to check any inventory valuation method.
CHAPTER 2 Tracking Purchases
83
Tracking Purchases
Here’s an example of how you calculate the cost of goods sold by using the
weighted average method:
Here’s an example of how you calculate the cost of goods sold by using the FIFO
method. With this method, you assume that the first items received are the first
ones sold, and because the first items received here are those in beginning inventory, this example starts with them:
Account
Units and Dollar Amounts
Total
Beginning inventory
50 units @ $10
$500
Next (April 1)
150 units @ $10
$1,500
Next (April 15)
150 units @ $25
$3,750
Next (April 30)
125 units @ $30
$3,750
Cost of goods sold
475 units
$9,500
Ending inventory
75 units @ $30
$2,250
Note: Only 125 of the 200 units purchased on April 30 are used in the FIFO method.
Because this method assumes that the first items into inventory are the first items
sold (or taken out of inventory), the first items used are those on April 1. Then the
April 15 items are used, and finally, the remaining needed items are taken from
those bought on April 30. Because 200 units were bought on April 30 and only 125
were needed, 75 of the items bought on April 30 are left in ending inventory.
Here’s an example of how you calculate the cost of goods sold by using the LIFO
method. With this method, you assume that the last items received are the first
ones sold, and because the last items received were those purchased on April 30,
this example starts with them:
Account
Units and Dollar Amounts
Total
April 30
200 units @ $30
$6,000
Next (April 15)
150 units @ $25
$3,750
Next (April 1)
125 units @ $10
$1,250
Cost of goods sold
475 units
$11,000
Ending inventory
75 units @$ 10
$750
Note: Because LIFO assumes the last items to arrive are sold first, the ending
inventory includes the 25 remaining units from the April 1 purchase plus the 50
units in beginning inventory.
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BOOK 2 Recording Transactions
Here’s how the use of inventory under the LIFO method affects company profits.
The example assumes that the items are sold to the customers for $40 per unit,
which means total sales of $19,000 for the month ($40 × 475 units sold). This
example looks only at gross profit, which is the profit from sales before expenses
incurred for operating the company. See Book 4, Chapter 2 for information about
the different profit types and what they mean. Gross profit is calculated with the
following equation:
Sales – Cost of goods sold = Gross profit
Table 2-1 shows a comparison of gross profit for the three methods used in this
example scenario.
TABLE 2-1
Comparison of Gross Profit Based on Inventory
Valuation Method
FIFO
LIFO
Weighted Average
Sales
$19,000
$19,000
$19,000
Cost of Goods Sold
$9,500
$11,000
$10,146
Gross Profit
$9,500
$8,000
$8,854
Looking at the comparisons of gross profit, you can see that inventory valuation
can have a major impact on your bottom line. LIFO is likely to give you the lowest profit because the last inventory items bought are usually the most expensive.
FIFO is likely to give you the highest profit because the first items bought are
usually the cheapest. And the profit produced by the weighted average method is
likely to fall somewhere between the two.
Keep in mind that all three inventory valuation methods generate the same total
cost and total profit when all the inventory items are sold, as explained earlier in
this section.
Buying Supplies
In addition to inventory, all businesses must buy supplies that are used to operate the business, such as paper, pens, and paper clips. If the supply cost can’t be
directly traced to the manufacturing or purchase of goods or services for sale, the
cost is immediately expensed.
CHAPTER 2 Tracking Purchases
85
Tracking Purchases
Income Statement Line Item
Your best bet is to carefully track supplies that make a big dent in your budget
with an individual account. If you anticipate that paper use will be very high,
monitor that use with a separate account called Paper Expenses.
Many companies don’t use the bookkeeping system to manage their supplies.
Instead, they designate one or two people as office managers or supply managers
and keep the number of accounts used for supplies to a minimum. Other businesses decide to monitor supplies by department or division and set up a supply
account for each one, putting the burden of monitoring supplies in the hands of
the department or division managers.
Handling Billing and Payables
Eventually, you have to pay for both the inventory and the supplies you purchase for your business. In most cases, the bills are posted to the accounts payable account when they arrive, and they’re paid when due. A large chunk of the
cash paid out of your cash account (see Book 8 for more information on the cash
account and handling cash) is in the form of the checks sent out to pay bills due
in accounts payable, so you need to have careful controls on the five key functions
of accounts payable:
»» Entering the bills to be paid into the accounting system
»» Preparing checks to pay the bills
»» Signing checks to pay the bills
»» Sending out payment checks to vendors
»» Reconciling the checking account
As you pay bills, you need to take precautions to keep everyone honest and try to
take advantage of any discounts vendors offer for early payment.
In some cases, companies offer a discount to customers who pay their bills early.
Suppose that a vendor gives you payment terms of “2% 10 Net 30.” Those terms
mean that if the bill is paid in 10 days, the vendor company can take a 2 percent
discount; otherwise, the amount due must be paid in full in 30 days. In addition,
many companies state that interest or late fees will be charged if a bill isn’t paid in
30 days. Suppose that a firm has a bill with an amount due of $1,000. If the company pays the bill in 10 days, it can take a 2 percent discount, or $20. That discount
may not seem like much, but if your company buys $100,000 worth of inventory
and supplies in a month, and each vendor offers a similar discount, you can save
$2,000. Over the course of a year, discounts on purchases can save your business
a significant amount of money and improve your profits.
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BOOK 2 Recording Transactions
IN THIS CHAPTER
»» Taking in cash and offering in-store
credit
»» Staying on top of discounts, returns,
and allowances
»» Monitoring customer payments due
»» Dealing with bad debt
Chapter
3
Tallying Your Sales
B
ookkeepers have a lot to do to make sure that sales are properly tracked and
recorded in the books. In addition to recording the sales, you must track
customer accounts, discounts offered to customers, and customer returns
and allowances. Unfortunately, some customers never pay, in which case you
must adjust the books to reflect nonpayment as a bad debt.
This chapter reviews the basic responsibilities that fall to a business’s bookkeeping and accounting staff: tracking sales, making adjustments to those sales,
monitoring customer accounts, and alerting management to slow- and no-paying
customers.
Collecting on Cash Sales
Most businesses collect some form of cash as payment for the goods or services
they sell. Cash receipts include more than just bills and coins; checks and credit
cards also are considered to be cash sales for the purpose of bookkeeping. In fact,
with electronic transaction processing, a deposit is usually made to the business’s
checking account the same day (sometimes within seconds of the transaction,
depending on the type of system the business sets up with the bank).
CHAPTER 3 Tallying Your Sales
87
The only type of payment that doesn’t fall under the umbrella of a cash payment
is purchases made on store credit — credit offered to customers directly by your
business rather than through a third party, such as a bank credit card or loan. See
“Selling on Credit” later in this chapter for details.
Discovering the value of sales receipts
Businesses use three methods to generate sales receipts: cash register, credit
card machine, and manual (written out by the salesperson). Whichever of these
three methods you choose for your sales transactions, the sales receipt serves two
purposes:
»» Gives the customer proof that the item was purchased on a particular day at a
particular price in your store, in case they need to exchange or return the
merchandise.
»» Gives the store a receipt that can be used later time to enter the transaction
into the company’s books. At the end of the day, the receipts are used to
prove out the cash register and ensure that the cashier took in the right
amount of cash based on the sales made.
You’re probably familiar with cash receipts. To show you how much usable information can be generated on a sales receipt, here’s a sample receipt from a sale at
a bakery:
Sales Receipt 4/25
Item
Quantity
Price
Total
White Serving Set
1
$40
$40
Cheesecake, Marble
1
$20
$20
Cheesecake, Blueberry
1
$20
$20
$80
Sales tax @ 6%
$4.80
$84.80
88
Cash paid
$90
Change
$5.20
BOOK 2 Recording Transactions
A look at a receipt such as this one tells you the amount of cash collected, the
type of products sold, the quantity of products sold, and the amount of sales tax
collected.
Your company may use some type of computerized system at the point of sale
(usually, the cash register) that’s integrated into the company’s accounting system. Sales information is collected throughout the day by the cash register. The
automated system can post accounting entries to sales, sales tax collected, cash,
inventory, and other accounts.
If you don’t use a computerized system, you can post accounting entries manually, based on cash-register activity. Here’s what an entry in the cash receipts
journal would look like for the receipt of cash:
Debit
Cash in checking
Credit
$84.80
Sales
$80.00
Sales tax collected
$4.80
Cash receipts for April 25
Here’s an explanation of each line item in the receipts journal:
»» Cash in checking, an asset account on the balance sheet, is debited, which
increases the asset account.
»» Sales is a revenue account that’s posted to the income statement. The credit
to sales increases the revenue account.
»» Sales tax collected is a liability account in the balance sheet. (See Book 4 for
Note that total debits equal total credits ($84.80). This entry is referred to as a
balanced entry. Debits and credits are discussed in Book 1, Chapter 2.
Businesses pay sales tax to state and local government entities either monthly
or quarterly, depending on rules set by the states. Your business must hold the
money owed in a liability account to be certain you’re able to pay the taxes collected from customers when they’re due.
CHAPTER 3 Tallying Your Sales
89
Tallying Your Sales
more about balance sheets and income statements.) The credit to sales tax
collected increases the liability account.
Recording cash transactions in the books
If you’re using a computerized accounting system, you can enter more detail
from the day’s receipts and track inventory sold as well. A standard sales receipt
includes the following key pieces of information:
»» Customer’s name and address and perhaps customer number
»» A description of the item(s) sold, along with the number or quantity sold
»» Payment method (such as cash, check, credit card, or debit card)
»» The option to print the receipt or email it to the client
Use a computerized accounting system so you can enter more detail from the day’s
receipts and track inventory sold. Computerized systems also collect information about the items sold in each transaction. The system automatically updates
inventory information, reducing the amount of inventory on hand as product is
sold. When the inventory number falls below the reorder number you set (see
Book 2, Chapter 2), the accounting system alerts you to pass the word to whoever
is responsible for ordering more inventory.
If your company accepts credit cards, expect sales revenue to be reduced by the
fees paid to credit card companies. You may face monthly fees as well as fees
per transaction, but each company sets up individual arrangements with its bank
regarding these fees. Sales volume affects how much you pay in fees, so when
researching bank services, be sure to compare credit card transaction fees to find
a good deal. A company records these fees in a credit card fee expense account.
Selling on Credit
Many businesses decide to sell to customers on direct credit — credit offered by the
business, not a bank or credit card provider. This approach offers more flexibility
in the type of terms you can offer your customers, and you don’t have to pay bank
fees. The bad news is that it involves more work for you, the bookkeeper, and
more risk if a customer doesn’t pay what they owe.
If you accept a customer’s bank-issued credit card for a sale, and the customer
doesn’t pay the bill, you get your money; the bank is responsible for collecting
from the customer and takes the loss if they don’t pay. That’s not the case if you
decide to offer credit to your customers directly. If a customer doesn’t pay, your
business takes the loss.
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BOOK 2 Recording Transactions
Deciding whether to offer store credit
Good ole’ store credit. The decision to set up your own store credit system depends
on what your competition is doing. If you run an office-supply store, and all other
office-supply stores allow store credit to make it easier for their customers to get
supplies, you probably need to offer store credit to stay competitive.
If you want to allow your customers to buy on store credit, the first thing you need
to do is set up some ground rules. You have to decide
»» How you plan to check a customer’s credit history
»» What the customer’s income level needs to be to be approved for credit
»» How long you give the customer to pay the bill before charging interest or late fees
»» What maximum dollar amount you plan to give the customer as a credit limit
The harder you make it to get store credit and the stricter you make the billpaying rules, the less chance you have of a taking a loss. But you may lose customers to a competitor that has less-restrictive credit rules.
If you loosen your qualification criteria and bill-paying requirements, you have
to monitor your customer accounts carefully to be sure they’re not falling behind.
The key risk you face is selling product for which you’re never paid.
Recording store credit transactions
in the books
Here’s how a journal entry of a sale made on store credit looks:
Debit
Accounts receivable
Credit
$84.80
Sales
$80.00
Sales tax collected
$4.80
Cash receipts for April 25
CHAPTER 3 Tallying Your Sales
91
Tallying Your Sales
When sales are made on store credit, you have to enter specific information
into the accounting system. In addition to inputting information regarding cash
receipts (see “Collecting on Cash Sales” earlier in this chapter), you update the
customer accounts to ensure that each customer is billed and the money is collected. You debit the accounts receivable account, an asset account shown on the
balance sheet (see Book 4), which shows money due from customers.
In addition to making this journal entry, you enter the information into the
customer’s account so that accurate customer statements can be sent out at the
end of the month. When the customer pays the bill, you update the individual
customer’s record to show that payment has been received and enter the
following into the bookkeeping records:
Debit
Cash
Credit
$84.80
Accounts receivable
$84.80
Payment from S. Smith on invoice 123.
You’ll send the customer an invoice (a bill). You see in the preceding table that
S. Smith was sent invoice #123.
An automated accounting system uses the information from the invoice form to
update the following accounts:
»» Accounts receivable
»» Inventory
»» The customer’s account
»» Sales tax collected
When the time comes to bill the customer at the end of the month, your accounting system can generate statements for all customers with outstanding invoices
(unpaid bills). You can easily generate statements for specific customers or all
customers on the books.
When you receive payment from a customer, here’s what happens:
1.
2.
3.
Accounts receivable is reduced by crediting.
Cash is increased with a debit.
The customer’s individual account is updated to reflect the payment.
If your company uses a point-of-sale program that’s integrated into the computerized accounting system, recording store credit transactions is even easier for
you. Sales details feed into the system as each sale is made, so you don’t have to
enter the detail at the end of day. These programs save a lot of time.
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Even if customers don’t buy on store credit, point-of-sale programs provide businesses an incredible amount of information about their customers and what they
like to buy. This data can be used for direct marketing and special sales to increase
return business.
Proving Out the Cash Register
To ensure that cashiers don’t pocket a business’s cash, at the end of each day,
cashiers must prove out cash. This process shows that the cashier has the correct
amount of cash in the register. The cash balance changes based on the sales transactions during the day. The balance is also affected by the amount of cash, checks,
and charges that the cashier took in during the day.
This process of proving out a cash register starts at the end of the previous day,
when cashier John Doe and his manager agree to the amount of cash left in John’s
register drawer. Cash sitting in cash registers or cash drawers is recorded as part
of the Cash on Hand account.
When John comes to work the next morning, he starts with the amount of cash
left in the drawer. At the end of the business day, either he or his manager runs a
summary of activity on the cash register for the day to produce a report of the total
sales taken in by the cashier. John counts the amount of cash in his register. He
totals the checks, credit card receipts, and store credit charges. Then he completes
a cash-out form that looks something like this:
Cash Register: John Doe, 4/25
Receipts
Sales
Total
Cash Register: John Doe, 4/25
$100
Cash sales
$400
Credit card sales
$800
Store credit sales
$200
Total sales
$1,400
Sales on credit
$1,000
Cash received
$400
Total cash in register
$500
CHAPTER 3 Tallying Your Sales
Tallying Your Sales
Beginning cash
93
A store manager reviews John Doe’s cash-register summary (produced by the
actual register) and compares with to the cash-out form. If John’s ending cash
(the amount of cash remaining in the register) doesn’t match the cash-out form,
he and the manager try to pinpoint the mistake. If they can’t find a mistake, they
fill out a cash-overage or cash-shortage form. Some businesses charge the cashier
directly for any shortages; others take the position that the cashier is fired after
a certain number of shortages of a certain dollar amount (say, three shortages
of more than $10). Most companies post cash shortages to a shortage expense
account.
The store manager decides how much cash to leave in the cash drawer or register
for the next day and deposits the remainder. The manager performs this task for
each cashier and then deposits all the cash and checks from the day in a nightdeposit box at the bank. They send a report with details of the deposit to the
bookkeeper so that the data makes it into the accounting system. The bookkeeper
enters the data on the cash receipts form (see the preceding table) if a computerized accounting system is being used or into the cash receipts journal if the books
are being kept manually.
Tracking Sales Discounts
Most businesses offer discounts at some point to generate more sales. Discounts
are usually in the form of a sale with 10 percent, 20 percent, or even more off
purchase price.
When you offer discounts to customers, it’s a good idea to track your sales discounts in a separate account so you can keep an eye on how much you discount
sales in each month. If you find that you’re losing more and more money to discounting, look closely at your pricing structure and competition to find out why
it’s necessary to lower your prices frequently to make sales. You can track discount information very easily by using the data from a standard cash-register
receipt. The following receipt from a bakery includes discount details:
Sales Receipt 4/25
Item
Quantity
Price
Total
White Serving Set
1
$40
$40
Cheesecake, Marble
1
$20
$20
Cheesecake, Blueberry
1
$20
$20
$80
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BOOK 2 Recording Transactions
Sale discount @ 10%
($8.00)
$72.00
Sales tax @ 6%
$4.32
$76.32
Cash paid
$80.00
Change
$3.68
In this example, you clearly see that the stores take in less cash when discounts
are offered. When recording the sale in the cash receipts journal, you record the
discount as a debit. This debit increases the sales discount account, which is subtracted from the sales account to calculate the net sales. (Book 4, Chapter 1 walks
you through all these steps and calculations as it discusses preparing the income
statement.) Here’s the bakery’s entry for this particular sale in the cash receipts
journal:
Debit
Cash in checking
$76.32
Sale discounts
$8.00
Credit
Sales
$80.00
Sales tax collected
$4.32
Cash receipts for April 25
If you use a computerized accounting system, add the sales discount as a line item
on the sales receipt or invoice; the system automatically adjusts the sales figures
and updates your sale discount account.
Most stores deal with returns on a regular basis. Instituting a no-return policy is
guaranteed to produce unhappy customers, so to maintain good customer relations, you generally should allow returns.
CHAPTER 3 Tallying Your Sales
95
Tallying Your Sales
Recording Returns and Allowances
Sales allowances (incentive programs) are becoming more popular with businesses.
Sales allowances most often come in the form of gift cards. A gift card that’s sold
is a liability for the company, because the company has received cash, but no merchandise has gone out. For that reason, gift-card sales are entered in a gift card
liability account.
When a customer makes a purchase by using the gift card, the gift card liability
account is reduced (debited), and inventory is also reduced (with a credit). Monitoring the gift card liability account allows businesses to keep track of how much
is yet to be sold without receiving additional cash.
Accepting sales returns can be a more complicated process than accepting sales
allowances. Usually, a business posts a set of rules for returns, such as the
following:
»» Returns are allowed only within 30 days of purchase.
»» You must have a receipt to return an item.
»» If you return an item without a receipt, you can receive only store credit.
You can set whatever rules you want for returns. For internal control purposes,
the key to returns is monitoring how your staff handles them. In most cases, you
should require a manager’s approval on returns. Also, be sure your staff pays close
attention to how the customer originally paid for the item being returned. You
certainly don’t want to give a customer cash if they paid on store credit; that’s
just handing over your money! After a return is approved, the cashier returns the
amount paid via cash or credit card. Customers who bought the items on store
credit don’t get any money back; they didn’t pay anything when they purchased
the item, and they expected to be billed later. Instead, a form is filled out so that
the amount of the original purchase can be subtracted from the customer’s store
credit account.
You use the information collected by the cashier who handled the return to input
the return data into the books. Suppose that a customer returns a $40 item that
was purchased with cash. You record the cash refund in the cash receipts journal
like this:
Debit
Sales returns and allowances
$40.00
Sales tax collected @ 6%
$2.40
Cash in checking
To record return of purchase, 4/30.
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BOOK 2 Recording Transactions
Credit
$42.40
If the item had been bought with a discount, you’d list the discount as well and
adjust the price to show that discount.
In this journal entry,
»» The sales returns and allowances account increases. This account normally
carries a debit balance and is subtracted from sales for the income statement,
thereby reducing revenue received from customers.
»» The debit to the sales tax collected account reduces the amount in that
account because sales tax is no longer due on the purchase.
»» The credit to the cash in checking account reduces the amount of cash.
Monitoring Accounts Receivable
Making sure that customers pay their bills is a crucial responsibility of the bookkeeper. Before sending out the monthly bills, you should prepare an aging summary report that lists all customers who owe money to the company and how old
each debt is.
If you keep the books manually, you collect the necessary information from each
customer account. If you keep the books in a computerized accounting system,
you can generate this report automatically. Either way, your aging summary
report should look similar to this example report from a bakery:
Aging Summary — As of April 30
Customer
Current
31–60 Days
S. Smith
$84.32
$46.15
H. Harris
$65.78
$89.54
M. Man
Totals
>90 Days
Tallying Your Sales
J. Doe
61–90 Days
$125.35
$173.86
$46.15
$65.78
$125.35
The aging summary quickly tells you which customers are behind in their bills. In
this example, customers are cut off from future purchases when their payments
are more than 60 days late, so J. Doe and M. Man aren’t able to buy on store credit
until their bills are paid in full.
CHAPTER 3 Tallying Your Sales
97
Give a copy of your aging summary to the sales manager so they can alert staff
to problem customers. They can also arrange for the appropriate collections procedures. Each business sets up its own collections process, but usually, the process starts with a phone call, followed by letters and possibly even legal action if
necessary.
Accepting Your Losses
You may encounter a situation in which a customer never pays your business,
even after an aggressive collections process. In this case, you have no choice but
to write off the purchase as a bad debt and accept the loss.
Most businesses review their aging reports monthly and decide which accounts
need to be written off as bad debt. Accounts written off are tracked in a general ledger account called bad debt. (See Book 1, Chapter 3 for more information
about the general ledger.) The bad-debt account appears as an expense account on
the income statement. When you write off a customer’s account as bad debt, the
bad-debt account increases (debit), and the accounts receivable account decreases
(credit).
To give you an idea of how you write off an account, suppose that one of your
customers never pays a bill for $105.75. Here’s what your journal entry looks like:
Debit
Bad debt
Accounts receivable
Credit
$105.75
$105.75
In a computerized accounting system, you enter the information by using a customer payment form and allocating the amount due to the bad-debt expense
account. Finally, make a note of the bad debt on the customer’s individual account.
Going forward, you’ll know which customers didn’t pay an invoice. That information will help you make a decision about doing business with those customers in
the future.
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BOOK 2 Recording Transactions
IN THIS CHAPTER
»» Hiring employees
»» Collecting and depositing employee
taxes
»» Keeping track of benefits
»» Preparing and recording payroll
Chapter
4
Processing Employee
Payroll and Benefits
U
nless your business has only one employee (you, the owner), you’ll most
likely hire employees, which means you’ll have to pay them, offer benefits,
and manage a payroll.
Responsibilities for hiring and paying employees usually are shared among the
human resources staff and the bookkeeping staff. As the bookkeeper, you must
be sure that all government tax-related forms are completed and handle all payroll responsibilities, including paying employees, collecting and paying employee
taxes, collecting and managing employee benefit contributions, and paying benefit providers.
In this chapter, we tell you about the various employee staffing issues that bookkeepers need to be able to manage, including staffing, labor hours, payroll, benefits, and other matters related to the accounting functions of human resources.
CHAPTER 4 Processing Employee Payroll and Benefits
99
Staffing Your Business
After you decide that you want to hire employees for your business, you must be
ready to deal with a lot of government paperwork. In addition to paperwork, you
face many decisions about how employees will be compensated and who will be
responsible for maintaining the paperwork required by state, local, and federal
government entities.
Knowing what needs to be done to satisfy government bureaucracies isn’t the only
issue you must consider before hiring your first employee; you also must decide
how frequently you’ll pay employees and what type of wage and salary scales you
want to set up.
Completing government forms
Even before you sign your first employee, you need to start filing government
forms related to hiring. If you plan to hire staff, you must first apply for an
Employer Identification Number, or EIN. Government entities use this number to
track your employees, the money you pay them, and any taxes collected and paid
on their behalf.
Before employees start working for you, they must fill out forms including the
W-4 (tax withholding form), I-9 (citizenship verification form), and W-5 (for
employees eligible for the Earned Income Credit). The following sections explain
each of these forms as well as the EIN.
Employer Identification Number (EIN)
Every company must have an EIN to hire employees. If your company is incorporated (see Book 6, Chapter 2 for the lowdown on corporations and other business
types), which means you’ve filed paperwork with the state and become a separate
legal entity, you already have an EIN. Otherwise, to get an EIN, you must complete
and submit Form SS-4, which you can see in Figure 4-1.
Luckily, the government offers four ways to submit the necessary information
and obtain an EIN. The fastest way is to call the IRS’s Business & Specialty Tax
Line at (800) 829-4933 and complete the form by telephone. IRS officials assign
your EIN over the telephone. You can also apply online at www.irs.gov, or you can
download Form SS-4 at www.irs.gov/pub/irs-pdf/fss4.pdf and submit it by
fax or by mail.
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Processing Employee
Payroll and Benefits
FIGURE 4-1:
You must file
IRS Form SS-4 to
get an Employer
Identification
Number before
hiring employees.
Courtesy of IRS
In addition to tracking pay and taxes, state entities use the EIN number to track
the payment of unemployment taxes and workers’ compensation taxes, both of
which the employer must pay (see Book 2, Chapter 5 for details).
W-4
Every person you hire must fill out a W-4 form called the Employee’s Withholding Allowance Certificate.” You’ve probably filled out a W-4 at least once in your
life if you’ve ever worked for someone else. You can download this form and make
copies for your employees at www.irs.gov/pub/irs-pdf/fw4.pdf.
This form, shown in Figure 4-2, tells you, the employer, how much to take out
of your employees’ paychecks in income taxes. On the W-4, employees indicate
whether they’re married or single. They can also claim additional allowances if
they have children or other major deductions that can reduce their tax bills. The
amount of income taxes you need to take out of each employee’s check depends
on how many allowances they claimed on the W-4.
It’s a good idea to ask an employee to fill out a W-4 immediately, but you can
allow the employee to take the form home if they want to discuss allowances with
a spouse or an accountant. If an employee doesn’t complete a W-4, you must take
income taxes out of their check based on the highest possible amount for that
person. See “Collecting Employee Taxes” later in this chapter.
CHAPTER 4 Processing Employee Payroll and Benefits
101
FIGURE 4-2:
IRS Form W-4
should be
completed by all
employees when
they’re hired so
that you know
how much to
take out of their
paychecks for
taxes.
Courtesy of IRS
An employee can always fill out a new W-4 to reflect life changes that affect the
tax deduction. If the employee was single when they started working for you and
gets married a year later, for example, they can fill out a new W-4 and claim their
spouse, lowering the amount of taxes that must be deducted from their check.
Another common life change that can reduce an employee’s tax deduction is the
birth or adoption of a child.
I-9
All employers in the United States must verify that any person they intend to hire
is a U.S. citizen or has the right to work in the United States. As an employer,
you verify this information by completing and keeping on file an I-9 form from
U.S. Citizenship and Immigration Services (USCIS). The new hire fills out Section 1
of the form by providing information, including name and address, birth history,
Social Security number, and U.S. citizenship or work permit.
You fill out Section 2, which requires you to check for documents that establish
identity and prove employment eligibility. Workers can provide a driver’s license;
a military, student, or official state ID; or a Social Security card, birth certificate,
or U.S. passport. Instructions provided with the form list all acceptable documents
you can use to verify work eligibility. You must complete Section 2 of the I-9;
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BOOK 2 Recording Transactions
Figure 4-3 shows a sample I-9 form, Section 2. You can download the form
and its instructions from the U.S. Citizenship and Immigration Services website at https://www.uscis.gov/system/files_force/files/form/i-9-paperversion.pdf.
FIGURE 4-3:
U.S. employers
must verify a new
hire’s eligibility
to work in the
United States by
completing
Form I-9.
Courtesy of U.S. Citizenship and Immigration Services
W-5
Some employees you hire may be eligible for the Earned Income Credit (EIC),
which is a tax credit that refunds some of the money the employee would otherwise pay in taxes, such as Social Security or Medicare. To get this credit, the
employee must have a child and meet other income qualifications that are detailed
in the form’s instructions.
The government started the EIC credit, which reduces the amount of tax owed,
to help lower-income people offset increases in living expenses and Social
CHAPTER 4 Processing Employee Payroll and Benefits
103
Processing Employee
Payroll and Benefits
making copies of the employment eligibility documents (IDs) for your files isn’t
enough.
Security taxes. Having an employee complete Form W-5 allows you to advance
the expected savings of the EIC to the employee in their paycheck each pay period
rather than make them wait to get the money back at the end of the year after
filing tax forms. The advance amount isn’t considered to be income, so you don’t
need to take out taxes on this amount.
As an employer, you aren’t required to verify an employee’s eligibility for the EIC
tax credit. The eligible employee must complete a W-5 each year to indicate that
they still qualify for the credit. If the employee doesn’t file the form with you,
you can’t advance any money to the employee. If an employee qualifies for the
EIC, you calculate their paycheck the same as you would any other employee’s
paycheck, deducting all necessary taxes to get the employee’s net pay. Then you
add back the EIC advance credit that’s allowed.
Any advance money you pay to the employee can be subtracted from the employee
taxes you owe to the government. If you’ve taken out $10,000 from employees’
checks to pay their income, Social Security, and Medicare taxes, for example, and
then returned $500 to employees who qualified for the EIC, you subtract that
$500 from the $10,000 and pay the government only $9,500.
You can find out more about form W-5 and its instructions at www.irs.gov.
Picking pay periods
Deciding how frequently you’ll pay employees is an important point to work out
before hiring staff. Most businesses choose one or more of these four pay periods:
»» Weekly: Employees are paid every week, and payroll must be done 52
times a year.
»» Biweekly: Employees are paid every two weeks, and payroll must be done 26
times a year.
»» Semimonthly: Employees are paid twice a month, commonly on the 15th and
last day of the month, and payroll must be done 24 times a year.
»» Monthly: Employees are paid once a month, and payroll must be done 12
times a year.
You can choose to use any of these pay periods, and you may even decide to use
more than one type. Some companies pay hourly employees (employees paid by
the hour) weekly or biweekly and pay salaried employees (employees paid by a set
salary regardless of how many hours they work) semimonthly or monthly. Whatever your choice, decide on a consistent pay period policy, and be sure to make it
clear to employees when they’re hired.
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BOOK 2 Recording Transactions
Determining wage and salary types
You have a lot of leeway regarding the level of wages and salary you pay your
employees, but you still have to follow the rules laid out by the U.S. Department
of Labor. When deciding on wages and salaries, you have to start by categorizing
your employees. Employees fall into either of two categories:
»» Exempt employees are exempt from the Fair Labor Standards Act (FLSA),
which sets rules for minimum wage, equal pay, overtime pay, and child labor
laws. Executives, administrative personnel, managers, professionals, computer specialists, and outside salespeople can all be exempt employees.
They’re normally paid a certain amount per pay period with no connection
to the number of hours worked. Often, exempt employees work well over
40 hours per week without extra pay.
»» Nonexempt employees must be hired according to rules of the FLSA,
meaning that companies within certain parameters must pay a minimum
hourly wage. Any nonexempt employee who works more than 40 hours in a
7-day period must be paid a higher hourly rate for the additional hours
worked, often called overtime. Minimum wage doesn’t have to be paid in cash.
The employer can pay some or all of the wage in room and board provided
that it doesn’t make a profit on any noncash payments. Also, the employer
can’t charge the employee to use its facilities if the employee’s use of a facility
is primarily for the employer’s benefit. For details about who can be designated an exempt employee, visit the U.S. Department of Labor’s website at
www.dol.gov.
Federal and state minimum wage laws change over time, so be sure to check with
your state department of labor to be certain you’re meeting the wage guidelines.
If you plan to hire employees who are younger than 18, pay attention to child labor
laws. Federal and state laws restrict what kind of work children can do, when
they can do it, and how old they have to be to do it, so be sure you become familiar
with the laws before hiring employees younger than 18. For minors below the age
of 16, work restrictions are even tighter than for teens aged 16 and 17. (You can
hire your own child without worrying about these restrictions, however.)
CHAPTER 4 Processing Employee Payroll and Benefits
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Processing Employee
Payroll and Benefits
For each employee who’s paid hourly, you need to have some sort of time sheet to
keep track of work hours. These time sheets are usually completed by the employees and approved by their managers. Completed and approved time sheets are sent
to the bookkeeper so that checks can be calculated based on the exact number of
hours worked.
Collecting Employee Taxes
In addition to following wage and salary guidelines set for your business, when
calculating payroll, you, the bookkeeper, must be familiar with how to calculate
the employee taxes that must be deducted from each employee’s paycheck. These
taxes include Social Security; Medicare; and federal, state, and local withholding
taxes.
Sorting out Social Security tax
Employers and employees share the Social Security tax equally: Each must pay a
certain percentage of their income toward Social Security up to a specified cap per
year per person. The amount an employee earns above the cap may not be subject
to Social Security tax. The federal government adjusts the cap each year based on
salary-level changes in the marketplace. Essentially, the cap gradually increases
as salaries increase.
The calculation for Social Security taxes is relatively simple. For an employee who
makes $1,000 per pay period, assuming a rate of 6.2 percent for Social Security,
you calculate Social Security tax this way:
$1,000 × 0.062 = $62
The bookkeeper deducts $62 from this employee’s gross pay, and the company
also pays the employer’s share of $62. Thus, the total amount submitted in Social
Security taxes for this employee is $124.
Making sense of Medicare tax
Employees and employers also share Medicare taxes. Unlike Social Security taxes,
Medicare taxes aren’t subject to a federal cap on the amount that must be paid. So
even if someone makes $1 million per year, the Medicare tax percentage is calculated for each pay period and paid by both the employee and the employer. Here’s
an example of how you calculate the Medicare tax for an employee who makes
$1,000 per pay period, assuming a Medicare tax rate of 1.45 percent:
$1,000 × 0.0145 = $14.50
The bookkeeper deducts $14.50 from this employee’s gross pay, and the company
also pays the employer’s share of $14.50. Thus, the total amount submitted in
Medicare taxes for this employee is $29.
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BOOK 2 Recording Transactions
To avoid dealing with nearly all withholdings from pay, you can hire a payroll
company to handle the task. ADP and Paychex are two large providers of payroll
services. You may find that the rate you pay an outside company is far less than
the time and expense of performing this task yourself.
For bookkeepers and accountants, deducting federal withholding taxes is a much
more complex task than deducting Social Security or Medicare taxes. You not only
have to worry about an employee’s tax rate, but also must consider the number
of withholding allowances the employee claimed on their W-4 and whether the
employee is married or single. Generally speaking, the first so many thousands of
dollars are taxed at one low rate. As a person or couple earns more, that income
may bump them into higher tax brackets, meaning that the extra income gets
taxed at a higher rate.
Trying to figure out taxes separately for each employee based on their tax rate
and number of allowances would be an extremely time-consuming task, but
luckily, you don’t have to do that. The IRS publishes tax tables in Publication 15,
­Employer’s Tax Guide, that let you look up an employee’s tax obligation based on
the taxable salary and withholdings.
You can access the IRS Employer’s Tax Guide, along with tables for calculating
withholding taxes, at www.irs.gov/publications/p15.
The IRS’s tax tables give you detailed numbers for levels of withholding allowances. Table 4-1 shows a sample tax table with only seven allowances because of
space limitations. But even with seven allowances, you get the idea: Just match
the employee’s wage range with the number of allowances they claim, and the
box where those figures meet contains the amount of that employee’s tax obligation. If you’re preparing a paycheck for an employee whose taxable income is
$1,000 per pay period, and they claim three withholding allowances — one for
themself, one for their spouse, and one for their child — the amount of federal
income taxes you deduct from their pay is $100.
TABLE 4-1
Portion of an IRS Tax Table for Employers
If Wages Are
And the Number of Allowances Claimed Is
At Least
But Less Than
1
2
3
4
5
6
7
$1,000
$1,010
$139
$119
$100
$88
$77
$65
$53
$1,010
$1,020
$141
$122
$102
$90
$78
$67
$55
$1,020
$1,030
$144
$124
$105
$91
$80
$68
$56
CHAPTER 4 Processing Employee Payroll and Benefits
107
Processing Employee
Payroll and Benefits
Figuring out federal withholding tax
The “Allowances” in W4s were eliminated in some tax changes beginning in
2020.
Settling up state and local
withholding taxes
In addition to the federal government, most states have income taxes, and some
counties and cities even have local income taxes. You can find all state tax rates
and forms online at www.payroll-taxes.com. If your state, county, or city has
income taxes, they need to be taken out of each employee’s paycheck.
Determining Net Pay
Net pay (commonly referred to as take-home pay) is the amount a person is paid
after subtracting all tax and benefit deductions.
After you figure out all the necessary taxes to be deducted from an employee’s
paycheck, you can calculate the check amount. Here’s the equation and an example of how you calculate the net pay amount:
Gross pay – (Social Security + Medicare + Federal withholding tax + State
withholding tax + Local withholding tax + Benefit deductions) = Net pay
1,000 – (62 + 14.50 + 106 + 45 + 0 + 0) = 772.50
Many businesses offer their employees health, retirement, and other benefits but
expect the employees to share a portion of those costs. The fact that some of
these benefits are tax-deductible and some aren’t makes a difference in when
you deduct the benefit costs. If an employee’s benefits are tax-deductible and
taken out of the check before federal withholding taxes are calculated, the federal
tax rate may be lower than if the benefits are deducted after calculating federal
withholding taxes. Many states follow the federal government’s lead on tax-­
deductible benefits, so the amount deducted for state taxes will be lower as well.
Surveying Your Benefits Options
Benefits include programs that you provide your employees to better their lives,
such as health insurance and retirement savings opportunities. Some benefits are
tax-exempt, which means that employees aren’t taxed for them. Some benefits
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BOOK 2 Recording Transactions
Tax-exempt benefits
Some benefits are tax-exempt (not taxed). In some cases, health care and retirement benefits are tax-exempt. You may have a flexible spending plan at work, for
example. Your company provides tax-exempt payments that you can use to pay
for medical expenses. In fact, accident and health benefits and retirement benefits make up the largest share of employers’ pay toward employees’ benefits. If
the benefits are tax-exempt, anything an employee pays toward them is deducted
from their gross pay, so the employee doesn’t have to pay taxes on that part of
their salary or wage. The rules change frequently, so check with a tax adviser. If
an employee’s share of tax-exempt health insurance is $50 per pay period, and
they make $1,000 per pay period, their taxable income is actually $1,000 minus the
$50 health insurance premium contribution, or $950. As the bookkeeper, you
calculate taxes in this situation on $950 rather than $1,000.
Employee contributions to the retirement plan you offer may be taxdeductible too. Here’s an example, assuming that the tax deduction is allowed:
If an employee contributes $50 per pay period to your company’s 401(k) retirement plan, that $50 can also be subtracted from the employee’s gross pay before
you calculate net pay. So if an employee contributes $50 to health insurance and
$50 to retirement, the $1,000 taxable pay is reduced to only $900 taxable pay.
You can offer myriad other benefits to employees as well, including
»» Adoption assistance: You can provide up to a certain cap per child that an
employee plans to adopt without having to include that amount in taxable
gross income. You must include the value of this benefit when calculating
Social Security and Medicare taxes, however.
»» Athletic facilities: You can offer your employees the use of a gym on
premises your company owns or leases without having to include the value of
the gym facilities in gross pay. For this benefit to qualify as tax-exempt, the
facility must be operated by the company primarily for the use of employees,
their spouses, and their dependent children.
»» Dependent-care assistance: You can help your employees with dependentcare expenses, which can include children and elderly parents, provided that
you offer the benefit to make it possible for the employee to work.
»» Education assistance: You can pay employees’ educational expenses up to a
certain amount without having to include that payment in gross income.
CHAPTER 4 Processing Employee Payroll and Benefits
109
Processing Employee
Payroll and Benefits
are taxable, however, so employees have to pay taxes on the money or the value
of the benefits received. This section reviews the tax-exempt and taxable benefits
you can offer your employees.
»» Employee discounts: You can offer employees discounts on the company’s
products without including the value of the discounts in their gross pay,
provided that the discount isn’t more than 20 percent less than what’s
charged to customers.
»» Group term life insurance: You can provide group term life insurance up to
a specified coverage level to your employees without including the value of
this insurance in their gross pay. Premiums for coverage above the cap may
be added to calculations for Social Security and Medicare taxes.
»» Meals: Meals that have little value (such as coffee and doughnuts) don’t have
to be reported as taxable income. Also, occasional meals brought in so
employees can work late don’t have to be reported in employees’ income.
»» Moving expense reimbursements: If you pay moving expenses for employ-
ees, you don’t have to report these reimbursements as employee income as
long as the reimbursements are for items that would qualify as tax-deductible
moving expenses on an employee’s individual tax return. Employees who
have been reimbursed by their employers can’t deduct the moving expenses
for which the employer paid.
Again, check with a tax professional on the deductibility and taxability of these
benefits.
Taxable benefits
You may decide to provide some benefits that are taxable. These benefits may
include the personal use of a company automobile, life insurance premiums for
coverage over the cap, and benefits that exceed allowable maximums.
Cafeteria plans
Cafeteria plans are benefit plans that offer employees a choice of benefits based
on cost. Employees can pick and choose among those benefits and put together
a benefit package that works best for them within the established cost structure.
Cafeteria plans are becoming more popular among larger businesses, but not all
employers decide to offer their benefits this way. Managing a cafeteria plan can
be much more time-consuming for the bookkeeping and human resources staff.
Many small businesses that offer a cafeteria plan for benefits do so by outsourcing
benefit management services to an outside company that specializes in managing
cafeteria plans. Suppose that a company tells its employees that it will pay up to
$5,000 in benefits per year and values its benefit offerings this way:
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BOOK 2 Recording Transactions
$4,600
Retirement
$1,200
Child care
$1,200
Life insurance
$800
Processing Employee
Payroll and Benefits
Health insurance
Joe, an employee, picks benefits until he reaches $5,000. If Joe wants more than
$5,000 in benefits, he pays for the additional benefits with a reduction in his
paycheck.
The list of possible benefits could be considerably longer, but in this case, if Joe
chooses health insurance, retirement, and life insurance, the total cost is $6,600.
Because the company pays up to $5,000, Joe needs to copay $1,600, a portion of
which is taken out in each paycheck. If Joe gets paid every two weeks, for a total of
26 paychecks per year, the deduction for benefits from his gross pay (with rounding) is $61.54 ($1,600 ÷ 26).
Preparing Payroll and Posting
It in the Books
When you know the details about your employees’ withholding allowances and
their benefit costs, you can calculate the final payroll and post it to the books.
Calculating payroll for hourly employees
When you’re ready to prepare payroll for nonexempt (hourly) employees, the
first thing you need to do is collect time records from each person who is paid
hourly. Some companies use time clocks, and some use time sheets to produce
the required time records. Whatever method is used, the manager of each department usually reviews the time records for each employee supervised. After the
manager’s review, they send those time records to you, the bookkeeper.
With time records in hand, you have to calculate gross pay for each employee. If
a nonexempt employee worked 45 hours and is paid $12 an hour, you calculate
gross pay like so:
40 regular hours × $12 per hour = $480
5 overtime hours × $12 per hour × 1.5 overtime rate = $90
$480 + $90 = $570
CHAPTER 4 Processing Employee Payroll and Benefits
111
In this case, because the employee isn’t exempt from the FLSA (see “Determining wage and salary types” earlier in this chapter), overtime must be paid for any
hours worked over 40 in a 7-day workweek. This employee worked 5 hours more
than the 40 hours allowed, so assume that they need to be paid time plus onehalf. (The hourly rate paid over 40 hours may change.)
Doling out funds to salaried employees
In addition to preparing payroll for hourly employees, you must prepare payroll
for salaried employees. Paychecks for salaried employees are relatively easy to
calculate; all you need to know are their base salaries and their pay period calculations. If a salaried employee makes $30,000 per year and is paid twice a month
(totaling 24 pay periods), that employee’s gross pay is $1,250 for each pay period.
Totaling up for commission checks
Running payroll for employees paid based on commission can involve complex
calculations. To show you several variables, this section calculates a commission check based on a salesperson who sells $60,000 worth of product during one
month.
For a salesperson on a straight commission of 10 percent, you calculate pay by
using this formula:
Total amount sold × Commission percentage = Gross pay
$60,000 × 0.10 = $6,000
For a salesperson with a guaranteed base salary of $2,000 plus an additional 5
percent commission on all products sold, you calculate pay by using this formula:
Base salary + (Total amount sold × Commission percentage) = Gross pay
$2,000 + ($60,000 × 0.05) = $5,000
Although this employee may be happier having a base salary they can count on
each month, they actually make less with a base salary because the commission
rate is so much lower. By selling $60,000 worth of products, they earned only
$3,000 in commission at 5 percent. Without the base pay, they would have made
10 percent on the $60,000, or $6,000. The salesperson actually got paid $1,000
less with a base-pay structure that includes a lower commission pay rate.
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BOOK 2 Recording Transactions
$30,000 × 0.10 = $3,000 on straight commission of 10 percent
and
$30,000 × 0.05 = $1,500 plus $2,000 base salary, or $3,500
For a slow month, the salesperson would make more money with the base salary
than with the higher commission rate. You have many other ways to calculate
commissions. One common way is to offer higher commissions on higher levels of
sales. Using the figures in the next example, this type of pay system encourages
salespeople to keep their sales levels above $30,000 to get the best commission
rate.
With a graduated commission scale, a salesperson can make a straight commission of 5 percent on their first $10,000 in sales, 7 percent on their next $20,000,
and 10 percent on anything over $30,000. Here’s what the gross pay calculation
looks like, using this commission pay scale:
($10,000 × 0.05) + ($20,000 × 0.07) + ($30,000 × 0.10) = $4,900 Gross pay
One other type of commission pay system involves a base salary plus tips. This
method is common in restaurant settings, in which servers receive between $2.50
and $5 per hour plus tips.
Businesses that pay less than minimum wage must prove that their employees
make at least minimum wage when tips are accounted for. Today, that’s relatively easy to prove, because most people pay their bills with credit cards and
include tips in their bills. Businesses can come up with an average tip rate by
using that credit card data.
Employees must report tips to their employers on IRS Form 4070, Employee’s
Report of Tips to Employer, which is part of IRS Publication 1244, Employees
Daily Record of Tips and Report to Employer. If your employees receive tips, and
you want to supply the necessary paperwork, you can download it at www.irs.
gov/pub/irs-pdf/p1244.pdf. The publication provides details about what the
IRS expects you and your employees to do if they work in an environment where
tipping is common.
CHAPTER 4 Processing Employee Payroll and Benefits
113
Processing Employee
Payroll and Benefits
If the employee has a slow sales month, with just $30,000 worth of products sold,
their pay would be
As an employer, you must report an employee’s gross taxable wages based on salary plus tips. Here’s how you calculate gross taxable wages for an employee whose
earnings are based on tips and wages:
Base wage + Tips = Gross taxable wages
($3 × 40 hours per week) + $300 = $420
If you pay your employees by using a combination of base wage plus tips, you
must be sure that your employees are earning at least the minimum wage rate.
Checking this employee’s gross wages, the hourly rate earned is $10.50:
Hourly wage = $10.50 ($420 ÷ 40)
Taxes due are calculated on the base wage plus tips, so the check you prepare for
the employee in this example is for the base wage minus any taxes due.
Putting it together to prepare payroll
After calculating paychecks for all your employees, you prepare the payroll,
make up the checks, and post the payroll to the books. In addition to cash, many
accounts are affected by payroll, including
»» Accrued federal withholding payable, where you record the liability for
future federal tax payments.
»» Accrued state withholding payable, where you record the liability for future
state tax payments. Many companies have withholding accounts for FICA,
Medicare, local taxes, and other categories.
»» Accrued employee medical insurance payable, where you record the
liability for future medical insurance premiums.
»» Accrued employee elective insurance payable, where you record the
liability for miscellaneous insurance premiums, such as life or accident
insurance.
When you post the payroll entry, you indicate the withdrawal of money from the
cash account as well as record liabilities for future cash payments that will be due
for taxes and insurance payments. As an example of the proper setup for a payroll
journal entry, assume the total payroll is $10,000 with $1,000 set aside for each
type of withholding payable. In reality, your numbers will be much different, and
your payables will probably never be all the same. Here’s what your journal entry
for posting payroll should look like:
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BOOK 2 Recording Transactions
Salaries and wages expense
Processing Employee
Payroll and Benefits
Debit
Credit
$10,000
Accrued federal withholding payable
$1,000
Accrued state withholding payable
$1,000
Accrued medical insurance payable
$1,000
Accrued elective insurance payable
$1,000
Cash
$6,000
To record payroll for May 27
In this entry, you increase the expense account for salaries and wages as well as
all the accounts in which you accrue future obligations for taxes and employee
insurance payments.
When cash payments are made for the taxes and insurance payments, you post
those payments in the books. Here’s an example of the entry you would post to the
books after making the federal withholding tax payment:
Debit
Accrued federal withholding payable
Credit
$1,000
Cash in checking
$1,000
To record the payment of May
federal taxes for employees
Depositing Employee Taxes
Any taxes collected on behalf of employees must be deposited in a financial institution authorized to collect those payments for the government or in the Federal Reserve Bank in your area. Most major banks are authorized to collect these
deposits; check with your bank to see whether it is or to get a recommendation
of a bank you can use. IRS Form 8109, Federal Tax Deposit (FTD) Coupon, is the
coupon businesses use to deposit taxes. You can’t get a copy of this form online;
it’s available only from the IRS or a bank that handles your deposits.
CHAPTER 4 Processing Employee Payroll and Benefits
115
Form 8109 can be used to deposit many kinds of federal payments, including
»» Form 941, Employer’s Quarterly Federal Tax Return (includes federal withholding taxes, Social Security taxes, and Medicare taxes)
»» Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return
»» Form 1120, U.S. Corporation Income Tax Return
When depositing funds by using Form 8109, be sure to include the EIN and name
of the company on the coupon, as well as the form number related to the payment. The IRS tracks payments by EIN number and form number filed.
For the purposes of tax payments collected from employees for the federal government, you must complete Form 941, which is shown in Figure 4-4. This form
summarizes the tax payments made on behalf of employees. You can get instructions and Form 941 online at www.irs.gov; just search on the site for the term
“Form 941.” (For more about the various forms employers must file, see Book 2,
Chapter 5.)
FIGURE 4-4:
Employers
must file Form
941 to report
taxes ­collected
on behalf of
employees.
Courtesy of IRS
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BOOK 2 Recording Transactions
As your business grows, you may need to make deposits more frequently. You can
also make employee tax payments electronically by using the Electronic Federal
Tax Payment System (EFTPS).
To find out more, check out IRS Publication 15 at www.irs.gov/pub/irs-pdf/
p15.pdf.
CHAPTER 4 Processing Employee Payroll and Benefits
117
Processing Employee
Payroll and Benefits
During the first year as an employer, the company will have to make monthly
deposits of employee taxes. Monthly payments must be made by the 15th day
of the month after the taxes were deducted. Taxes collected from employees in
April, for example, must be paid by May 15. If the date on which the deposit is due
falls on a weekend or bank holiday, the payment is due the next day the banks
are open.
IN THIS CHAPTER
»» Tallying the employer’s share of
Social Security and Medicare
»» Filing and paying unemployment
taxes
»» Figuring out workers’ compensation
»» Keeping accurate employee records
Chapter
5
Taxing Payrolls
A
fter your company hires employees, you need to complete regular
reports for the government regarding the taxes you must pay toward the
employees’ Social Security and Medicare, as well as unemployment
taxes. In most states, employers also are required to buy workers’ compensation
insurance based on employees’ salary and wages.
This chapter reviews the federal, state, and local government reporting requirements for employers as well as the records you, the accountant, must keep to
complete these reports. You also find out about the requirements for buying
workers’ compensation insurance.
Paying Employer Taxes on Social
Security and Medicare
In the United States, both employers and employees must contribute to the Social
Security and Medicare systems. In most cases, employers share equally with
employees the tax obligation for both Social Security and Medicare.
CHAPTER 5 Taxing Payrolls
119
As discussed in Book 2, Chapter 4, the employer and the employee each must pay
a certain percentage of an employee’s compensation for Social Security. Employer
and employee must also pay a percentage of wages toward Medicare.
When you finish calculating payroll checks, you calculate the employer’s portion
of Social Security and Medicare. When you post the payroll to the books, you set
aside the employer’s portion of Social Security and Medicare in an accrual account.
Filing Form 941
Each quarter you must file federal Form 941, Employer’s Federal Tax Return,
which details the number of employees who received wages, tips, or other compensation for the quarter. In Book 2, Chapter 4, you can see what the form looks
like. Table 5-1 shows you what months are reported during each quarter and
when the reports are due.
TABLE 5-1
Filing Requirements for Employer’s Quarterly
Federal Tax Return (Form 941)
Months in Quarter
Report Due Date
January, February, March
On or before April 30
April, May, June
On or before July 31
July, August, September
On or before October 31
October, November, December
On or before January 31
The following key information must be included in Form 941:
»» Number of employees who received wages, tips, or other compensation
during the pay period
»» Total of wages, tips, and other compensation paid to employees
»» Total tax withheld from wages, tips, and other compensation
»» Taxable Social Security and Medicare wages
»» Total paid out to employees in sick pay
»» Adjustments for tips and group-term life insurance
»» Amount of income tax withholding
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BOOK 2 Recording Transactions
»» Advance earned income credit payments made to employees (see Chapter 4
for an explanation)
»» Amount of tax liability per month
Knowing how often to file
Employers on a monthly payment schedule (usually, small companies) must
deposit all employment taxes due by the 15th day of the following month. The taxes
for the payroll in April must be paid by May 15, for example. Larger employers
must pay taxes more frequently, depending on the number of workers employed
and the dollar amount of payroll.
Completing Unemployment Reports and
Paying Unemployment Taxes
As an employer, you’re responsible for paying a share of unemployment compensation based on your record of firing and laying off employees. The fund you
pay into is known as the Federal Unemployment Tax Act (FUTA) fund. For FUTA,
employers pay a percentage rate based on each employee’s earnings.
The employee earnings are capped at a certain dollar amount. So even though each
employee earns a different level of salary, FUTA taxes are calculated only on the
first dollars each employee earns. As of this writing, the cap for FUTA taxes is on
the first $7,000 of income.
States also collect taxes to fill their unemployment fund coffers. The federal government allows you to subtract a portion of the state unemployment payments
from your federal contributions. Essentially, the amount you pay to the state can
serve as a credit toward the amount you must pay to the federal government.
CHAPTER 5 Taxing Payrolls
121
Taxing Payrolls
As an employer, you file Form 941 on a quarterly basis, but you may have to pay
taxes more frequently. Most new employers start out making monthly deposits
for taxes due by using Form 8109 (shown in Book 2, Chapter 4), which is a payment coupon that your company can get from a bank approved to collect deposits
or from the Federal Reserve branch near you. Others make deposits online by
using the IRS’s Electronic Federal Tax Payment System (EFTPS). For more information on EFTPS, go to www.eftps.gov.
Each state sets its own unemployment tax rate. Many states also charge additional fees for administrative costs and job-training programs. You can check out
the full charges for your state at https://www.payroll-taxes.com.
Figuring out how states calculate
the FUTA tax rate
States use four methods to calculate how much you may need to pay in FUTA
taxes:
»» Benefit ratio formula: The state looks at the ratio of benefits collected by
former employees to your company’s total payroll over the past three years.
States also adjust your rate depending upon the overall balance in the state
unemployment insurance fund.
»» Benefit wage formula: The state looks at the proportion of your company’s
payroll that’s paid to workers who become unemployed and receive benefits,
and then divides that number by your company’s total taxable wages.
»» Payroll decline ratio formula: The state looks at the decline in your company’s payroll from year to year or from quarter to quarter.
»» Reserve ratio formula: The state keeps track of your company’s balance in
the unemployment reserve account, which gives a cumulative representation
of its use by your former employees who were laid off and paid unemployment. This recordkeeping dates back from the date you were first subject to
the state unemployment rate. To calculate the reserve account, add all your
contributions to the account and then subtract total benefits paid. This
amount is divided by your company’s total payroll. The higher the reserve
ratio, the lower the required contribution rate.
These formulas can be very complicated, so your best bet is to contact your state’s
unemployment office to review how your company’s unemployment rate will be
set. In addition to getting a better idea of what may affect your FUTA tax rate, you
can discuss how best to minimize that rate.
Calculating FUTA tax
After you know what your rate is, calculating the actual FUTA tax you owe isn’t
difficult. Here’s what you do:
1.
Multiply $7,000 by the federal unemployment tax rate to determine how
much you owe per employee in federal unemployment.
That $7,000 is the cap on earnings.
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BOOK 2 Recording Transactions
2.
Multiply the result from Step 1 by the number of employees to determine
the total federal unemployment tax you owe.
If the state rate is lower than the federal rate, you’re done. You pay the federal
program the federal calculation less the amount you pay into the state
unemployment fund. If the state rate is higher than the federal rate, proceed
to Step 3.
3.
4.
Multiply the result from Step 3 by $7,000 to determine the additional
amount of state unemployment tax you must pay per employee.
Multiply the result from Step 4 by the number of employees.
Add the amounts from steps 2 and 5.
Here’s an example, assuming a state tax rate of 2.7 percent and a federal rate of
6 percent:
State unemployment taxes:
$7,000 × 0.027 = $189 per employee
$189 × 10 employees = $1,890
Federal unemployment taxes:
$7,000 × 0.062 = $434
$434 × 10 employees = $4,340
Because the federal rate is higher than the state rate, you can subtract the amount
in state unemployment tax you owe from the total. In this case, you’d pay $1,890
to the state and $2,450 ($4,340 – $1,890) to the federal unemployment fund.
Each year, you must file IRS Form 940, Federal Unemployment (FUTA) Tax
Return, shown in Figure 5-1. You can find Form 940 online at www.irs.gov/pub/
irs-pdf/f940.pdf.
You can pay taxes for Form 940 by using the same coupon (Form 8109) used to
pay Form 941 taxes. (See “Filing Form 941” earlier in this chapter for an explanation.) Most employers pay unemployment taxes quarterly.
CHAPTER 5 Taxing Payrolls
123
Taxing Payrolls
5.
6.
Subtract the state rate from the federal rate.
FIGURE 5-1:
Employers report
their FUTA tax on
Form 940.
Courtesy of IRS
Filing and paying unemployment taxes to
state governments
Many states collect their unemployment taxes on a quarterly basis, and most
states allow you to pay your unemployment taxes online. Check with your state to
find out how to file and make unemployment tax payments.
Unfortunately, the filing requirements for state unemployment taxes may be more
difficult to complete than those for federal taxes. States require you to detail each
employee by name and Social Security number. The state must know how much
an employee was paid each quarter to determine their unemployment benefit, if
the need arises. Some states also require you to report the number of weeks an
employee worked in each quarter because the employee’s unemployment benefits
are calculated based on the number of weeks worked.
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BOOK 2 Recording Transactions
Each state has its own form and filing requirements. Some states require a
detailed report as part of your quarterly wage and tax reports. Other states allow
a simple form for state income tax and a more detailed report with your unemployment tax payment.
Carrying Workers’ Compensation
Insurance
If an employee gets hurt on the job, workers’ compensation covers the costs of
lost income, medical expenses, vocational rehabilitation, and (if applicable) death
benefits. Each state sets its own rules regarding how much medical coverage you
must provide. If the injury also causes the employee to miss work, the state determines the percentage of the employee’s salary you must pay and how long you
must pay that amount. If the injury results in the employee’s death, the state also
sets the amount you must pay toward funeral expenses and the amount of financial support you must provide the employee’s family.
Each state makes up its own rules about how a company must insure itself against
employee injuries on the job. Some states create state-based workers’ compensation funds to which all employers must contribute. Other states allow you the
option of participating in a state-run insurance program or buying insurance
from a private company. Several states permit employers to use health maintenance organizations (HMOs), preferred provider organizations (PPOs), and other
managed-care providers to handle workers’ claims.
If your state doesn’t have a mandatory state pool, you have some other resources
to obtain workers’ compensation insurance coverage. States set the requirements
for coverage, and either a national rating bureau called the National Council on
Compensation Insurance (NCCI) or a state rating bureau establishes the premiums. For the lowdown on NCCI and workers’ compensation insurance, visit www.
ncci.com.
You may find lower rates over the long term if your state allows you to buy private
workers’ compensation insurance. Many private insurers give discounts to companies with good safety standards in place and few past claims, so the best way to
keep your workers’ compensation rates low is to encourage safety and minimize
your company’s claims.
CHAPTER 5 Taxing Payrolls
125
Taxing Payrolls
Taxes aren’t the only things you need to worry about when figuring out your
state obligations after hiring employees. Nearly every state requires employers to
carry workers’ compensation insurance, which covers your employees in case they’re
injured on the job.
Your company’s rates are calculated based on risks identified in two areas:
»» Classification of the business: These classifications are based on historic
rates of risk in different industries. If you operate a business in an industry
that historically has a high rate of employee injury, such as a construction
business, your base rate for workers’ compensation insurance is higher than
that of a company in an industry without a history of frequent employee
injury, such as an office that sells insurance.
»» Classification of the employees: The NCCI publishes classifications of
hundreds of jobs in a book called the Scopes Manual. Most states use this
manual to develop the basis for their classification schedules. Businesses that
employ most workers at desk jobs pay less in workers’ compensation than
businesses with a majority of employees operating heavy machinery.
Be careful how you classify your employees. Many small businesses pay more
than needed for workers’ compensation insurance because they misclassify
employees. Be sure you understand the classification system and classify your
employee positions properly before applying for workers’ compensation
insurance. Be sure to read the information at www.ncci.com before classifying your employees.
When computing insurance premiums for a company, the insurer (the state or
a private firm) looks at employee classifications and the rate of pay for each
employee. Consider the position of an administrative assistant who earns $25,000
per year. If that job classification is rated at 29 cents per $100 of income, the
workers’ compensation premium for that employee is
($25,000 ÷ 100) × 0.29 = $72.50
Most states allow you to exclude any overtime paid when calculating workers’
compensation premiums. You may also be able to lower your premiums by paying
a deductible on claims. A deductible is the amount you would have to pay before
the insurance company pays anything. Deductibles can lower your premium by as
much as 25 percent, so consider it as well to keep your up-front costs low.
Maintaining Employee Records
When you consider all the state and federal filing requirements for employee taxes
that you must keep, it’s clear that you must have very good employee records.
Otherwise, you’ll have a hard time filling out all the necessary forms and providing details on your employees and your payroll. The best way to track employee
126
BOOK 2 Recording Transactions
information is to set up an employee journal and create a separate journal page
for each employee. You can set up this journal manually or through an automated
accounting system.
The detailed individual records you keep for each employee should include this
basic information, most of which is collected or determined as part of the hiring
process:
Taxing Payrolls
»» Name, address, phone number, and Social Security number
»» Department or division within the company
»» Start date with the company
»» Pay rate
»» Pay period (weekly, biweekly, semimonthly, or monthly)
»» Whether hourly or salaried
»» Whether exempt or nonexempt
»» W-4 withholding allowances
»» Benefits information
»» Payroll deductions
»» All payroll activity
If an employee asks to change the number of withholding allowances and file a
new W-4 or asks for benefits changes, their record must be updated to reflect such
changes.
The personal detail that doesn’t change each pay period should appear at the top
of the journal page. Divide the remaining information into columns. Here’s a
sample showing what the top of an employee’s journal page might look like:
NameSocial Security number
Address:
Tax info: Married, 2 WH
Pay information: $8 hour, nonexempt, biweekly
Benefits: None
Following is an example of the body of the journal page, containing columns for
date of check, taxable wages, Social Security and Medicare tax (in one total), federal tax withholding, state tax withholding, and the net check amount:
CHAPTER 5 Taxing Payrolls
127
Date
Taxable Wages
SS and Med
Fed WH
State WH
Check
4/8
$640
$39.68
$9.28
$8.62
$582.42
4/22
$640
$38.68
$9.28
$8.62
$582.42
You may want to add other columns to your employee journal to keep track of
things such as
»» Nontaxable wages: Examples include health or retirement benefits that are
paid before taxes are taken out.
»» Benefits: If the employee receives benefits, you need at least one column to
track any money taken out of the employee’s check to pay for those benefits.
In fact, you may want to consider tracking each benefit in a separate column.
Check out Book 2, Chapter 4 for more on benefits.
»» Sick time: Most employers provide paid days off for an employee illness, and
the number of sick days taken must be tracked by worker. In some cases,
unused sick days may carry over for use in a future year.
»» Vacation time: Employers also must track the number of paid vacation days
earned by each worker and the number of vacation days taken during the
year. Some firms allow unused vacation days to be carried over for use in
future years.
Clearly, these employee journal sheets can get very lengthy very quickly, which
is why many small businesses use computerized accounting systems to monitor
both payroll and employee records.
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3
Adjusting and
Closing Entries
Contents at a Glance
CHAPTER 1:
Depreciating Your Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Appreciating Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Comparing Depreciation Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
Tackling Taxes and Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
CHAPTER 2:
Interesting Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
Deciphering Types of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
Handling Interest Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
Delving into Loans and Interest Expenses. . . . . . . . . . . . . . . . . . . . . 147
CHAPTER 3:
Proving Out Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Making Sure That Ending Cash Is Right . . . . . . . . . . . . . . . . . . . . . . . 153
Closing the Cash Journals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
Using a Temporary Posting Journal . . . . . . . . . . . . . . . . . . . . . . . . . . 160
CHAPTER 4:
Reconciling Accounts and Closing
Journal Entries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
Reconciling Bank Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Prepping to Close: Checking for Accuracy and Tallying
Things Up. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Posting to the General Ledger. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Checking Out Computerized Journal Records. . . . . . . . . . . . . . . . . . 173
CHAPTER 5:
Checking Your Accuracy. . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Working with a Trial Balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Testing Your Balance by Using Computerized Accounting
Systems. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
Developing a Financial Statement Worksheet . . . . . . . . . . . . . . . . . 183
Replacing Worksheets with Computerized Reports. . . . . . . . . . . . . 185
CHAPTER 6:
Adjusting the Books. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
Adjusting All the Right Areas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
Testing an Adjusted Trial Balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
IN THIS CHAPTER
»» Understanding depreciation: What
you do and why you do it
»» Exploring depreciation methods
»» Looking at depreciation’s tax impact
Chapter
1
Depreciating Your Assets
A
ll businesses have fixed assets: equipment, furnishings, and vehicles that
last more than a year. Although they may last longer than other assets,
even fixed assets eventually wear out or become obsolete and need replacing. Fixed assets, like other assets, are an expense, of course, but because fixed
assets last longer, you have options in how you account for those expenses. You
might choose to deduct the entire cost of a fixed asset the year you purchase it,
for example. Another option is to use a method called depreciation to write off the
cost of the asset over several years or perhaps even over the life of that asset. Each
option has its benefits and drawbacks.
In this chapter, you’ll get introduced to the various ways you can depreciate your
assets and see how to choose a depreciation method, calculate depreciation, and
reap its tax benefits. Changes in the tax law may also affect your decisions about
depreciation.
Appreciating Depreciation
Accountants use depreciation as a way to allocate the costs of a fixed asset over
the period in which the asset is usable to the business. You, the accountant, normally record the full cost of the asset when the asset is purchased. Subtracting a
portion of that value as a depreciation expense each year gradually reduces the
value of the asset.
CHAPTER 1 Depreciating Your Assets
131
Depreciation expenses don’t involve the exchange of cash; they’re done solely for
accounting purposes and for the purpose of reaping tax benefits. Most companies
enter depreciation expenses into the books once a year just before preparing their
annual reports, but others calculate depreciation expenses monthly or quarterly.
One key reason to write off assets is to lower your tax bill, so the Internal Revenue
Service gets involved in depreciation too. As a business owner, you probably won’t
be able to write off the cost of all major purchases in one year. The IRS has strict
rules about how you can write off assets as tax-deductible expenses. For more
about the IRS’s rules, see “Tackling Taxes and Depreciation” later in this chapter.
Knowing what you can and can’t depreciate
Businesses don’t depreciate all assets. Low-cost items or items that aren’t
expected to last more than one year are expensed immediately. In other words,
these items aren’t recorded as assets. Office supplies, for example, are expense
items and not depreciated, but that office copier, which you’ll use for more than
one year, is recorded in the books as a fixed asset and depreciated each year over
the course of its expected useful life.
Life span isn’t the deciding factor for depreciation, however. Some assets that last
many years are never depreciated. One good example is land; you can always make
use of land, so its value never depreciates. Also, you can’t depreciate any property
that you lease or rent. If you make improvements to leased property, however,
you can depreciate the cost of those improvements. In that case, you write off the
lease or rent as an expense item and depreciate the lease improvements over their
estimated useful life.
You can’t depreciate any items that you use outside your business, such as your
personal car or home computer. If you use these assets for both personal needs
and business needs, you can depreciate a portion of them based on the percentage
of time or other measurement that proves how much you use the car or computer
for business. The portion of a car that can be depreciated can be based on the miles
driven for business versus the miles driven for personal use. If you drive your car
a total 12,000 miles in a year and have records showing that 6,000 of those miles
were for business purposes, you can depreciate 50 percent of the cost of the car.
That percentage is allocated over the anticipated useful life of the car.
Another example of depreciation of a dual-use asset is a room in your home designated exclusively for your business. You may be able to depreciate a portion of
your home’s cost as part of your business expenses. The amount you can depreciate is based on the portion of your home used for business.
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BOOK 3 Adjusting and Closing Entries
Figuring out the useful life of a fixed asset
You’re probably wondering how you figure out the useful life of a fixed asset. Well,
the IRS has done the dirty work for you by creating a chart that spells out the
recovery periods allowed for business equipment (see Table 1-1). Recovery periods
are the anticipated useful life span of a fixed asset. Cars, for example, generally
have a five-year recovery period because the IRS anticipates that they’ll have a
useful life span of five years. Although the car will probably run longer, you’re not
likely to continue using it for business purposes after the first five years; you’re
more likely to trade it in and get a new car.
Delving into cost basis
To calculate depreciation for an asset, you need to know the cost basis of that
asset. Cost basis represents all the costs you incur to use the asset in your business.
You use assets to make money — to make a product or service to sell. The equation for cost basis is
Cost of the fixed asset + Sales tax + Shipping and delivery costs + Installation
charges + Other costs = Cost basis
Depreciating Your
Assets
TABLE 1-1
Depreciation Recovery Periods for Business Equipment
Property Class
Recovery Period
Business Equipment
3-year property
Tractor units and horses more than two years old
5-year property
Cars, taxis, buses, trucks, computers, office machines (faxes,
copiers, calculators), research equipment, and cattle
7-year property
Office furniture and fixtures
10-year property
Water-transportation equipment, single-purpose agricultural
or horticultural structures
15-year property
Land improvements, such as shrubbery, fences, roads,
and bridges
20-year property
Farm buildings that aren’t agricultural or horticultural
structures
27.5-year property
Residential rental property
39-year property
Nonresidential real estate, including a home office but not
including the value of the land
CHAPTER 1 Depreciating Your Assets
133
»» Cost of the fixed asset: What you paid for the equipment, furniture, structure, vehicle, or other asset.
»» Sales tax: What you were charged in sales tax to buy the fixed asset.
»» Shipping and delivery costs: Any shipping or delivery charges you paid to get
the fixed asset.
»» Installation charges: Any charges you paid to have the equipment, furniture,
or other fixed asset installed on your business’s premises.
»» Other costs: Any other charges you need to pay to make the fixed asset
usable for your business. If you buy a new computer and need to set up
certain hardware to use that computer for your business, those setup costs
can be added as part of the cost basis of the fixed asset (the computer).
Training costs may also be part of your cost basis.
For additional details on how to determine which costs can be included in depreciation, see Book 8, Chapter 1.
Comparing Depreciation Options
There are four common methods of depreciation. Three of these methods are
based on time: straight-line, declining balance, and sum-of-the-years’-digits.
The fourth method, units-of-production, is based on actual physical use of the
fixed asset. Here’s a brief explanation of each type:
»» Straight-line method: This method spreads the cost of the fixed asset evenly
over its useful life.
»» Declining balance method: Declining balance is an accelerated method of
depreciation, meaning that the depreciation expense is higher in the earlier
years of ownership.
»» Sum-of-the-years’-digits method: This method is another accelerated
method of depreciation. You figure depreciation expense by assigning
numbers (in declining order) to each year of the fixed asset’s expected useful
life. An asset used for three years would require this calculation: 3 + 2 + 1 = 6.
Your depreciation rate for any given year is the year’s assigned number
divided by that sum, so the year 1 rate would be 3/6 (or 1/2).
»» Units-of-production method: Using this method, you compare the total
estimated number of units the fixed asset will produce over its expected
useful life with the number of units produced in the current accounting
period.
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BOOK 3 Adjusting and Closing Entries
Depletion, which is the annual expense for the use of natural resources, is also
based on actual physical use. Examples of natural resources that are subject to
depletion are oil, timber, and minerals.
Don’t worry; the sections that follow walk you through detailed examples of the
methods of depreciation. To show how the choice of a depreciation method affects
the amount of depreciation expense taken each year, each example uses the same
asset facts and circumstances.
For the purposes of calculating depreciation in this chapter, here are the facts and
circumstances for your sample fixed asset, a delivery van that the company buys
on January 1:
»» The cost basis of the asset: The earlier section “Delving into cost basis”
explains which costs to include in the cost basis — the total cost of the fixed
asset. The cost base of the delivery van is $30,000.
»» How long the company anticipates being able to use the fixed asset: The
company might measure the length in years, in production hours, or in miles
driven. For this example, the business anticipates using the delivery van for
5 years or 50,000 miles.
Depreciating Your
Assets
»» The value of the asset after the company is done using it (known as its
salvage value): The salvage value is an estimate that management makes for
how much the fixed asset will be worth when it’s retired. When the delivery
van is replaced, the company anticipates receiving $3,000 in trade-in value.
Cost basis less salvage value equals depreciable base: the dollar amount you
use to compute depreciation.
»» The depreciation method that the company uses: The method that the
business uses to depreciate should be appropriate for the asset. Accountants
apply the matching principle to match revenue with the expense incurred to
generate the revenue. For financial accounting, the standard of appropriateness is met if the company uses the method that most closely matches
expenses with revenue.
A business can’t arbitrarily switch methods after using one depreciation
method for an asset; doing so would involve changing the accounting method.
If you do choose to change an accounting method, you need to justify the
change. (See Book 1, Chapter 4 for more on selecting accounting methods.)
»» Date of purchase and whether the company is on a calendar or fiscal
year-end: The date is when the fixed asset is ready for use. Calendar year-end
is December 31. A fiscal year ends on the last day of any other month of the
company’s choice during the year. A fiscal year can be April 1 through
March 31, for example. This business has a calendar year-end of December 31.
The delivery van is purchased on January 1.
CHAPTER 1 Depreciating Your Assets
135
Ready? Well, start your engine, and let’s depreciate this delivery van!
Walking through the straight-line method
When you’re using the straight-line method, the salvage value reduces the depreciable base. So the cost of the delivery van ($30,000) less its salvage value ($3,000)
gives you a depreciable base of $27,000.
The expected useful life is 5 years, so depreciation expense for the van is $27,000/5
or $5,400 depreciation expense per year for each of the 5 years. Book value at the
end of year 5 is $3,000.
Accelerating by using declining balance
To depreciate an asset faster during the earlier years of its use than by using the
straight-line method, you can use the declining balance method. Several declining balance methods are available, but the double declining balance method is
used most often because it enables you to depreciate an asset at twice the rate of
the straight-line method. The double declining balance method is ideal for assets
whose primary utility is in the early years.
To calculate depreciation by using the double declining balance method, use this
formula:
2 × (1 ÷ Estimated useful life) × Book value at the beginning of the year =
Depreciation expense
Note that double declining balance calculates depreciation on cost ($30,000), not
depreciable base ($27,000). Also, the straight-line method spreads depreciation
evenly over 5 years, or 20 percent a year. Double declining balance multiplies the
cost by 40 percent — twice the 20 percent rate.
The calculation for the van’s depreciation expense in the first year, using the
declining balance method, is
2 × (1 ÷ 5) × $30,000 = $12,000
At the beginning of the second year, you need to reduce the value of the asset by
the year 1 depreciation amount, which in this example is $30,000 – $12,000 =
$18,000. $18,000 is your new book value. In other words, $18,000 is the amount
you plug into the formula to get year 2 depreciation. Plug that number into the
formula, and you get
2 × (1 ÷ 5) × $18,000 = $7,200
136
BOOK 3 Adjusting and Closing Entries
Perform the same calculation for the remaining years of useful life, and the fiveyear depreciation looks like this:
»» Year 1: $12,000
»» Year 2: $7,200
»» Year 3: $4,320
»» Year 4: $2,592
»» Year 5: $888
If you add the 5 years of depreciation in this example, the total is $27,000. You’ve
seen the number before: $30,000 cost less $3,000 salvage value. Your total depreciation using double declining balance can’t be more than cost less salvage value.
When you reach salvage value, you sell the asset. So depreciation stops at that
point.
Figure 1-1 shows how to figure double declining balance depreciation. Note that in
year 5, the 40 percent depreciation rate doesn’t matter because you have to limit
the depreciation to salvage value. Because the ending net book value is $3,888 in
year 4, depreciation is limited to $888 in year 5.
Depreciating Your
Assets
FIGURE 1-1:
A double
declining balance
depreciation
calculation.
© John Wiley & Sons, Inc.
Calculating sum-of-the-years’-digits
Like all methods of depreciation, the sum-of-the-years’-digits method of depreciation bases the depreciation rate on the useful life of the asset, but with a twist.
When you use this method, you depreciate the asset by adding the useful life years
(5 + 4 + 3 + 2 + 1 = 15) to get the denominator for the rate fraction. The numerator is the number of years remaining in the depreciation schedule. In year 1,
CHAPTER 1 Depreciating Your Assets
137
your multiplier is 5/15 (1/3); in year 2, the multiplier is 4/15; and so on. As with
straight-line depreciation, you back out the salvage value before you start, so
in this example, you start with $30,000 – $3,000 = $27,000. The depreciation
expense for the first year is
$27,000 × 5/15 or 1/3 = $9,000Here’s how sum-of-the-years’-digits depreciation
expense plays out for the delivery van over five years:
»» Year 1: $27,000 × 5/15 = $9,000 depreciation expense
»» Year 2: $27,000 × 4/15 = $7,200 depreciation expense
»» Year 3: $27,000 × 3/15 = $5,400 depreciation expense
»» Year 4: $27,000 × 2/15 = $3,600 depreciation expense
»» Year 5: $27,000 × 1/15 = $1,800 depreciation expense
Check the math: Adding up all 5 years of depreciation expense equals $27,000,
which is the cost of the delivery van minus the salvage value!
Using the units-of-production method
The units-of-production (UOP) method of depreciation works well primarily in a
manufacturing environment because it calculates depreciation based on the number of units produced in a year. Companies whose machinery use varies greatly
each year depending on the market and the number of units needed for sale
use this depreciation method. Finally, this method helps you match an expense
(depreciation expense) with revenue (sales of the items produced).
The formula for calculating depreciation by using units of production is a twostep process:
1.
Find the UOP rate by using this formula:
•
2.
(Cost – Salvage value) ÷ Estimated number of units to be produced during
estimated useful life = UOP rate
Find the depreciation expense by using this formula:
•
Units produced during the year × UOP rate = Depreciation expense
You need to use the UOP depreciation method only if you’re manufacturing the
products you sell and the use of your equipment fluctuates widely from year to
year.
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BOOK 3 Adjusting and Closing Entries
Here’s how this method works with the delivery van purchase example: The business anticipates using the delivery van for 50,000 miles over the course of the
5 years when a depreciation expense is to be deducted. First, find the cost of the
delivery van less salvage value: $30,000 – $3,000 = $27,000. Divide this figure by
your anticipated use: $27,000/50,000 miles equals 54 cents per mile. If the van
travels 8,000 miles in any given year, the depreciation expense for that year is
8,000 × $0.54 = $4,320
In essence, using this method for the delivery van gives you a standard mileage rate. If you’ve ever done your own tax return and had to figure your mileage
expense for charitable work you’ve done, the concept is the same.
Seeing how the methods compare
Just for fun, Figure 1-2 shows how the different depreciation methods result in
different amounts of depreciation expense per year. Notice that over the entire
5-year useful life, total depreciation is $27,000 regardless of the method used.
Thus, the different methods result in different depreciation expense amounts in
each of the years, but not in different total depreciation over the life of the asset.
More depreciation expense in an accounting period results in less net income, and
vice versa.
Figuring partial year depreciation
The delivery-van example was neat and clean because the company purchased
the van on January 1 (the first day of its fiscal year). What happens if the company
buys a fixed asset midyear? How do you figure depreciation expense for a partial
year?
Here’s the solution: You prorate the depreciation expense among the accounting
periods involved. If the company buys a delivery van on June 1, the first year of
depreciation is prorated by using the fraction 7/12 (because seven months remain
in the fiscal year). Any leftover depreciation is taken in year 6.
CHAPTER 1 Depreciating Your Assets
139
Depreciating Your
Assets
Pretty cool, huh? Depending on the depreciation method the company uses for the
fixed asset, depreciation expense can be all over the map. A business can use a different depreciation method for different types of assets as long as the depreciation
method fairly shows the use of the asset over time.
FIGURE 1-2:
Comparison of
depreciation
methods.
© John Wiley & Sons, Inc.
Consider the delivery van while using the straight-line method. Depreciation
expense in year 1 is now $3,150 ($5,400 × 7/12). For years 2 through 5, the depreciation expense remains $5,400. In year 6, you finish by expensing the remaining
$2,250 ($5,400 × 5/12).
The journal entry (see Book 1, Chapter 3) to book depreciation is made to debit
depreciation expense and credit accumulated depreciation.
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BOOK 3 Adjusting and Closing Entries
Tackling Taxes and Depreciation
Depreciation calculations for tax purposes are completely different animals from
the calculations used to record depreciation for accounting purposes. You can
use straight-line depreciation to calculate your depreciation expense for book
(accounting record) purposes. Many businesses, however, use an accelerated
method of depreciation for tax purposes. These companies prefer to write off
the highest expense legally permissible and reduce their tax bills by the greatest
amount as soon as possible.
Accountants reconcile differences between the accounting records (book) and the
tax return (tax). You may hear accountants discussing book versus tax issues. One
issue that causes these differences is the treatment of depreciation. The reconciliation process isn’t discussed in this book, but you should keep this concept in
mind.
Section 179
Section 179, which gets its name from a section of the tax code, is a great boon for
companies. Businesses can write off up to 100 percent of the full purchase price
of the property.
The primary reason for this part of the tax code is to encourage businesses to buy
new property to stimulate the economy. For that reason, only certain types of
property are included, and the tax code limits the amount that can be deducted for
some types of property.
Basically, Section 179’s qualifying property includes tangible property such as
machines, equipment, and furniture. In addition, some storage facilities qualify.
Cars and sport-utility vehicles between 6,000 and 14,000 pounds can be partially
written off under Section 179.
CHAPTER 1 Depreciating Your Assets
141
Depreciating Your
Assets
In addition to straight-line depreciation, two acceptable IRS methods for writing off assets are Section 179 and Modified Accelerated Cost Recovery System
(MACRS). The big advantage of the Section 179 deduction is that you can write
off up to 100 percent of the cost basis of qualifying property. If the property
doesn’t qualify under Section 179, many businesses choose to use MACRS rather
than straight-line depreciation. The following sections describe Section 179 and
MACRS depreciation in greater detail.
You can get full details about Section 179 by ordering a copy of IRS Publication
946, How to Depreciate Property, or accessing it online at www.irs.gov/pub/irspdf/p946.pdf. If you’re a business owner, work with your accountant to determine what’s eligible and how much of the cost basis is eligible for the Section 179
deduction.
MACRS
The most common type of depreciation write-off used by businesses is Modified
Accelerated Cost Recovery System (MACRS). The recovery period shown in
Table 1-1 earlier in this chapter is the basis for this depreciation method. After
you know what type of property you have (three-year, five-year, and so on), you
use the MACRS table in IRS Publication 946, How to Depreciate Property, to figure
out the depreciation expense you can write off. If you’re a business owner, you
can leave MACRS calculations for your accountant to do when they prepare your
business tax forms.
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BOOK 3 Adjusting and Closing Entries
IN THIS CHAPTER
»» Understanding interest calculations
»» Making the most of interest income
»» Calculating loan interest
Chapter
2
Interesting Rates
F
ew businesses are able to make major purchases without taking out loans.
Whether loans are for vehicles, buildings, or other business needs, businesses must pay their lenders interest: a percentage of the amount loaned.
Some businesses also loan money to borrowers and receive interest payments as
income. In fact, a savings account can be considered to be a type of loan because
by placing your money in the account, you’re giving the bank the opportunity to
loan that money to others. That interest is income for your company.
This chapter reviews different types of loans and shows how to calculate and
record interest expenses for each type. It also explains how to calculate and record
interest income in your business’s books.
Deciphering Types of Interest
Any time you make use of someone else’s money (whether that someone else is a
person or a bank), you have to pay interest for that use, whether you’re buying a
house, a car, or some other item you want. The same is true when someone else is
using your money. When you buy a corporate bond or deposit money in a money
market account, for example, you’re paid interest for allowing someone to use
your funds.
CHAPTER 2 Interesting Rates
143
The financial institution that has your money will likely combine your money with
that of other depositors and loan it to other people to make more interest than it’s
paying you. A corporation will use the proceeds from the bond issue to finance its
expansion. The company wants to generate more in earnings than it will pay in
interest expense.
Financial institutions use two types of interest calculations:
»» Simple interest is calculated only on the principal amount of the loan.
»» Compound interest is calculated on the principal and on the interest
previously earned.
Simple interest
Simple interest is simple to calculate. Here’s the formula for calculating simple
interest:
Principal × Interest rate × n = Interest
The n in the equation stands for number of periods. To understand how interest is
calculated, assume that someone deposited $10,000 in the bank in a money market account earning 3 percent (0.03) interest for 3 years. So the interest earned
over 3 years is $10,000 × 0.03 × 3 = $900.
Compound interest
Compound interest is computed on both the principal and any interest earned. You
must calculate the interest each year and add it to the balance before you can calculate the next year’s interest payment, which will be based on both the principal
and the interest earned.
Here’s how you calculate compound interest:
Principal × Interest rate
=
Interest for year 1
(Principal + Year 1 interest earned) × Interest rate
=
Interest for year 2
(Principal + Years 1 and 2 interest earned) × Interest rate
=
Interest for year 3
You repeat this calculation for all years of the deposit or loan. Compound interest assumes that interest payments are reinvested and earn additional interest.
Compounding means that you’re earning interest on a larger investment amount.
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BOOK 3 Adjusting and Closing Entries
To understand how compounding interest affects your earnings, notice how the
amount of interest changes from each year to the next on a 3-year deposit of
$10,000 at 3 percent (0.03):
$10,000 × 0.03
=
$300.00 (Year 1 interest)
($10,000 + 300) × 0.03
=
$309.00 (Year 2 interest)
($10,000 + 300 + 309) × 0.03
=
$318.27 (Year 3 interest)
Total interest earned
=
$927.27
You can see that you earn an extra $27.27 during the first three years of the deposit
if interest is compounded. When you’re working with much larger sums or higher
interest rates for longer periods, compound interest can make a big difference in
how much you earn or how much you pay on a loan. Financial professionals refer
to this concept as earning interest on interest.
The Rule of 72 is a tool you can use to remember how compound interest works:
72 divided by the rate of compound interest gives you the number of years it will
take for your money to double. If the rate of compound interest is 6 percent, for
example, your money will double in 72 ÷ 6, or 12 years. The higher the compound
interest rate is, the faster your money will double. At 12 percent, your money
doubles in 72 ÷ 12, or 6 years.
Ideally, you want to find a savings account, certificate of deposit, or other savings
instrument that earns compound interest. But if you want to borrow money, look
for a simple-interest loan (see the preceding section).
Monthly compounding means that interest earned is calculated each month and
added to the principal each month before the next month’s interest is calculated, resulting in a lot more interest than you’d get from a bank that compounds
interest just once a year. Likewise, opt for loans that compound interest annually
instead of quarterly or monthly.
Hybrid interest
Particularly in “exotic” financial products (the term exotic here refers to financial products that are engineered for specific purposes and tend to be rare or
otherwise very specific), interest rates may combine elements of fixed-rate and
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Interesting Rates
Also, not all accounts that earn compound interest are created equal. Watch carefully to see how frequently the interest is compounded. The preceding example
assumes that interest is compounded annually. But if you can put your money in an
account that compounds interest monthly, the interest you earn will be even higher.
variable-rate interests. Phrases like “introductory rates” refer to loans that
maintain a low fixed rate for a specified period of time, after which the rate will
increase dramatically via a variable-rate calculation. Some investment products
guarantee a minimum return of some rate that is fixed, with the potential to earn
more depending on how the stock market (or some other measured index of economic growth) is performing. There are a wide variety of ways to combine fixed
and variable rate financial products, and they all fall into the category of hybrid
interest rate products.
Hybrid interest rates do have a valid place in the world of accounting and finance,
but they’re very often also used in a manipulative manner. Very attractive rates
of interest are offered to lure people into agreements that they aren’t expected to
understand fully or that will be difficult to change after the introductory period.
Handling Interest Income
The income that your business earns from its savings accounts, certificates of
deposits, or other investment vehicles is called interest income. As the bookkeeper,
you’ll rarely be required to calculate interest income by using the simple interest
or compounded interest formulas described in earlier sections of this chapter. In
most cases, the financial institution sends you a monthly, quarterly, or annual
statement that has a separate line item reporting interest earned.
When you get your monthly statement, you reconcile the books — your accounting records. Reconciliation is a process in which you prove out whether your bank
balance (on the bank statement) is equal to the cash balance in your accounting
records. For more about reconciling bank accounts, see Book 3, Chapter 4.
One step in the reconciliation process involves recording any bank activity that
may not be posted to your books. Often, companies wait until they get the bank
statement to post certain bank transactions. Two common transactions are interest earned and bank fees. You might post these entries after you receive the
monthly bank statement.
If you’re keeping the books manually, a journal entry to record interest income
would look similar to this example:
Debit
Cash
Interest income
To record interest income from American Savings Bank
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BOOK 3 Adjusting and Closing Entries
Credit
$100
$100
To record bank fees, you’d debit (increase) an expense account and credit cash
(a decrease). You pay bank fees in cash via your bank account.
When preparing financial statements, you show interest income on the income
statement in a section called Other Income. (See Book 4, Chapter 1 for more information about the income statement.) Other Income includes any income your
business earned that wasn’t directly related to your primary business activity:
selling your goods or services.
Delving into Loans and Interest Expenses
Businesses borrow money for both short-term periods (less than 12 months) and
long-term periods (more than 12 months). Short-term debt usually involves some
form of credit card debt or line-of-credit debt. Long-term debt can include a
5-year car loan, 20-year mortgage, or any other type of debt paid beyond one year.
Short-term debt
Any money due in the next 12-month period is shown on the balance sheet as
short-term or current debt. Any interest paid on that money is shown as an interest expense on the income statement.
For the purposes of this book, a current asset represents cash or items that will be
converted to cash within one year. Current liabilities will be paid in cash within one
year. Your firm’s ability to manage current assets and make timely payments on
current liabilities is referred to as liquidity. Check out Book 5 Chapter 3 to find out
more about liquidity.
Calculating credit card interest
When you get a credit card bill at home, a line always shows you new charges,
the amount to pay in full to avoid all interest, and the amount of interest charged
during the current period on any money not paid from the previous bill. If you
don’t pay your credit card in full, interest on most cards is calculated by using a
daily periodic rate of interest, which is compounded each day based on the unpaid
balance. When the balance isn’t paid in full, interest is calculated on the unpaid
principal balance plus any unpaid interest. Table 2-1 shows what a typical interest
calculation on a credit card looks like.
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147
Interesting Rates
In most cases, you don’t have to calculate your interest due. The financial institution that sends you a bill gives you a breakdown of the principal and interest to
be paid.
Credit Card Interest Calculation
TABLE 2-1
Average
Daily Balance
Daily
Periodic Rate
Corresponding
Annual Rate
Purchases
$1,000
0.033973%
Cash
$200
0.045178%
Finance Charges
Daily Rate
Transaction Fees
12.40%
$0.34
$50
16.49%
$0.09
$20
On many credit cards, you start paying interest on new purchases immediately, if
you haven’t paid your balance due in full the previous month. When you’re opening a credit card account for your business, be sure you understand how interest
is calculated and when the bank starts charging on new purchases. Some issuers
offer a grace period of 20 to 30 days before charging interest.
In Table 2-1, the finance charges include the daily rate charged in interest based
on the daily periodic rate plus any transaction fees. If you take a cash advance on
your credit card, for example, many credit card companies charge a transaction
fee of 2 to 3 percent of the total amount of cash taken. This fee may also apply
when you transfer balances from one credit card to another.
Although the company entices you with an introductory rate of 1 or 2 percent to
get you to transfer the balance, be sure to read the fine print. You may have to
pay a 3 percent transaction fee on the full amount transferred, which makes the
introductory rate much higher.
Using credit lines
As a small-business owner, you generally get better interest rates by using a line
of credit with a bank than with a credit card. Interest rates are usually lower on
lines of credit. Typically, a business owner uses a credit card for purchases, but if
they can’t pay the bill in full, they draw money from their line of credit rather than
carry over the credit card balance.
When the money is first received from the credit line, you record the cash receipt
and the liability. Just to show you how this transaction works, here’s a sample
journal entry for the receipt of a credit line of $1,500:
Debit
Cash
Credit line payable
To record receipt of cash from credit line
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Credit
$1,500
$1,500
In this entry, you increase the cash account and the credit line payable account
balances.
When you make your first payment, you must record the use of cash, the amount
paid on the principal of the loan, and the amount paid in interest. Here’s what that
journal entry looks like:
Debit
Credit line payable
$150
Interest expense
$10
Cash
Credit
$160
To make monthly payment on credit line
This journal entry reduces the amount due in the credit line payable account,
increases the amount paid in the interest expense account, and reduces the
amount in the cash account.
If you’re using a computerized system, you simply complete a check form and
indicate which accounts are affected by the payment. The system updates the
accounts automatically.
When you prepare the check for printing in an automated system, you can add the
accounts that are affected by the payment. Then your accounting system can print
the check and update all affected accounts. You don’t need to do any additional
postings to update your books.
Long-term debt
Long-term debt also plays a role in determining a company’s solvency — its ability
to manage cash inflows and make timely payments on its long-term debt. Head
over to Book 5, Chapter 3 to find out more about solvency.
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149
Interesting Rates
Most companies take on some form of long-term debt — debt to be paid over a
period longer than 12 months. This debt may include car loans, mortgages, or
promissory notes. A promissory note is a written agreement stating that you agree
to repay someone a set amount of money at some point in the future at a particular interest rate. The term can be monthly, yearly, or some other period specified
in the note. Most installment loans are types of promissory notes.
Recording a debt
When the company first takes on a long-term debt, it’s recorded in the books in
much the same way as a short-term debt:
Debit
Cash
Credit
$500
Notes payable
$500
To record receipt of cash from American Bank promissory note
Payments are also recorded in a manner similar to short-term debt:
Debit
Notes payable
$100
Interest expense
$5
Cash
Credit
$105
To record payment on American Bank promissory note
Although the way you enter the initial information isn’t very different, a big difference exists between how short- and long-term debts appear on the financial
statements. All short-term debt appears in the Current Liability section of the
balance sheet.
Long-term debt is split and appears in different line items. The portion of the debt
due in the next 12 months appears in the Current Liabilities section, which usually is a line item named something like “Current portion of long-term debt.” The
remaining balance of the long-term debt due beyond the next 12 months appears
in the long-term liability section of the balance sheet as notes payable.
Considering major purchases and long-term debt
Sometimes, a long-term liability is set up at the same time that you make a major
purchase. You may pay some portion of the amount due in cash as a down payment
and the remainder as a note. To see how to record such a transaction, assume that
a business purchased a truck for $25,000, made a down payment of $5,000, and
signed a 5-year (60-month) promissory note at an interest rate of 6 percent for
$20,000. Here’s how you record this purchase in the books:
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BOOK 3 Adjusting and Closing Entries
Debit
Vehicles
Credit
$25,000
Cash
$5,000
Notes payable – vehicles
$20,000
To record payment for the purchase of the blue truck
Then you record payments on the note in the same way that you do for any other
loan payment:
Debit
Notes payable – vehicles
$2,000
Interest expense
$300
Cash
Credit
$2,300
To record payment on the purchase of the blue truck
Separating principal and interest
Some banks provide an amortization schedule automatically when you sign all the
paperwork for the note. If your bank can’t give you one, you can easily generate
one online by using an amortization calculator. BankRate.com has a good one at
www.bankrate.com/calculators/mortgages/amortization-calculator.aspx.
You can use that calculator to generate an amortization schedule for the entire
60-month term of the loan, showing the principal and interest breakdown for
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151
Interesting Rates
When you’re recording the payment on a long-term debt for which you have a
set installment payment, you may not get a breakdown of interest and principal
with every payment. When you take out a car loan, for example, you may receive a
coupon book with just the total payment due each month. Each payment includes
both principal and interest, but you don’t get any breakdown detailing how much
goes toward interest and how much goes toward principal, which may change
with each payment. (With many loans, you pay a greater portion of interest earlier
in the term, so banks can collect their interest earlier and receive a greater portion
of the principal with later payments.) To record long-term debt for which you
don’t receive a breakdown each month, you need to ask the bank that gave you
the loan for an amortization schedule, create your own amortization schedule, or
enter the details of the loan into your accounting program. An amortization schedule lists the total payment, the amount of each payment that goes toward interest,
the amount that goes toward principal, and the remaining balance to be paid on
the note.
each payment. Table 2-2 displays payment information for each of the first
six months. As you can see, the amount paid to principal on a long-term note
increases gradually, and the amount of interest paid decreases gradually as the
note balance is paid off.
TABLE 2-2
Six-Month Amortization Chart for Truck Payments
Total Payment
Principal
Interest
Remaining Note Balance
$386.66
$286.66
$100.00
$19,713.34
$386.66
$288.09
$98.57
$19,425.25
$386.66
$289.53
$97.13
$19,135.72
$386.66
$290.98
$95.68
$18,844.75
$386.66
$292.43
$94.22
$18,552.32
$386.66
$293.89
$92.76
$18,258.42
Looking at the six-month amortization chart, here’s what you’d need to record in
the books for the first payment on the truck:
Debit
Notes payable – vehicles
$286.66
Interest expense
$100.00
Cash
Credit
$386.66
To record payment on note for blue truck
In reading the amortization chart in Table 2-2, notice that the amount paid toward
interest is slightly less each month as the balance on the note still due is gradually reduced. By the time you start making payments for the final year of the loan,
interest costs drop dramatically, because the principal balance is so much lower.
As you lower your principal balance, much less of your payment goes toward
interest, and much more goes toward reducing principal. That’s why many financial specialists advise you to pay down principal as fast as possible if you want
to reduce the term of a loan and, more important, the total amount you end up
paying in interest.
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IN THIS CHAPTER
»» Understanding the purpose of closing
out cash
»» Counting your company’s cash
»» Finalizing the cash journals
»» Using temporary posting journals
Chapter
3
Proving Out Cash
T
he process of verifying the accuracy of your cash is called proving out the
cash. Any accounting system is susceptible to mistakes, and unfortunately,
any business can fall victim to incidents of theft or embezzlement. One way
to minimize the risk is to prove out the cash periodically.
This chapter explains how to ensure the cash counts are accurate, finalize the
cash journals for the accounting period, prove out the bank accounts, and post any
adjustments or corrections to the general ledger.
Making Sure That Ending Cash Is Right
Testing your books starts with counting your cash. Why start with cash? For
most businesses, the cash account has more transactions than any other account.
More transactions in an account can mean a higher risk of error. Also, cash is the
asset that’s most susceptible to theft. If you prove your cash balance first, you’re
addressing your most difficult account first. Before you can even begin to test
whether the books are right, you need to know whether your books have captured
what’s happened to your company’s cash and whether the amount of cash shown
in your books actually matches the amount of cash you have on hand.
CHAPTER 3 Proving Out Cash
153
Accountants spend a lot of time looking at business transactions and considering
which accounts are affected. When mulling over a transaction, ask yourself “Did
anything happen to cash?” Because cash is so often affected by business activity,
this approach helps you post the activity to the right accounts.
Book 2, Chapter 3 discusses how a business proves out the cash taken in by each of
its cashiers. That process gives a business good control of the point at which cash
comes in the door. The cashier accepts cash from customers who buy the company’s products or services. Cashiers also process cash refunds given to customers
who returned items. So proving cash handled by cashiers is important. But the
points of sale and return aren’t the only times cash comes into or goes out of the
business. If your business sells products on store credit (see Book 2, Chapter 3),
you (or the bookkeeping staff responsible for tracking customer credit accounts)
collect some of the cash from customers later. And when your business needs
something — whether products to sell or supplies for various departments — you
must pay cash to vendors, suppliers, and contractors. Sometimes, you pay cash on
the spot, but many times, you record the bill in the accounts payable account and
pay it at a later date.
Your amount of cash on hand at any one time includes not only what’s in the cash
registers, but also what’s on deposit in the company’s bank accounts. You need
to know the balances of those accounts and test those balances to be sure they’re
accurate and match what’s in your company’s books.
Some departments also have petty-cash accounts, requiring you to total that cash
as well. The total cash figure is what you report as an asset called Cash on the
first line of your company’s balance sheet. The balance sheet shows all that the
company owns (its assets) and owes (its liabilities), as well as the equity the owners have in the company. (To find out more about the balance sheet and how you
prepare one, see Book 4, chapters 3–5.)
The balance sheet is always generated on a specific day to provide a snapshot in
time. The income statement, on the other hand, displays your profit and loss for
a specific period (month or year). If you try to generate a balance sheet for the
month of June, you’ll get an error message. Likewise, if you ask your system to
produce an income statement for June 15, you’ll get another error message.
If you’re preparing monthly financial reports at the end of the month, you test the
amount of cash your business has on hand as of that certain time and day, such
as 6 p.m. on June 30 after your store closes for the day. The rest of the testing
process — running a trial balance, creating a worksheet, adjusting journal entries,
closing the books, and creating financial statements — is based on what happened
before that point in time. When you open the store the next day, sell more products, and buy new things to run your business, those transactions and any others
that follow your test become part of the next accounting cycle.
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Closing the Cash Journals
As explained in Book 1, Chapter 3, you can find a record of every transaction that
involves cash in one of two cash journals: the cash receipts journal (cash that
comes into the business) and the cash disbursements journal (cash that goes out
of the business).
If you use a computerized accounting system, you have many additional ways
to find the same information. You can run reports of sales by customer, item, or
sales representative. You can also run reports that show you all the company’s
purchases by vendor or item, as well as list any purchases that are still on order.
Cash receipts should be debited to increase cash. In the same way, cash disbursements are credited to reduce cash. If you identify all the cash receipts and disbursements, you should be able to match those transactions with the debits and
credits.
A typical automated accounting system can generate purchase reports, which you
can by the week, month, quarter, or year. You can also customize the reports to
show a particular period of time that you’re analyzing. If you want to know what
purchases occurred between June 5 and 10, you can run a report specifying those
exact dates. You have the same capability to generate sales reports.
In addition to the sales and purchase reports, you can generate transaction detail
reports, including customers and receivables; jobs, time, and mileage; vendors
and payables; inventory; employees and payroll; and banking. One big advantage
of a computerized accounting system when you’re trying to prove out your cash is
the number of ways you can develop reports to check for accuracy in your books
if you suspect an error.
Although the ability to generate tons of information is great, try to avoid information overload. Get training on your accounting system so you can access the
most meaningful and useful reports quickly. Knowing how to generate the most
useful reports quickly will save you time. Don’t create ten sales reports if you use
only two.
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Proving Out Cash
The actual cash you have on hand is just one tiny piece of the cash moving through
your business during the accounting period. The true detail of what cash has
flowed into and out of the business is in your cash journals. Closing those journals
is the next step in the process of figuring out how well your business is doing.
Finalizing cash receipts
If all your books are up to date, when you summarize the cash receipts journal to
prove out your cash, you should come up with a total of all cash received by the
business at that time. Up-to-date books ensure that all cash receipt transactions
are posted to your accounting system.
Unfortunately, in the real world of bookkeeping, things don’t always come out
so nice and neat. In fact, you probably wouldn’t even start entering the transactions from that particular day into the books until the next day, when you enter
the cash reports from all cashiers and others who handle incoming cash (such as
the accounts receivable staff who collect money from customers buying on credit)
into the cash receipts journal.
After entering all the transactions from the day in question, the books for the period
you’re looking at may still be incomplete. Sometimes, adjustments or corrections
must be made to the ending cash numbers. Monthly credit card fees and interest
received from the bank may not yet be recorded in your cash journals, for example.
As the bookkeeper or accountant, you must be sure that all bank fees are recorded
to the cash disbursement journal. Interest earned is recorded in the cash receipts
journal. After posting those entries, you can summarize the journals for the period
you’re analyzing.
Remembering credit card fees
When your company allows customers to use credit cards, you must pay fees to
the bank that processes these transactions, which is probably the same bank that
handles all your business accounts. These fees actually lower the amount you take
in as cash receipts, so the amount you record as a cash receipt must be adjusted
to reflect those costs of doing business. Monthly credit card fees vary greatly,
depending on the bank you’re using and other factors, but here are some of the
most common fees your company should expect:
»» The address verification service (AVS) fee is a fee that companies pay if
they want to avoid accepting fraudulent credit card sales. Businesses that
use this service take orders by phone or email; therefore, they don’t have the
credit card in hand to verify a customer’s signature. Banks charge this fee for
every transaction that’s verified.
»» Chargeback and retrieval fees are charged if a customer disputes a
transaction and wins the dispute.
»» Customer support fees are charged to companies that want bank support
for credit card transactions 24 hours a day, 365 days a year. Companies such
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BOOK 3 Adjusting and Closing Entries
Proving Out Cash
as mail-order catalogs that allow customers to place orders 24 hours a day
look for this support. Sometimes, companies want this support in more than
one language if they sell products internationally.
»» The discount rate is a fee that all companies using credit cards must pay; it’s
based on a percentage of the sale or return transaction. The rate your
company may be charged varies greatly, depending on the type of business
you conduct and the volume of your monthly sales. Companies that use a
terminal to swipe cards and send transaction information electronically
usually pay lower fees than companies that use paper credit card transactions, because the electronic route creates less work for the bank and
eliminates the possibility of key-entry errors by employees.
»» Equipment and software fees are charged to your company if you lease
credit card equipment and related software from the bank. You may have the
option of buying the equipment and software for a one-time charge instead.
»» The monthly minimum fee is the smallest amount a business is required to
pay for the ability to offer its customers the convenience of using credit cards
to buy products.
»» The secure payment gateway fee, which allows merchants to process
transactions securely, is charged to companies that transact business over the
Internet. If your business sells products online, you can expect to pay this fee
based on a set monthly amount.
»» The transaction fee is a standard fee charged to your business for each
credit card transaction you submit for authorization. You pay this fee even if
the cardholder is denied and you lose the sale.
Reconciling your credit card statements
Each month, the bank that handles your credit card sales will send you a statement listing
»» All your company’s transactions for the month
»» The total amount your company sold through credit card sales
»» The total fees charged to your account
If you find a difference between what the bank reports was sold on credit cards
and what the company’s books show regarding credit card sales, it’s time to play
detective and find the reason for the difference. In most cases, the error involves
the charging back of one or more sales because a customer successfully disputes
the charge. In this case, the cash receipts journal is adjusted to reflect that loss
of sale, and the bank statement and company books should match. Suppose that
CHAPTER 3 Proving Out Cash
157
$200 in credit card sales were disputed. The original entry of the transaction in
the books should look like this:
Debit
Sales
Credit
$200
Cash
$200
To reverse disputed credit card sales recorded in June
This entry reduces the total sales for the month as well as the amount of the cash
account. If the dispute is resolved and the money is later retrieved, the sale is
reentered when the cash is received.
You also record any fees related to credit card fees in the cash disbursements
journal. If credit card fees for the month of June total $200, the entry in the books
should look like this:
Debit
Credit card fees
Credit
$200
Cash
$200
To record credit card fees paid for the month of June
Summarizing the cash receipts journal
When you’re sure that all cash receipts and any corrections or adjustments to
those receipts have been entered properly in the books (see the previous two sections), you summarize the cash receipts journal, as explained in detail in Book 1,
Chapter 3. After summarizing the cash receipts journal for the accounting period
you’re analyzing, you know the total cash that was taken into the business from
sales as well as from other channels.
A customer who buys a product either pays at the time of purchase or on credit. So
in the cash receipts journal, sales usually appear in two columns:
»» Sales: The cash shown in the Sales column is cash received when the
customer purchases the goods by using cash, check, or bank credit card.
»» Accounts Receivable: The Accounts Receivable column is for sales in which
no cash was received when the customer purchased the item. Instead, the
customer bought on credit and intends to pay cash at a later date. (For more
about accounts receivable and collecting money from customers, see Book 2,
Chapter 3.)
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BOOK 3 Adjusting and Closing Entries
In addition to the sales and accounts receivable columns, your cash receipts journal should have these two columns:
»» General: The General column lists all other cash received, such as owner
investments in the business.
»» Cash: The Cash column contains the total of all cash received by the business
during an accounting period.
Finalizing cash outlays
After you close the cash receipts journal (refer to “Summarizing the cash receipts
journal” earlier in this chapter), the next step is closing the cash disbursements
journal. Any adjustments related to outgoing cash receipts, such as bank credit
card fees, should be added to the cash disbursements journal. Before you close the
journal, you must also be certain that any bills paid at the end of the month have
been added.
Bills that are related to financial activity for the month being closed but that
haven’t yet been paid have to be accrued (recorded in the books) so that they can
be matched with the revenue for the month. These accruals are necessary only
if you use the accrual accounting method. If you use the cash-basis accounting
method, you need to record the bills only when cash is actually paid. For more on
the accrual and cash-basis methods, see Book 1, Chapter 4.
You accrue bills yet to be paid in the accounts payable account. Suppose that your
company prints and mails flyers to advertise a sale during the last week of the
month. A bill for the flyers totaling $500 hasn’t been paid yet. Here’s how you
enter the bill in the books:
Debit
Advertising
Credit
$500
Accounts payable
$500
To accrue the bill from Jack’s Printing for June sales flyers
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159
Proving Out Cash
After you add all receipts to the cash receipts journal, entries for items bought
on store credit can be posted to the accounts receivable journal and the individual customer accounts. Then you send bills to customers that reflect all transactions from the month just closed, as well as any payments still due from previous
months. Billing customers is a key part of the closing process that occurs each
month.
This entry increases advertising expenses for the month and increases the amount
due in accounts payable. When you pay the bill, the accounts payable account is
debited (to reduce the liability), and the cash account is credited (to reduce the
amount in the cash account). You make the actual entry in the cash disbursements
journal when the cash is paid out.
When proving out the cash, also review any accounts in which expenses are
accrued for later payment, such as sales tax collected, to be sure that all accrual
accounts are up to date. These tax accounts are actually liability accounts for taxes
that will need to be paid in the future. If you use the accrual accounting method,
the expenses related to these taxes must be matched with the revenue collected
for the month in which they’re incurred.
Using a Temporary Posting Journal
Some companies use a temporary posting journal to record payments that are
made without full knowledge of how the cash outlay should be posted to the books
and which accounts will be affected. A company that uses a payroll service probably has to give that service a certain amount of cash to cover payroll, even if it’s
not yet known exactly how much is needed for taxes and other payroll-related
costs.
In this payroll example, cash must be disbursed, but transactions can’t be entered
into all affected accounts until the payroll is done. Suppose that a company’s payroll is estimated to cost $15,000 for the month of May. The company sends a check
to cover that cost to the payroll service and posts the payment to the temporary
posting journal.
After the payroll is calculated and completed, the company receives a statement of
exactly how much was paid to employees and how much was paid in taxes. After
the statement arrives, allocating the $15,000 to specific accounts such as payroll
expenses or tax expenses, that information is posted to the cash disbursements
journal.
If you decide to keep a temporary posting journal to track cash coming in or
going out, before summarizing your cash disbursements journal and closing the
books for an accounting period, be sure to review the transactions listed in the
temporary posting journal that may need to be posted in the cash disbursements
journal.
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IN THIS CHAPTER
»» Monitoring accounts and making
adjustments
»» Confirming that your journals are
correct
»» Gathering journal information for
closing
»» Posting adjustments to the general
ledger
»» Examining your journals in a
computerized system
Chapter
4
Reconciling Accounts
and Closing Journal
Entries
W
hen it comes to your bookkeeping, especially if you keep your books
manually, the finickier details are in the accounts and journals you
keep. Any errors in those tiny details can lead to big problems down
the road.
In this chapter, you’ll find out how you can ensure that your books are meticulous
and correct. I’ll show you how to reconcile your accounts, prove out your journals,
and close them at the end of an accounting period. Within these pages, you also
find out how to post all corrections and adjustments to the general ledger after
you make them in the appropriate journal. (To find out how to set up your journals, see Book 1, Chapter 3.)
CHAPTER 4 Reconciling Accounts and Closing Journal Entries
161
Reconciling Bank Accounts
Reconciling bank accounts involves verifying whether the cash balance in your
accounting records agrees with the cash balance on your bank statement. Accountants use the phrase balance per book to refer to the cash balance in the accounting records. Balance per bank refers to your cash balance according to the bank
statement.
Reconcile all bank accounts within a few days of getting access to the bank statements. Your cash account may contain more accounting activity than any other
account, so monitoring your bank transactions closely is critical. Reconciling your
bank account allows you to identify and correct any errors and to detect fraudulent
transactions early.
Table 4-1 walks you through the bank reconciliation process. You’ve probably reconciled your personal checking account at least a few times over the years, and
you’ll be happy to hear that reconciling business accounts is a similar process that
goes something like this:
1.
Set up bank reconciliation template.
Set up a template with two columns. The bank statement column represents
bank activity, and the cash account column lists information from your
accounting records. Post the beginning balances at the top. The bank balance
is taken from the bank statement. The cash balance is the ending balance from
your cash account.
2.
Mark cleared transactions.
Compare the transactions in your cash accounting records with the bank
statement, and mark cleared transactions — transactions that appear both in
the bank records and in your records. Because your book balance (accounting
records) agrees with the bank statement, you don’t need to do anything further
with these transactions. Note, however, that you’re not finished with the
reconciliation process.
3.
Note deposits in transit.
Deposits in your cash account that aren’t listed in the bank statement are
called deposits in transit. Post the total dollar amount as an addition to the bank
column. In Table 4-1, deposits in transit total $300.
4.
Post outstanding checks.
Checks that aren’t posted to the bank statement are considered to be outstanding checks. Post the total dollar amount as a subtraction from the bank column.
In Table 4-1, outstanding checks total $600.
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BOOK 3 Adjusting and Closing Entries
5.
Review the bank activity that isn’t posted to the cash account.
Some transactions in your bank statement may not be posted to the cash
account. In Table 4-1, $20 in bank interest is added to the cash balance —
because the interest isn’t yet posted to the cash account. If you have bank fees,
you subtract those fees from the cash account column.
6.
Compare the bank and cash balances.
TABLE 4-1
Bank Reconciliation
Bank Statement
Cash Account
Starting balance
$1,020
$700
Deposits in transit (not shown on statement)
$300
Outstanding checks (not shown on statement)
($600)
Interest (on statement but not posted to books)
Adjusted balance
$20
$720
$720
Table 4-1 shows a common format for reconciling a bank account. It includes
three reconciling items (entries accounted for on the statement but not on the
books, or vice versa): outstanding checks, deposits in transit, and bank interest.
Tracking down reconciling items
Often, your book balance and the bank statement balance don’t agree. That’s
okay, because reconciling items are common. You just need to adjust for uncleared
transactions. Here’s a more complete list of reconciling items:
»» If the adjusted bank balance is higher than your balance, check to be sure
that all the deposits listed by the bank appear in the cash account in your
books. If you find that the bank lists a deposit that you don’t have, do some
detective work to figure out what that deposit was for, and add the detail to
your accounting records. Also, make sure that you’ve recorded all outstanding
debits and added those amounts (as negative values) to the ending balance
on the bank statement.
CHAPTER 4 Reconciling Accounts and Closing Journal Entries
163
Reconciling Accounts and
Closing Journal Entries
If you’ve reconciled properly, the bank balance should agree with the cash
balance. In the table, both ending balances are $720. Your cash account is
reconciled with the bank statement. If the balances don’t agree, you have more
reconciling items to investigate.
»» If the bank balance is lower than your balance, verify that all checks listed
by the bank are recorded in your cash account. You may have missed one or
two checks that were written but not recorded properly. You also may have
missed a deposit that you’ve listed in your cash account but the bank hasn’t
listed on the statement yet. If you notice a missing deposit on the bank
statement, be sure that you have your proof of deposit and confirm with
the bank that the cash is in the account.
»» If all deposits and checks are correct, but you still see a difference,
your only option is to make sure that all checks and deposits were entered
correctly (not entered twice by mistake or for a different dollar amount, for
example), and check your calculations.
Using a computerized system
If you use a computerized accounting system, reconciliation should be much
easier than if you keep your books manually. In QuickBooks, for example, when
you start the reconciliation process, you see a screen in which you can enter the
ending bank statement balance and any bank fees or interest earned. Figure 4-1
shows you that screen.
FIGURE 4-1:
Displaying the
­reconciliation
process in
QuickBooks.
Intuit.com
After you click Continue, you get a screen that lists all checks written since the
last reconciliation, as well as all deposits. You put a check mark next to the checks
and deposits that have cleared on the bank statement, as shown in Figure 4-2,
and then click Reconcile Now.
QuickBooks automatically reconciles the accounts and provides reports that
indicate any differences. It also provides a reconciliation summary (shown in
Figure 4-3) that includes the beginning balance, the balance after all cleared
164
BOOK 3 Adjusting and Closing Entries
transactions have been recorded, and a list of all uncleared transactions. QuickBooks also calculates what your check register should show when the uncleared
transactions are added to the cleared transactions.
Reconciling Accounts and
Closing Journal Entries
FIGURE 4-2:
To reconcile
checking by using
QuickBooks, put a
check mark next
to all the checks
and deposits that
have cleared the
account and
then click
Reconcile Now.
Intuit.com
FIGURE 4-3:
After you
reconcile your
accounts,
­QuickBooks
­automatically
provides a
reconciliation
summary.
Intuit.com
Posting Adjustments and Corrections
After you close out the cash receipts and cash disbursements journals and reconcile
the bank account with your accounting system, you need to post any adjustments
or corrections that you uncover to accounts that may be impacted by the change.
CHAPTER 4 Reconciling Accounts and Closing Journal Entries
165
Table 4-1 earlier in this chapter lists a reconciling item of $20 for bank interest;
that interest isn’t yet posted to your books. To post the item, debit (increase) cash
$20 and credit (increase) other income $20.
If you find that several customer payments haven’t been entered in the cash
receipts journal, you need to post those payments to the cash receipts journal,
the accounts receivable journal, and the customers’ accounts. The same is true
if you find payments on outstanding bills that haven’t been entered into the
books. In such cases, post the payments to the cash disbursements journal and
the accounts payable journal, as well as to the individual vendors’ accounts.
Prepping to Close: Checking for Accuracy
and Tallying Things Up
Closing the books is the process of finishing all your accounting activity for the
period (month or year). Said another way, closing the books ensures that your
accounting records are ready to start the next accounting period. As you prepare
to close the books, you first need to total what’s in your journals, which is called
summarizing the journals. During the process, it’s a good idea to look for errors and
make sure that the entries accurately reflect the business transactions during the
accounting period.
Even the smallest error in a journal can cause a lot of frustration when you try to
run a trial balance and close out your books, so it’s best to do a thorough search
for errors as you close out each journal for the month. Finding an error at this
point in the closing process is much easier than trying to track it back through
all your various accounts.
Paying attention to initial
transaction details
Do a quick check to be sure that the transaction details in your journals are
accurate. The section titled “Reconciling Bank Accounts” explains how to make
this type of check with the cash journals. When you follow the rules of accrual
accounting, however, not all transactions involve cash. In accrual accounting,
noncash transactions can include customer purchases made on store credit (which
you track in the accounts receivable journal) and bills you will pay in the future
(which you track in the accounts payable journal). You may also create other
journals to track transactions in your most active accounts, and you probably also
keep details about sales in the sales journal and payroll in the payroll journal.
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BOOK 3 Adjusting and Closing Entries
In the payroll journal, make sure that all payroll for the month has been added,
with all the proper details about salaries, wages, and taxes. Also verify that
you’ve recorded all employer taxes that need to be paid. These taxes include the
­employer’s portion of Medicare and Social Security, as well as unemployment
taxes. (For more about payroll and payroll taxes, see Book 2, chapters 4 and 5.)
Summarizing journal entries
Summarizing a journal is a four-step process:
1.
2.
Number each journal page at the top, if it isn’t already numbered.
Total any column that’s not titled General Debit or General Credit.
Any transactions recorded in the General Debit or General Credit column need
to be recorded individually in the general ledger.
3.
Post the totals to the general ledger account.
Each transaction in the General Credit or General Debit column must be
posted separately. Enter the date and journal page number as well as the
amount of the debit or credit so that you can quickly find the entry for the
original transaction if you need more details. Keep in mind that total debits in
the general ledger should equal total credits.
4.
In the Post Reference (PR) column of the journal, record information
about where the entry is posted.
If the entry to be posted to the accounts is summarized and totaled at the
bottom of the page, you can put a check mark next to the entry in the PR
column. For transactions listed in the General Credit or General Debit column,
you should indicate an account number for the account in which the transaction is posted. This process helps you confirm that you’ve posted all entries in
the general ledger.
Figure 4-4 shows a summarized journal page — specifically, the cash receipts
journal. You can see that entries listed in the Sales Credit and Cash Debit columns
on the cash receipts journal are checked. Only one entry was placed in the General
Credit column, and that entry has an account number in the PR column. Although
Figure 4-4 doesn’t list all the transactions for the month, which would of course
be a much longer list, it does show how you summarize the journal at the end of
the month.
CHAPTER 4 Reconciling Accounts and Closing Journal Entries
167
Reconciling Accounts and
Closing Journal Entries
When you close your books at the end of the month, you summarize all the
­journals — that is, total the columns and post the totals to the general ­ledger.
Journals are temporary holding accounts for transactions. Eventually, all accounting activity must be posted to the general ledger. The general ledger, after all, is
used to create financial statements.
FIGURE 4-4:
Summary of cash
receipts journal
entries after the
first five days.
©John Wiley & Sons, Inc.
As you can see in Figure 4-4, after you summarize the cash receipts journal, there
are only four general ledger accounts (General Credit, Accounts Receivable Credit,
Sales Credit, and Cash Debit) and three customer accounts (S. Smith, J. Jones,
and P. Perry) in which you need to post entries. Even better, the entries balance:
$2,900 in debits and $2,900 in credits! To verify the credit total, add the totals at
the bottom of each credit column.
The customer accounts total $500, which is good news because it’s the same
amount credited to accounts receivable. The accounts receivable account is
decreased (credited) by $500 because payments were received, as is the amount
due from the individual customer accounts.
Summarizing the accounts receivable journal gives you a grand total of all transactions for that period that involved customer credit accounts. Figure 4-5 shows
a summary of an accounts receivable journal. The accounts receivable journal
includes transactions from the sales journal (where customer purchases on store
credit first appear) and the cash receipts journal (where customers’ payments
toward their store credit accounts first appear), as well as any credit memos
for customer returns. The example in Figure 4-5 is only a few lines long, but in
most companies, the accounts receivable journal is very active, with transactions
posted every day the business is open during the month. When you summarize
the accounts receivable journal, you get a closing balance that shows the total of all
financial activity recorded in that journal. Figure 4-5 shows a closing balance of
$2,240, which is the amount outstanding from customers.
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BOOK 3 Adjusting and Closing Entries
FIGURE 4-5:
©John Wiley & Sons, Inc.
Each transaction in the journal should have a reference number next to it, which
tells you where the detail for that transaction first appears in the books. Each line
item in Figure 4-5 has a journal page reference.
When you check for errors in the journal, you may need to review the original
source information used to enter some transactions so that you can double-check
that entry’s accuracy. In Chapter 3, you go over how to prove out cash, which
includes a review for errors. In addition to the accounts receivable journal,
you have individual journal pages for each customer; these pages detail each
customer’s purchases on store credit and any payments made toward those purchases. At the end of an accounting period, accountants prepare an aging summary
detailing all outstanding customer accounts. This report shows you what money
is due from customers and how long it has been due.
For the purpose of proving out the books, the aging report is a quick summary
that ensures that the customer accounts information matches what’s in the
accounts receivable journal. Table 4-2 shows what an aging summary would look
like as of March 31.
TABLE 4-2
Aging Summary: Accounts Receivable as of March 31
Customer
Current
31–60 Days
61–90 Days
S. Smith
$300
J. Doe
$100
$300
$200
H. Harris
$500
$240
M. Man
$400
$200
Total
$1,300
$740
>90 Days
$200
CHAPTER 4 Reconciling Accounts and Closing Journal Entries
169
Reconciling Accounts and
Closing Journal Entries
A sample
accounts
­receivable
journal
summary.
In this sample accounts receivable aging summary, the total amount outstanding from customers matches the balance total in the accounts receivable journal
($2,240) in Figure 4-5. To compute the total, add the total receivable amount
in each column above ($1,300 + $740 + $200 = $2,240). Therefore, all customer
accounts have been entered accurately in the books, and the bookkeeper shouldn’t
encounter any errors related to customer accounts when running a trial balance.
If you find a difference between the information in your journal and your aging
summary, review your customer account transactions to find the problem. An
error may result from any of the following actions:
»» Recording a customer purchase in the accounts receivable journal without
recording the details of that transaction in the customer’s account
»» Recording a customer purchase directly in the customer’s account without
adding the purchase amount to the accounts receivable journal
»» Recording a customer’s payment in the customer’s account without recording
the cash receipt in the accounts receivable journal
»» Recording a customer’s payment in the accounts receivable journal without
recording the cash receipt in the customer’s account record
The process of summarizing and closing out the accounts payable journal is similar to that of summarizing and closing out the accounts receivable journal. For
accounts payable, you can prepare an aging summary for your outstanding bills
as well. That summary should look something like Table 4-3.
TABLE 4-3
Aging Summary: Accounts Payable as of March 31
Vendor
Current
American Bank
$150
Carol’s Realty
$800
31–60 Days
Helen’s Paper Goods
$250
Henry’s Bakery Supplies
$500
Plates Unlimited
$400
$200
Total
$1,350
$950
61–90 Days
>90 Days
The total outstanding bills on the accounts payable aging summary should match
the total shown on the accounts payable journal summary for the accounting
period. If yours match, you’re ready for a trial balance; if they don’t, you must
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BOOK 3 Adjusting and Closing Entries
figure out the reason for the difference before closing out the accounts payable
journal. Keep in mind that the vendor is the company that sold you the product or
service on credit. The problem may be the result of any of the following actions:
»» Recording a bill due in the accounts payable journal without recording it in the
vendor’s account
»» Recording a bill due in the vendor’s account without recording it in the
accounts payable journal
»» Making a payment to the vendor in the vendor’s account without recording it
»» Making a payment to the vendor and recording it in the accounts payable
journal but neglecting to record it in the vendor’s account
Correct any problems you find before closing out the journal. If you know that you
may be working with incorrect data, you don’t want to try to do a trial balance. A
trial balance with errors can’t be used to generate accurate financial reports. Generating a trial balance without checking for errors is wasted effort.
Analyzing summary results
You may be wondering how you can find problems in your records by just reviewing a page in a journal. Well, that skill comes with experience and practice. As you
summarize your journals each month, you’ll become familiar with the expected
level of transactions and the types of transaction that occur month after month. If
you don’t see a transaction that you expect to find, take the time to research the
transaction to find out why it’s missing. Perhaps the transaction didn’t occur, or
someone forgot to record it. Suppose that when you’re summarizing the payroll
journal, you notice that the payroll for the 15th of the month seems lower than
normal. As you check your details for that payroll, you find that the amount paid
to hourly employees was recorded, but someone didn’t record the amount paid
to salaried employees. For that particular payroll, the payroll company experienced a computer problem after running some checks, and as a result, it sent the
final report on two separate pages. The person who recorded the payroll numbers
didn’t realize that there was a separate page for salaried employees, so the final
numbers entered into the books didn’t reflect the full amount paid to employees.
As you close the books each month, you’ll get an idea of the numbers you can
expect for each type of journal. After a while, you’ll be able to pick out problems
just by scanning a page, with no detailed research required!
CHAPTER 4 Reconciling Accounts and Closing Journal Entries
171
Reconciling Accounts and
Closing Journal Entries
in the accounts payable journal
Planning for cash flow
The process you go through each month as you prepare to close your books helps
you plan for future cash flow. Reviewing the accounts receivable and accounts
payable aging summaries tells you what additional cash you can expect from customers during the next few months and how much cash you’ll need to pay bills
for the next few months.
If you notice that your accounts payable aging summary indicates that more and
more bills are slipping into past-due status, you may need to find another source
for cash, such as a credit line from the bank. The accounts payable aging summary
might reveal that three key vendors — Helen’s Paper Goods, Henry’s Bakery Supplies, and Plates Unlimited — haven’t been paid on time. Late payments can hurt
your business’s working relationship with vendors, who may refuse to deliver
goods unless you pay cash up front. And if you can’t get the raw materials you
need, you may have trouble filling customer orders on time. The lesson here is to
act quickly and find a way to improve cash flow before your vendors cut you off.
(For more on accounts payable management, check out Book 2, Chapter 2.)
You may also find that your accounts receivable aging summary reveals that certain previously good customers are gradually becoming slow or nonpaying customers. Perhaps J. Doe’s account is past due, and at least some portion of that
account is overdue by more than 60 days. The bookkeeper who deals with the
account may need to consider putting a hold on it until payment is received in
full. (For more on accounts receivable management, check out Book 2, Chapter 3.)
Posting to the General Ledger
An important part of closing your books is posting to the general ledger any corrections or adjustments you find as you close the journals. This type of posting
consists of a simple entry that summarizes any changes you found. Suppose that
you discover that a customer purchase was recorded directly in the customer’s
account record but not in the accounts receivable journal. You have to research
how that transaction was originally recorded. If the only record was a note in the
customer’s account, both the sales account and the accounts receivable account
are affected by the mistake; both balances are understated. The correcting entry
looks like this:
Debit
Accounts receivable
Sales
To record sale to J. Doe on 3/15 — corrected 3/31
172
BOOK 3 Adjusting and Closing Entries
Credit
$100
$100
If you find this type of error, the sales transaction record for that date of sale
isn’t accurate, which means that someone bypassed your standard bookkeeping
process when recording the sale. You may want to research that part of the issue
as well, because there may be more than just a recording problem behind this
incident. Someone in your company may be allowing customers to take product,
deliberately not recording the sale appropriately in your books and pocketing the
money instead. It’s also possible that a salesperson recorded a sale for a customer
that never took place. If that’s the case, and you bill the customer, the customer
would likely question the bill, and you’d find out about the problem at that point.
Repeat errors may call for additional staff training to ensure that your bookkeeping rules are being followed to a T. Unfortunately, such errors may be evidence
that someone in the company is deliberately recording false information. Whatever the explanation is, you need to take corrective action. (See Book 9, Chapter 2
for coverage of internal controls.)
Checking Out Computerized
Journal Records
Although you don’t have to close out journal pages if you keep your books by using
a computerized accounting system, running a spot check (at the very least) of
what you have in your paper records versus what you have on your computer is a
smart move. Simply run a series of reports by using your computerized accounting system and then check to be sure that those computer records match what
you have in your files. In QuickBooks, for example, go to the Report Navigator,
and click Vendors & Payables. The first section of the navigator page, shown in
Figure 4-6, is called A/P Aging (Due and Overdue Bills). This section offers three
possible reports: Summary, which shows how much is due for each vendor; Detail,
which gives a list of bills due and overdue; and an Accounts Payable graph that
illustrates your outstanding bills.
CHAPTER 4 Reconciling Accounts and Closing Journal Entries
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Reconciling Accounts and
Closing Journal Entries
The process of proving out your journals or any other part of your bookkeeping
records is a good opportunity to review your internal controls as well. As you find
errors during the process of proving out the books, keep an eye out for exceptions (probably similar errors that appear frequently), which may indicate bigger
problems than bookkeeping mistakes.
FIGURE 4-6:
QuickBooks
allows you to
run reports
concerning
vendors and
payables.
Essentially, these
reports tell you
how much money
your company
owes to others.
Intuit.com
Figure 4-7 shows you the kind of detail you get when you select the Detail report.
The Detail report is divided into
»» Current bills
»» Bills overdue by 1 to 30 days
»» Bills overdue by 31 to 60 days
»» Bills overdue by 61 to 90 days
»» Bills overdue by more than 90 days
Obviously, anything in the last two sections — overdue by more than 60 days —
is bad news. You can expect a supplier or vendor whose bills appear in these columns to cut you off from additional credit until your account is up to date.
In addition to locating your bill-paying problem areas, you can use the information in the Detail report to verify that the paper bills you have waiting to be paid
in vendor files match what you have on your computer. You don’t need to check
every bill, but doing a spot check of several bills is good practice. The goal is to
verify the accuracy of your records as well as make sure that no one’s entering and
paying duplicate or nonexistent bills.
When it comes to controlling cash flow out of the business, keep tight controls
on who can sign checks and how the information that explains those checks
is recorded. See Book 2, Chapter 2 for more information about the importance
of separating duties to protect each aspect of your bookkeeping system from
corruption.
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BOOK 3 Adjusting and Closing Entries
FIGURE 4-7:
Intuit.com
You can also run reports showing the information recorded in your accounts
receivable account. Figure 4-8 shows a list of possible reports to run from the
Customers & Receivables page. In addition to the Summary, Detail, and Accounts
Receivable graph, you can run a report for Open Invoices, which lists outstanding
customer invoices or statements, and Collections, which lists not only overdue
customers, but also how much they owe and their contact information.
FIGURE 4-8:
In QuickBooks,
you can
run a series
of reports that
summarize
customer
accounts.
Intuit.com
CHAPTER 4 Reconciling Accounts and Closing Journal Entries
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Reconciling Accounts and
Closing Journal Entries
When you run an
Accounts Payable
Detail report in
QuickBooks, you
get a listing of all
outstanding bills,
the dates the bills
were received,
and the dates
they’re due.
Again, running spot checks on a few customer accounts to make sure that your
paper records of their accounts match the information in your computerized system is a good idea. There’s always a chance that a customer’s purchase was
entered in error in the computer, and you could end up sending the bill to the
wrong person.
Some companies double-check their accounts receivable bookkeeping for accuracy by sending surveys to customers periodically (usually, twice a year) to see
whether their accounts are correct. If you choose to do this, include with the
customer’s bill a postage-paid card asking whether the account is correct and
giving the customer room to indicate any account problems before mailing the
card back to your company. You can also send a survey by email. In most cases, a
customer who has been incorrectly billed will contact you soon after getting that
bill — especially if they’ve been billed for more than anticipated.
In addition to keeping actual accounts, such as accounts payable or accounts
receivable, your computerized accounting system keeps a journal of all your company’s transactions. This journal contains details about all your transactions over
a specified time period and the accounts that were affected by each transaction.
Figure 4-9 shows a sample computerized journal page.
FIGURE 4-9:
A ­computerized
accounting
system keeps
a journal of all
transactions,
which you can
review during the
closing process.
Intuit.com
If you need to be reminded of how you recorded a transaction into your computerized accounting system, run the journal report by date, isolating all transactions that took place at a particular time. Running a report by date can be helpful
if you’re trying to locate the source of an error in your books; if you find a questionable transaction, you can open the detail of that transaction to see how it was
entered and where you can find the original source material.
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BOOK 3 Adjusting and Closing Entries
IN THIS CHAPTER
»» Checking your math with a trial
balance
»» Finding and correcting errors
»» Preparing a worksheet
»» Generating reports from your
computerized system
Chapter
5
Checking Your Accuracy
A
fter you close all your journals and do your best to catch any and all errors
(flip to Book 3, Chapter 4 for instructions), the time comes to test your
work. If you’ve entered all double-entry transactions into the books correctly, the books balance out, and your trial’s a success!
Unfortunately, few bookkeepers get their books to balance on the first try, or the
books balance as the result of errors.
This chapter explains how you do a trial balance of your books and gives tips on
finding any errors that may be lurking. You also find out how to take your first
step toward developing financial reports by creating a worksheet.
Working with a Trial Balance
When you start entering transactions in a dual-entry accounting system, you may
think, “This is a lot of work, and I don’t know how I’m ever going to use all this
information.” You enter all your transactions, using debits and credits, without
knowing whether they’ll produce useful financial information that you can use
to gauge how well your business is doing. It’s not until after you close your journals and prepare your first set of financial reports that you truly see the value of
double-entry accounting.
CHAPTER 5 Checking Your Accuracy
177
The first step toward producing usable reports that help you interpret your financial results is doing a trial balance — a worksheet prepared manually or spit out by
your computer accounting system that lists all the accounts in your general ledger
and each account balance at the end of an accounting period.
The purpose of the trial balance is to prove that, at least mathematically, your
debits and credits are equal. If any errors exist in your calculations or in the way
you summarized the journals or posted the summaries to the general ledger,
they’re uncovered in the trial balance when total debits and total credits don’t
come out equal.
Conducting your trial balance
If you’ve entered transactions manually, you create a trial balance by listing all
the accounts with their ending debit or credit balances. After preparing the list,
you total both the debit and credit columns. If the totals at the bottom of the two
columns are the same, the trial is a success, and your books are in balance. Following are step-by-step instructions for developing a trial balance:
1.
2.
3.
4.
5.
Prepare a worksheet with three columns: one for account titles, one for
debits, and one for credits.
Fill in all the account titles. and record their balances in the appropriate
debit or credit columns.
Total the dollar amounts in the debit column, and write the total at the
bottom of the column.
Total the dollar amounts in the credit column, and write the total at the
bottom of the column.
Compare the debit and credit column totals.
Figure 5-1 shows a sample trial balance for a company. Note that both the debit
column and the credit column equal $57,850, making this trial balance a successful one.
A successful trial balance is no guarantee that your books are free of errors; it just
means that all your transactions have been entered in balance. The books may
still contain errors related to how you entered your transactions, including the
following:
»» You forgot to put a transaction in a journal or in the general ledger.
»» You forgot to post a journal entry to the general ledger.
»» You posted a journal entry twice in either the general ledger or in the journal.
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Checking Your Accuracy
FIGURE 5-1:
A sample trial
balance.
©John Wiley & Sons, Inc.
»» You posted the wrong amount.
»» You posted a transaction to the wrong account.
»» Your account doesn’t display a normal balance, as explained in the next
section.
Understanding normal balances
for your accounts
Every account should consistently display either a debit or credit balance, depending on the type of account. Accountants refer to these balances as normal balances.
Asset accounts normally display debit balances. Cash, an asset account, should
CHAPTER 5 Checking Your Accuracy
179
have a debit balance at any point in time. Expense accounts in the income statement also have a normal debit balance.
Liability and equity accounts have normal credit balances. Accounts payable, a
liability account, should have a credit balance. Revenue (or sales) in the income
statement also has a normal credit balance.
During your trial balance review, if you notice an account that doesn’t have a
normal balance, that could be the sign of an error. You should consider making a
journal entry to adjust the account. Every account should have a normal balance,
or a balance of zero.
Adjusting an account to properly
reflect a normal balance
Assume that you compile your trial balance and notice that your ending balance in
cash is a credit balance of $100. A normal balance for cash, an asset account, is a
debit balance. The credit balance in cash is a negative balance. If you have a negative balance in the bank, the bank has given you a loan. The negative amount (or
overdraft) must be paid back to the bank.
As mentioned in the preceding section, you need to post a journal entry to adjust
the cash balance to zero. In this case, you would debit cash $100 and credit loans
payable (a liability account) $100. Now your cash balance is zero, and you’ve
properly set up a loan balance for the amount you owe the bank.
If by chance the errors listed here slip through the cracks, there’s a good chance
that the discrepancy will become evident in the financial reports.
Dealing with trial balance errors
If your trial balance isn’t correct, you need to work backward in your closing process to find the source of the mathematical error. Bookkeepers and accountants
work with pencils instead of pens for this reason: Pencils make correcting errors
much easier. When you need to find errors after completing a trial balance that
fails, follow these four basic steps to identify and fix the problem:
1.
Check your math.
Keep your fingers crossed and total the debits and credits in your trial balance
again to make sure that the error isn’t just one of addition — the simplest kind
of error to find. Correct the addition mistake and retotal your columns.
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BOOK 3 Adjusting and Closing Entries
2.
Compare your balances.
Double-check the balances on the trial balance worksheet by comparing them
with the totals from your journals and your general ledger. Be sure you didn’t
make an error when transferring the account balances to the trial balance.
Correcting this type of problem isn’t very difficult or time-consuming. Simply
correct the incorrect balances and total the debits and credits in your trial
balance again.
3.
Check your journal summaries.
Double-check the math in all your journal summaries, making sure that all
totals are correct and that any totals you posted to the general ledger are
correct. Running this kind of check, of course, is somewhat time-consuming,
but it’s still better than rechecking all your transactions. If you do find errors in
your journal summaries, correct them, reenter the totals correctly, change the
numbers on the trial balance worksheet to match your corrected totals, and
retest your trial balance.
4.
Check your journal and general ledger entries.
Checking Your Accuracy
Unfortunately, if steps 1, 2, and 3 fail to fix your problem, all that’s left is to
go back and check your actual transaction entries. The process can be
time-consuming, but the information in your books isn’t useful until your
debits equal your credits.
If Step 4 is your last resort, scan your entries, looking specifically for ones that
appear questionable. If you see an entry for office supplies that’s much larger
or much smaller than usual, for example, check the original source material
for that entry to be sure it’s correct. If you carefully proved out the accounts
payable and accounts receivable journals, you can concentrate your efforts on
accounts with separate journals. After you find and correct the error(s), run
another trial balance. If total debits and total credits still don’t match, repeat
the steps listed here until your debits and credits equal out.
You can always go back, correct the books, and do another trial balance before
you prepare the financial reports. Don’t close the books for the accounting period
until the financial reports are completed and accepted. See Books 4 and 5 for more
about preparing financial reports.
CHAPTER 5 Checking Your Accuracy
181
Testing Your Balance by Using
Computerized Accounting Systems
If you use a computerized accounting system, it automatically generates your trial
balance for you. Because the system enables you to enter only transactions that
are in balance, the likelihood that your trial balance won’t be successful is pretty
slim, but that your accounts aren’t guaranteed to be error-free.
Remember the saying “Garbage in, garbage out”? If you make a mistake when
you enter transaction data into the system, even if the data’s in balance, the
information that comes out will also be in error. Although you don’t have to go
through the correction steps covered in “Dealing with trial balance errors” to
reach a successful trial balance, you still may have errors lurking in your data.
Accountants frequently run an automated trial balance report at the end of every
period. You’ll get into the habit of reviewing the trial balance, making corrections, and running a new trial balance. In addition to the trial balance, automated
systems can generate a report showing the general ledger, transaction detail by
account, journal detail, voided transactions, and transactions by date. In QuickBooks, you can assess the Accountant & Taxes page (shown in Figure 5-2) to find
these reports.
FIGURE 5-2:
The Accountant
& Taxes page
of QuickBooks’s
Report ­Navigator
provides the
option to create
many useful
reports.
Intuit.com
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BOOK 3 Adjusting and Closing Entries
A business’s accountant is likely to use many of the report options to doublecheck that transactions were entered correctly and that no one is playing with the
numbers. In particular, the accountant may use a report option called Audit Trail,
which reveals what changes affected the company’s books during an accounting period and who made those changes. This type of report is available in most
automated accounting systems.
Although it doesn’t match the trial balance done manually in Figure 5-1, the
QuickBooks trial balance shown in Figure 5-3 gives you an idea of what a computerized accounting trial balance looks like.
Checking Your Accuracy
FIGURE 5-3:
A sample trial
balance report
produced by
QuickBooks.
Intuit.com
Developing a Financial Statement
Worksheet
After your accounts successfully pass a trial balance test (see “Conducting your
trial balance” earlier in this chapter), you can take your first stab at creating
financial statements, including a balance sheet and an income statement. The first
step in producing these statements is using the information from the trial balance
and its corrections to develop a worksheet that includes the initial trial balance,
CHAPTER 5 Checking Your Accuracy
183
the accounts that would normally appear on a balance sheet, and the accounts
that would normally appear on an income statement.
You create the worksheet that includes these seven columns:
»» Column 1: Account list
»» Columns 2 and 3: Trial balance (one column for debits, one column for
credits)
»» Columns 4 and 5: Balance sheet (one column for debits, one column for
credits)
»» Columns 6 and 7: Income statement (one column for debits, one column for
credits)
Figure 5-4 shows a sample of a worksheet developed from trial balance numbers. Note that the numbers of the trial balance are transferred to the appropriate financial statement. The cash account, for example, is an asset account and
is shown in the debit column of the balance sheet. (See Books 4 and 5 for more
about creating financial statements.)
After you transfer all the accounts to their appropriate balance sheet or income
statement columns, you total the worksheet columns. Don’t panic when you see
that the totals at the bottom of your columns aren’t equal, because the net income
hasn’t been calculated yet. But the difference between the debits and credits in
both the balance sheet and the income statement totals should be the same. That
amount should represent the net income that will appear on the income statement. (See Book 4, Chapter 2 for more about the income statement.)
In Figure 5-4, the $4,500 difference for the balance sheet is shown as a credit,
representing an increase in retained earnings. The retained earnings account
reflects the profits that have been reinvested into the company’s assets to grow
the company. You can find more about retained earnings in Book 4, Chapter 5.
In some companies, earnings are taken out in the form of dividends paid to stockholders. Dividends are a portion of the earnings divided among stockholders. The
board of directors of the corporation establishes that a certain amount per share
be paid to stockholders. A company must have earnings (either from the current
year or in retained earnings) to pay a dividend. If a company has no earnings at
all — either in the current year or accumulated in retained earnings from past
years — payments to shareholders are considered to be return of capital.
Many other small companies that haven’t incorporated pay earnings to their
owners by using a drawing account, which tracks any cash taken out by the owners. Each owner should have their own drawing account so that you have a history
of how much each owner withdraws from the company’s resources.
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©John Wiley & Sons, Inc.
Replacing Worksheets with
Computerized Reports
If you use a computerized accounting system, you don’t have to create a worksheet. Instead, the system gives you the option of generating many types of
reports to help you develop your income statement and balance sheet.
One advantage of using a computerized system’s reports is that you can easily
look at your numbers in many ways. To get the report you want, all you do is click
the report title.
CHAPTER 5 Checking Your Accuracy
185
Checking Your Accuracy
FIGURE 5-4:
This sample
worksheet shows
the first step in
developing a
company’s
financial
statements.
A typical computerized accounting system can generate a variety of reports in the
following categories:
»» Profit and loss (income statement): Key reports in this section include
• A standard report that shows how much the company made or lost during
a specific period
•
•
A detail report that includes all the year-to-date transactions
A report that compares year-to-date figures with those of the previous
year (provided that you kept the accounts by using the computerized
system in the previous year)
»» Income and expenses: Key reports in this section include
• Income by customer (both a summary and a detailed report)
• Expenses by vendor (both a summary and a detailed report)
»» Balance sheet and net worth: Key reports in this section include
• A standard balance sheet showing a summary of assets, liabilities, and
equity
•
•
A detail report of assets, liabilities, and equity
A report that compares assets, liabilities, and equity levels with those of the
previous year
»» Cash flow: Key reports in this section include
• A statement of cash flows for the year
• A forecast of cash flows during the next few weeks or months based on
money due in accounts receivable and money to be paid out in accounts
payable
Computerized accounting systems provide the tools to manipulate your
company’s numbers in whatever way you find useful for analyzing your ­company’s
results. And if a report isn’t quite right for your needs, you can customize it. If you
want to see the profit and loss results for a particular week during an accounting
period, you can set the dates for only that week and generate the report. You can
also produce a report looking at data for just one day, one month, one quarter, or
any combination of dates.
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BOOK 3 Adjusting and Closing Entries
Most computerized accounting systems, including QuickBooks, enable you to
custom-design reports that meet your company’s unique financial information
needs. Many companies customize reports to collect information by department
or division. You’re limited only by your imagination!
As you work with your computerized system, you’ll be asked for information
that isn’t easy to find in standardized reports. The first few times you pull that
information together, you may need to do so manually. But as you get used to
your computerized accounting system and its report functions, you’ll be able to
design customized reports that compile and present information in just the way
you need it.
Checking Your Accuracy
CHAPTER 5 Checking Your Accuracy
187
IN THIS CHAPTER
»» Going over types of accounting
adjustments
»» Making adjustments for noncash
transactions
»» Taking your adjustments for a trial
(balance) run
Chapter
6
Adjusting the Books
D
uring an accounting period, your bookkeeping duties focus on your
business’s day-to-day transactions. When the time comes to report transactions in financial statements, you must make some adjustments to your
books. Your financial reports are supposed to report your company’s financial
condition, so your books must reflect any significant change in the value of your
assets, even if that change doesn’t involve the exchange of cash. Those changes
are adjustments.
If you use cash-basis accounting, many adjustments aren’t necessary because
you record transactions only when cash changes hands. (See Book 1, Chapter 4
to find out more about the two accounting methods: accrual and cash basis.)
The accrual basis of accounting, on the other hand, requires you to make adjustments to match revenue with the expenses incurred to generate revenue. Because
the accrual method isn’t directly connected to cash transactions, you must post
adjustments.
In this chapter, you’ll review the types of adjustments you need to make to the
books before preparing financial statements. Adjustments include calculating
asset depreciation, dividing prepaid expenses, updating inventory numbers, dealing with bad debt, and recognizing salaries and wages not yet paid.
CHAPTER 6 Adjusting the Books
189
Adjusting All the Right Areas
Even after testing your books by using the trial balance process explained in Book 3,
Chapter 5, you still need to make some adjustments before you’re able to prepare
accurate financial reports.
Adjusting entries can be grouped into four categories:
»» Converting assets into expenses: This book defines assets as resources you
use to make money in your business. As you use assets, those dollars become
expenses. Assume that your company owns a truck. When you recognize
depreciation on your truck, you make an adjusting entry to reduce the asset’s
value and record depreciation expense.
»» Converting liabilities into revenue: Unearned revenue is defined as pay-
ments you receive from customers before you provide a product or service.
Unearned revenue is a liability account. If you don’t deliver the product or
service, you have to return the payment. When you pay for a one-year
magazine subscription in advance, your payment represents unearned
revenue to the magazine publisher. As the publisher delivers magazines to
you, it moves some of your payment into earned revenue. That journal entry
is an adjustment.
»» Accruing unpaid expenses: When you owe money for an expense at the end
of an accounting period, you make an adjustment to accrue the expense.
Suppose you owe payroll to your staff for the last week of December. Your
next payroll pay date is January 5. On December 31, you debit payroll expense
and credit accrued payroll liability for December payroll.
»» Accruing uncollected revenue: If you’ve earned revenue, but haven’t yet
received the payment in cash, you make an adjustment to accrue revenue. If
you’ve earned interest on your bank balance, but haven’t yet received interest
from the bank, you make an adjustment. You debit (increase) accounts
receivable and credit interest income (revenue) for the interest earned.
An adjusting entry always uses a balance sheet account and an income statement
account. Keep that in mind when posting adjusting entries.
Here are three other specific adjustments you may make to your books:
»» Prepaid expenses: Prepaid expenses are expenses incurred for benefits to
be received in the future. This adjustment matches expenses incurred with
the benefits received for a period of time. For example, if you pay an annual
insurance premium with a single payment, you should move one-twelfth of
that payment to insurance expense each month of the year.
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BOOK 3 Adjusting and Closing Entries
»» Bad debts: Bad debt expense is posted to acknowledge that some customers
will never pay. Accountants refer to the process as writing off a receivable
account. You debit bad debt expense and credit (reduce) accounts receivable.
»» Supplies: Many companies perform a count of the supplies they have on
hand at the end of the month. They use that count to calculate the dollar
amount of supplies used during the month. The adjustment is to debit supply
expense and credit an asset account — supplies.
Depreciating assets
The largest noncash expense for many businesses is depreciation. Depreciation is
an accounting chore that’s important for every business because it reflects the use
and decline in value of assets. (For more on depreciation and why you do it, check
out Book 3, Chapter.)
The time to adjust the books for depreciation is when you close the books for an
accounting period. Some businesses record depreciation expenses every month to
more accurately match monthly expenses with monthly revenues, but many business owners make depreciation adjustments only once a year, when they prepare
their annual financial statements.
Depreciation doesn’t involve the use of cash. By accumulating depreciation
expenses on an asset, you’re reducing the value of the asset as shown on the balance sheet (see Book 4, Chapter 4 for the lowdown on balance sheets).
Usually, you calculate depreciation for accounting purposes by using the straightline depreciation method. This method is used to calculate an amount to be depreciated that will be equal each year based on the anticipated useful life of the asset.
For example, suppose your company purchases a car that costs $25,000. You anticipate that car will have a useful lifespan of five years and will be worth $5,000
after five years. Using the straight-line depreciation method, you first subtract
$5,000 from the total car cost of $25,000 to find the value of the car during its
five-year useful lifespan ($20,000). $20,000 represents the depreciable base. Next,
CHAPTER 6 Adjusting the Books
191
Adjusting the Books
Readers of your financial statements can get a good idea of the usefulness of your
assets by reviewing your accumulated depreciation. If a financial statement shows
that assets are close to being fully depreciated, readers know that you’ll probably need to spend significant funds on replacing or repairing those assets sometime soon. As readers evaluate the financial health of the company, they take that
future obligation into consideration before making a decision to loan money to the
company or possibly invest in it.
you divide $20,000 by 5 to find your depreciation expense for the car ($4,000 per
year). When adjusting the assets at the end of each year in the car’s five-year
lifespan, your entry to the books should look like this:
Debit
Depreciation expense
Credit
$4,000
Accumulated depreciation: Vehicles
$4,000
To record depreciation for vehicles
This entry increases depreciation expense, which appears on the income statement (see Book 4, Chapter 2). The entry also increases accumulated depreciation,
which is the use of the asset and appears on the balance sheet directly below the
vehicles asset line. The vehicle asset line always shows the value of the asset at
the time of purchase (cost). So the fixed asset section of your balance sheet after
one year of vehicle depreciation would be
Vehicle
$25,000 (Cost)
Accumulated depreciation: Vehicles
($4,000)
You see several times in this book that you debit asset accounts to increase
them. Accumulated depreciation is an exception to that rule — this account is a
contra-asset account (an account with a normal balance that is the opposite of
other accounts in the same category, as explained in Book 4, Chapter 3). In the
previous journal entry, accumulated depreciation is credited for an increase in
depreciation expense. Using a credit for accumulated depreciation allows you to
present a reduction in the asset you’re depreciating. So the $25,000 vehicle has
$4,000 in depreciation expense. Each asset in your fixed asset listing has its own
accumulated depreciation account.
You can speed up depreciation if you believe that the asset will be used more
­heavily in the early years of ownership. Book 3, Chapter 1 discusses alternative
depreciation methods in greater detail.
If you use a computerized accounting system as opposed to keeping your books
manually, you may not need to make this adjustment at the end of an accounting
period. If your system is set up with an asset management feature, depreciation is
automatically calculated, and you don’t have to do it. Check with the person who
set up the asset management feature before calculating and recording depreciation expenses.
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BOOK 3 Adjusting and Closing Entries
Allocating prepaid expenses
Most businesses have to pay certain expenses at the beginning of the year even
though they’ll benefit from that expense throughout the year. Insurance is a prime
example of this type of expense. Most insurance companies require you to pay the
premium annually at the start of the year even though the value of that insurance
protects the company throughout the year.
For example, suppose your company’s annual car insurance premium is $1,200.
You pay that premium in January in order to maintain insurance coverage
throughout the year. For accounting purposes, you need to match the benefit you
receive (insurance coverage) with the expense of that benefit (paying insurance
premiums).
As a first step, you record the cost as an asset called prepaid expenses, and then you
adjust the value of that asset to reflect that it’s being used up. Prepaid expenses
are assets, because they represent costs that are already paid for. In other words,
you don’t have to pay the cost later — and that’s an asset to you. Your $1,200
annual insurance premium is actually valuable to the company for 12 months, so
you calculate the actual expense for insurance by dividing $1,200 by 12, resulting
in a monthly expense of $100. At the end of each month, you record the use of that
asset by preparing an adjusting entry that looks like this:
Debit
Insurance expenses
Credit
$100
Prepaid expenses
$100
To record insurance expenses for one month
Counting inventory
Inventory is a balance sheet asset that needs to be adjusted at the end of an
accounting period. During the accounting period, your company has several issues
related to inventory:
»» Beginning inventory: When you open your doors at the beginning of a
period (month, year), you have a certain amount of inventory on hand, or
beginning inventory.
CHAPTER 6 Adjusting the Books
193
Adjusting the Books
This entry increases insurance expenses on the income statement and decreases
the asset prepaid expenses on the balance sheet. No cash changes hands in this
entry because cash was reduced when the insurance bill was paid, and the asset
account prepaid expenses was increased in value at the time the cash was paid.
»» Purchases: During the month, you make purchases. You debit inventory and
credit cash or accounts payable.
»» Sales: When you sell inventory, you debit cash or accounts receivable and
credit sales for the sale price. You also debit cost of sales (an expense account)
and credit inventory for the cost of inventory. The difference between sales
and cost of sales is your profit.
At the end of the accounting period, you adjust the inventory value to reflect your
ending inventory balance. Here’s the formula to calculate ending inventory:
Beginning inventory + Purchases – Sales = Ending inventory
Regardless of which inventory valuation method you choose, your total units purchased and the total cost of your inventory are the same. The only difference
between inventory valuation methods is the timing of the expense. Some methods move inventory costs into the cost of goods sold expense account sooner than
other methods. Check out Book 2, Chapter 2 to find out more about inventory
valuation methods.
The steps for making proper adjustments to inventory in your books are as follows:
1.
Perform a physical count of ending inventory.
In addition to calculating ending inventory by using the previous formula, you
should consider performing a physical count of inventory to be sure that
what’s on the shelves matches what’s in the books. Try to perform the physical
count as close as possible to the last day of the accounting period, so the
physical inventory on hand will be close to your accounting record balance for
the last day of the period.
2.
Consider the value of your ending inventory.
The value of ending inventory varies depending on the method your company
chooses to use for valuing inventory. For more about inventory value and how
to calculate the value of ending inventory, see Book 2, Chapter 2. As mentioned
in that chapter, you should apply the same valuation method for your inventory each year. If you choose to change the method, you need a justification.
3.
Adjust the ending inventory balance.
When you physically count the units of inventory and compute each unit’s
value, you add up the total. The total ending inventory value in the physical
count may differ from that value in your accounting records. If the two values
differ, you need to investigate. Either the accounting records are wrong, or
your count had an error. You may need to adjust your inventory records,
depending on the results of the count. That’s another adjustment at the end of
the period.
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BOOK 3 Adjusting and Closing Entries
If you track inventory by using your computerized accounting system, the system makes adjustments to inventory as you record sales and make purchases. At
the end of the accounting period, the value of your company’s ending inventory
should be adjusted in the books already.
Allowing for bad debts
No company likes to accept the fact that it will never see the money owed by some
of its customers. Unfortunately, that’s what happens to most companies that sell
items on store credit. When your company determines that a customer who has
bought products on store credit will never pay for them, you record the value of
that purchase as a bad debt. (For an explanation of store credit, check out Book 2,
Chapter 3.) To find out more about accounting for bad debt, continue reading the
sections that follow.
Using an aging report
At the end of an accounting period, you should list all outstanding customer
accounts in an aging report (see Book 2, Chapter 3). This report shows which customers owe you money, how much they owe, and for how long they’ve owed you.
After a certain amount of time, you have to admit that some customers simply
aren’t going to pay. Each company sets its own determination of how long it waits
before tagging an account as a bad debt. For example, your company may decide
that when a customer is six months late with a payment, you’re unlikely to ever
see the money.
After you determine that an account is a bad debt, you should no longer include
its value as part of your assets in accounts receivable. Including its value
doesn’t paint a realistic picture of your situation for the people reading your
financial reports. Because the bad debt is no longer an asset, you reduce the value
of your accounts receivable to reflect the loss of that asset.
Adjusting the Books
Selecting a bad debt method
You can record bad debts (write them off) in a couple of ways:
»» By customer: Some companies identify the specific customers whose
accounts are bad debts and calculate the bad debt expense each accounting
period based on specific customer accounts.
»» By percentage: Other companies look at their bad-debts histories and
develop percentages that reflect those experiences. Instead of taking the time
to identify each specific account that qualifies as a bad debt, these companies
record bad debt expenses as a percentage of their accounts receivable.
CHAPTER 6 Adjusting the Books
195
However you decide to record bad debts, you need to prepare an adjusting entry at
the end of each accounting period to record bad debt expenses. Here’s an adjusting
entry to record bad debt expenses of $1,000:
Debit
Bad debt expense
Credit
$1,000
Accounts receivable
$1,000
To write off uncollectible customer accounts
You can’t have bad debt expenses if you don’t sell to your customers on store
credit. You need to deal with bad debt only if you offer your customers the convenience of buying your products on store credit.
If you use a computerized accounting system, check the system’s instructions for
how to write off bad debt. The following steps walk you through the process of
writing off a bad debt and present an example to put all the concepts in context:
1.
Initial accounting entries for a sale.
Suppose you sell $1,000 in goods to Acme Painting Company. You debit
accounts receivable and credit sales for $1,000. Assume your inventory
cost was $870. You make a second entry to debit cost of sales and credit
(reduce) inventory for $870. Your profit is sales less cost of sales, or
($1,000 – $870 = $130).
2.
Review your aging reports.
You review an aging report for accounts receivable each month. As time goes
on, you notice that the $1,000 Acme Painting receivable becomes older.
3.
Attempt collection of the debt.
Every company should have a process for following up on past due
amounts. In your case, you send Acme letters requesting collection
and make phone calls.
4.
Determine whether the amount is collectable.
Acme Painting goes out of business. Because the company has insufficient
assets to pay its bills, you determine that the $1,000 receivable isn’t collectible.
5.
Post the bad debt expense entry.
Knowing the specific debt isn’t collectible; you debit bad debt expense and
credit accounts receivable for the $1,000 Acme owed.
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BOOK 3 Adjusting and Closing Entries
Consider the impact on your business. The bad debt means that you’ll collect
$1,000 less than you planned. If bad debt amounts are large, they can impact
your cash flow planning. Check out Book 4, Chapter 3 for details on planning your
cash flow.
Growing your sales and dealing
with the issue of bad debt
Every company wants to grow, which means increasing sales. Selling more usually
means selling to new customers. By definition, a new customer has no payment
history, so do your homework. Many companies purchase data that documents
the creditworthiness of various businesses. The data is similar to what you’d find
in a personal credit report. Set financial guidelines for new clients. In addition to
checking credit reports, insist that new customers pay on time. Until that client
builds a track record of timely payments, you can’t take the risk of the client paying late or not at all. If a new customer doesn’t pay or pays late, consider whether
continuing to do business with that customer is a good idea.
Suppose your company generates $1,000,000 in sales and has bad debts totaling
2 percent of sales ($20,000). Next year, you’re able to grow sales by $200,000,
with bad debt on your new sales of $10,000. A $10,000 bad debt level is 5 percent
of your new sales ($10,000 ÷ $200,000). Your bad debt as a percentage of sales for
the entire $1,200,000 is $30,000, or 2.5 percent. You sold more, but your bad debt
expense (both in total dollars and as a percentage of sales) increased.
Increasing sales is good, but if your collections on the new total sales amount
decline, you have a problem. A larger bad debt expense can result in lower profit.
In the previous example, bad debt expense increased from 2 to 2.5 percent of sales.
Profit declined by 0.5 percent for every dollar in sales revenue.
Not all pay periods fall at the end of a month. If you pay your employees every
two weeks, you may end up closing the books in the middle of a pay period. For
example, assume employees aren’t paid for the last week of March until the end
of the first week of April. Your fiscal period ends on March 31, which isn’t a payroll pay date.
CHAPTER 6 Adjusting the Books
197
Adjusting the Books
Recognizing unpaid salaries and wages
In this case, you need to make an adjusting entry to record the payroll expense
incurred but not yet paid, also called accrued payroll. You estimate the amount
of the adjustment based on what you pay every two weeks. Here’s how you can
accrue for payroll:
1.
Calculate your daily payroll expense.
Take your total payroll for the period (both before and after the end of the
period) and divide that amount by the number of days in the pay period.
Typically, a pay period is two weeks. Assume your two-week payroll is $2,800.
Your daily payroll accrual is ($2,800 ÷ 14 days = $200 per day).
2.
Compute payroll accrual.
Compute the number of days to be accrued. In this case, assume you need to
accrue 7 days — the last week of March. Your payroll accrual is (7 days × $200
per day = $1,400).
3.
Post your accrual entry.
Here’s the entry you post on March 31 to accrue unpaid March payroll:
Debit
Payroll expenses
Credit
$1,400
Accrued payroll expenses
$1,400
To record payroll expenses for the last week of March
After the cash is actually paid out, you debit to reduce the liability account
(accrued payroll expenses) and credit cash account, to account for the payment.
Doing these extra entries may seem like a lot of extra work, but if you didn’t
match the payroll expenses for March with the revenues for March, your income
statements wouldn’t reflect the actual state of your affairs. Without the payroll
accrual, your March payroll would be understated.
Testing an Adjusted Trial Balance
In Book 3, Chapter 5, you find out why and how you run a trial balance on the
accounts in your general ledger. Adjustments to your books call for another trial
balance, the adjusted trial balance, to ensure that your adjustments are correct and
ready to be posted to the general ledger. You track all the adjusting entries on a
worksheet similar to the one shown in Book 3, Chapter 5. You need to use this
worksheet only if you’re doing your books manually. It’s not necessary if you’re
using a computerized accounting system.
198
BOOK 3 Adjusting and Closing Entries
The key difference in the worksheet for the adjusted trial balance is that additional columns must be added to the worksheet. Columns include
»» Column 1: Account titles.
»» Columns 2 and 3: Unadjusted trial balance — the trial balance before the
adjustments are made — with Column 2 for debits and Column 3 for credits.
»» Columns 4 and 5: Adjustments. All adjustments to the trial balance are listed
in Column 4 for debits and Column 5 for credits.
»» Columns 6 and 7: Adjusted trial balance. A new trial balance is calculated that
includes all the adjustments. Be sure that the credits equal the debits when
you total that new trial balance. If they don’t, find any errors before posting
entries to the balance sheet and income statement columns.
»» Other columns: Use data from the adjusted trial balance columns and create
columns for a balance sheet and an income statement.
When you’re confident that all the accounts are in balance, post your adjustments
to the general ledger so that all the balances in the general ledger include the
adjusting entries. With the adjustments, the general ledger can be used to generate financial statements. After you finalize your general ledger for the year, you
may want to make changes to your chart of accounts, which lists all the accounts
in your accounting system. You may add or subtract accounts, depending on the
activity in your business.
Adjusting the Books
CHAPTER 6 Adjusting the Books
199
4
Preparing
Income
Statements and
Balance Sheets
Contents at a Glance
CHAPTER 1:
Stating Your Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Understanding the Nature of Profit . . . . . . . . . . . . . . . . . . . . . . . . . . 204
Choosing the Income-Statement Format. . . . . . . . . . . . . . . . . . . . . . 204
Deciding What to Disclose in the Income Statement. . . . . . . . . . . . 206
Examining How Sales and Expenses Change Assets and
Liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
Considering the Diverse Financial Effects of Making a Profit. . . . . 210
Reporting Extraordinary Gains and Losses. . . . . . . . . . . . . . . . . . . . 213
Correcting Common Misconceptions about Profit. . . . . . . . . . . . . . 217
CHAPTER 2:
Balancing Your Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
Homing in on Historic Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
Discovering What Makes an Asset Current. . . . . . . . . . . . . . . . . . . . 222
Exploring the Asset Section of the Balance Sheet . . . . . . . . . . . . . . 234
CHAPTER 3:
Digging for Debt in the Balance Sheet. . . . . . . . . . . . 237
Seeing How Businesses Account for Liabilities. . . . . . . . . . . . . . . . . 238
Keeping Current Liabilities under Control. . . . . . . . . . . . . . . . . . . . . 239
Planning for Long-Term Obligations. . . . . . . . . . . . . . . . . . . . . . . . . . 244
Accounting for Bond Issuances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
CHAPTER 4:
Explaining Equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
Understanding How Owner Equity Varies among Business
Entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
Distinguishing between Two Types of Capital Stock . . . . . . . . . . . . 253
Defining Paid-In Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
Recording Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
Spotting Reductions to Stockholders’ Equity. . . . . . . . . . . . . . . . . . . 256
Exploring Stock Splits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259
Computing Earnings per Share. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
CHAPTER 5:
Interpreting Income Statements and
Balance Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
Rejoining the Income Statement and Balance Sheet. . . . . . . . . . . . 264
Introducing Operating Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
Adding Fixed Assets, Depreciation, and Owners’ Equity. . . . . . . . . 272
Completing the Balance Sheet with Debt . . . . . . . . . . . . . . . . . . . . . 274
IN THIS CHAPTER
»» Getting a grip on what profit is
and isn’t
»» Designing the income statement and
deciding what to disclose
»» Recognizing how profit affects a
business and its financial condition
»» Handling unusual gains and losses in
the income statement
»» Correcting misconceptions about
profit
Chapter
1
Stating Your Income
A
n income statement shows in black and white how much money a business
earned and spent over any given period, along with a bottom-line figure:
net profit or loss. As an accountant, you create income statements for your
company and other users, including investors. Business owners and managers
use income statements to determine the overall financial condition of their business and to make informed decisions. Investors and lenders may also refer to a
company’s income statements when deciding whether to buy or sell shares in the
company or loan the company money.
This chapter begins with the components that make up the income statement;
then it moves on to disclosures and income-statement presentation, and leads
you through the process of deciding how much information a financial statement
reader needs. The chapter also explains extraordinary gains and losses. Finally,
you find out about common misconceptions surrounding the calculation and
reporting of profit.
CHAPTER 1 Stating Your Income
203
Understanding the Nature of Profit
Profit doesn’t have one universal meaning or definition. Generally, you can separate profit into three categories:
»» Selling an asset for a gain: You profit when you buy something and sell it for
a gain. Real estate and investment companies are in the business of buying
assets that appreciate in value.
»» Selling a product: Manufacturers make a product and sell it for a profit.
Retailers buy products as inventory and make a profit when the inventory is
sold. Both types of companies sell a product for more than their total costs.
»» Providing a service: Plumbers, carpenters, and electricians provide a service
for a fee. If the total fees generated are more than the total costs, the
business earns a profit.
For more about the various ways a business generates profits and reports those
profits, keep reading.
Profit is a calculated number equal to the difference between revenue and expenses.
Revenue is on one side of the scale, expenses are on the other side, and profit is
the measure of how much the revenue side outweighs the expense side. To locate
profit, you must trace the effects of revenue and expenses.
Suppose that a business collects cash for all its sales and pays cash for all its
expenses during the year. You need to look to only one place — its cash account —
to find the business’s profit. A business may make credit sales, however, and not
collect cash from all its sales during the year. Furthermore, the typical business
doesn’t pay all its expenses during the year and pays some expenses before the
start of the year. In short, sales and expenses affect several assets, including cash
and liabilities.
Choosing the Income-Statement Format
The bottom-line profit (or loss) in an income statement draws the most attention,
but the income statement is really about revenue and expenses. A business can’t
make profit without revenue and expenses.
204
BOOK 4 Preparing Income Statements and Balance Sheets
»» Revenue
»» Expenses
»» Profit or loss
Income statements are reported in two basic formats (although in actual practice,
you see many variations):
»» Multistep format: This format typically presents four measures of profit:
gross margin, operating earnings, earnings before income tax, and net income
(see Figure 1-1 for an example). One revenue line and four profit lines are
presented. One purpose of this format is to disclose gross margin, which is a
key determinant in the bottom-line profit performance of businesses that sell
products. Gross margin is the revenue less cost of goods sold. Any slippage in
gross margin as a percent of sales revenue is viewed with alarm.
»» Single-step format: In this format, all expenses are added, and their total is
deducted from revenue (see Figure 1-2 for an example). Unlike the multistep
format, the single-step format presents only one profit line, which is bottomline net income.
The income statement examples shown in figures 1-1 and 1-2 are simplified versions compared with actual income statements in external financial reports.
FIGURE 1-1:
Example of
multistep income
statement
format.
© John Wiley & Sons, Inc.
CHAPTER 1 Stating Your Income
205
Stating Your Income
An income statement reports three basic items of information, in the following
order:
FIGURE 1-2:
Example of
single-step
income statement format.
© John Wiley & Sons, Inc.
Deciding What to Disclose in
the Income Statement
After a business decides on the format for reporting its income statement (multistep or single-step, as explained in the preceding section), the next decision
concerns how much information to disclose about its expenses.
Considering expense disclosure
Accountants work with different requirements for expense disclosure, depending
on whether the company is public or private.
Public companies are subject to financial disclosure rules issued by the U.S. Securities and Exchange Commission (SEC). A publicly owned business has no choice
but to abide by these rules. Otherwise, trading in its stock shares could be suspended by the SEC — the kiss of death for a public company.
Income-statement disclosure standards for nonpublic businesses (that is, those
not subject to the SEC’s jurisdiction) are less specific. Generally accepted accounting principles (GAAP) provide broad guidance on how much information should
be disclosed about expenses in the income statement.
Generally speaking, businesses that sell products report their cost of goods
sold expenses, and almost all businesses report their interest and income tax
expenses. Generalizing about the disclosure of other expenses, however, is much
more difficult.
Figures 1-1 and 1-2 disclose only one large operating expense category: selling and general expenses. Some businesses disclose only this expense because
they’re reluctant to reveal any more detail about their operating expenses. Other
businesses report five or ten operating expenses in their income statements.
206
BOOK 4 Preparing Income Statements and Balance Sheets
When deciding how much expense disclosure to include in income statements,
consider the following three factors:
»» Confidentiality: Many businesses don’t want to reveal the compensation of
the officers of the business, for example. They argue that this information is
private and personal.
»» Materiality: Most businesses don’t see any point in reporting expense
information that’s relatively insignificant and would only clutter the income
statement.
»» Practicality: Businesses limit the income statement contents to what fits on
one page. A business can put additional detail about expenses in the footnotes to its financial statements, but many people argue that shareowners
and lenders have only so much time to read financial statements, so putting
too much information in financial reports is counterproductive.
If you’re a major outside shareowner in a business, you may request information
about four expenses: repairs and maintenance, advertising, pension and profitsharing plans, and employee benefit plans. The information could be reported in
the income statement itself or in the footnotes to the financial statements. Why
these four? Repairs and maintenance expense can be manipulated by management
to push profit up or down for the year. Advertising is a discretionary expense that
you may want to compare with sales revenue. Pension and profit-sharing plans
and employee benefit plans can be large encumbrances on a business.
Examining How Sales and Expenses
Change Assets and Liabilities
In a financial report, the income statement may seem to be disconnected from
the balance sheet and the statement of cash flows. Nothing is further from the
truth. The three financial statements are interdependent and interconnected. If
sales revenue or one of the expenses had been just $10 different from the amount
reported in the income statement, a $10 difference would appear somewhere in
the balance sheet and statement of cash flows. The following sections explain
how income statement activity is connected to the balance sheet and how the two
together reflect the financial condition of a business.
CHAPTER 1 Stating Your Income
207
Stating Your Income
Presenting the right amount
of expense information
Sizing up a business’s financial condition
Financial condition is the status of the firm’s assets, liabilities, and equity at a certain point in time. In this book, financial condition refers to the amounts presented
in the balance sheet. This section explains how income statement activity is connected to the balance sheet.
As explained in “Choosing the Income-Statement Format” earlier in this chapter, an income statement reports revenue, expenses, and profit (or loss). But an
income statement doesn’t report how revenue and expenses change the financial
condition of the business. In Figure 1-1 earlier in this chapter, $26,000,000 in
revenue is reported in the annual income statement of a business. The business
also reports $24,310,000 total expenses for the year (the sum of the four expense
line items). How did sales revenue and expenses change the financial condition of
the business? The income statement doesn’t answer that question.
Business managers rely on their accountants to explain how sales and expenses
change the assets and liabilities of their businesses. Business lenders and shareowners also need to understand these effects to assess the health of a business.
Noting how accounting transactions affect
the income statement and balance sheet
Typical accounting transactions — accounting entries that many businesses make
every month — affect income statement activity that relates to balance sheet
accounts.
Suppose that you’re the chief accountant of the business whose income statement
is presented in Figure 1-1 earlier in this chapter. The president asks you to explain
the financial effects of revenue and expenses reported in the company’s latest
annual income statement at the next meeting of its board of directors.
To help organize your thoughts for the presentation, you decide to prepare summary revenue and expense journal entries for the year. Based on your analysis,
you prepare the following summary journal entries for revenue and expenses
reported in the income statement:
Revenue and receivables
Account
Debit
Cash
$25,000,000
Accounts receivable
$1,000,000
Sales revenue
208
Credit
$26,000,000
BOOK 4 Preparing Income Statements and Balance Sheets
Cost of goods sold expense and inventory
Account
Debit
Credit
Cost of goods sold expense
$14,300,000
Inventory
$2,000,000
Cash
$14,500,000
Accounts payable
$1,800,000
The business purchases $16,300,000 of product during the year. Of that total,
$14,300,000 represents cost of goods sold. The remaining $2,000,000 in
purchases remained in inventory. The company didn’t pay cash for all its
$16,300,000 in purchases. Its accounts payable for inventory purchases increased
$1,800,000. Therefore, cash outlay for purchases during the year was $14,500,000
($16,300,000 – $1,800,000).
Selling and general expenses and payables
Account
Debit
Credit
Selling and general expenses
$8,700,000
Prepaid expenses
$300,000
Cash
$6,900,000
Accounts payable
$850,000
Accrued expenses payable
$725,000
Accumulated depreciation
$525,000
Selling and general expenses is a somewhat complicated entry because operating
expenses involve several balance sheet accounts. The business added $300,000
to its prepaid expenses balance during the year. It recorded $525,000 depreciation expense for the year. In this instance, depreciation expense is included in
the selling and general expenses debit amount reported in the income statement.
That same amount is credited to accumulated depreciation, as shown in the previous table.
CHAPTER 1 Stating Your Income
209
Stating Your Income
The business makes credit sales. When recording a credit sale, the asset account
called accounts receivable is debited (increased). When the customer pays,
accounts receivable is credited (a decrease). The business initially collected
$25,000,000 in cash payments from customers. The accounts receivable balance
for the period increased by $1,000,000.
Not all expenses were paid for by the end of the year; unpaid expenses caused
an $850,000 increase in accounts payable and a $725,000 increase in accrued
expenses payable.
Interest expense and payables
Account
Debit
Interest expense
$400,000
Credit
Cash
$350,000
Accrued expenses payable
$50,000
The business paid $350,000 interest during the year. The amount of unpaid interest at year end increased $50,000. A general liability account for accrued expenses
is shown in this entry. (The business might credit a more specific account, such
as accrued interest payable.)
Income tax expense and payables
Account
Debit
Income tax expense
$910,000
Credit
Cash
$830,000
Accrued expenses payable
$80,000
At the end of the preceding year, the business didn’t owe any income tax. During
the year, it made $830,000 installment payments toward its estimated income
tax. Based on the final determination of its income tax for the year, the business still owes $80,000, which it will pay when it files its tax return. The general
liability account for accrued expenses is shown in this entry. (The business might
credit a more specific account, such as income tax payable.)
Considering the Diverse Financial
Effects of Making a Profit
Making sales and incurring expenses cause a multitude of effects on the assets
and liabilities of a business. In other words, making profit causes many changes
in the financial condition of a business. It would be convenient if a $1 profit
caused a $1 cash increase and nothing more, but the effects of making profit are
much broader and reach throughout the balance sheet.
210
BOOK 4 Preparing Income Statements and Balance Sheets
Introducing T-accounts
The journal entries in the preceding section summarize the effects of sales and
expenses on a business’s assets and liabilities. Figure 1-3 shows these changes
in T-accounts for the assets and liabilities. T-accounts aren’t the official, formal
accounts of a business; rather, they’re like scratch paper that accountants use to
analyze and “think out” the effects of transactions.
FIGURE 1-3:
Changes in assets
and liabilities
caused by sales
and expenses.
© John Wiley & Sons, Inc.
A T-account has two columns. Debits are always put in the left column, and
credits are put in the right column. The rules for debits and credits are explained
in Book 2, Chapter 1.
Figure 1-3 uses seven asset and liability accounts to illustrate the recording of
revenue and expenses for the year. Even a relatively small business may have 100
or more asset and liability accounts in its chart of accounts (see Book 1, Chapter 2).
The seven asset and liability accounts in the example, however, are sufficient
to illustrate the effects of revenue and expenses on the financial condition of a
business.
CHAPTER 1 Stating Your Income
211
Stating Your Income
This section introduces a tool called a T-account to explain how profit affects the
entire balance sheet.
Combining activity into one journal entry
To help you understand what profit consists of, the activity in Figure 1-3 is combined into one comprehensive journal entry. In this entry, the $1,690,000 profit
for the year is shown as an increase in the retained earnings owners’ equity
account:
Comprehensive Journal Entry that Summarizes Changes in Assets
and Liabilities from Profit-Making Activities during the Year
Account
Debit
Cash
$2,420,000
Accounts receivable
$1,000,000
Inventory
$2,000,000
Prepaid expenses
$300,000
Credit
Accounts payable
$2,650,000
Accrued expenses payable
$855,000
Accumulated depreciation
$525,000
Owners’ equity — retained earnings
$1,690,000
The totals for each balance sheet account represent the totals in the T-accounts
in Figure 1-3. Simply add the amounts you see in each T-account. The cash total,
however, is a little more complicated. For cash, take the $25,000,000 debit and
subtract the sum of the credit entries ($22,580,000) to arrive at the $2,420,000
balance in cash.
Profit improves the net worth of a business. Net worth, another name for the
­owners’ equity, equals total assets minus total liabilities. In this example, the
business makes a profit, and the effect on the balance sheet is that assets increase
more than liabilities, which is the typical profit effect.
Explaining additional transactions
related to profit
The profit-making activities of a business include more than just recording revenue and expenses. Additional transactions are required, taking place before or
after revenue and expense are recorded. You see some common transactions in
“Noting how accounting transactions affect the income statement and balance
sheet” earlier in this chapter. This section offers a more generic explanation of
212
BOOK 4 Preparing Income Statements and Balance Sheets
»» Collecting cash from customers for credit sales made to them. The cash is
collected after recording the sales revenue.
»» Purchasing (or manufacturing) products that are put in inventory and held
there until the products are sold. When a sale occurs, the cost of products
sold is charged to expense to match costs with the revenue from the sale.
»» Paying for products bought on credit and for other items that aren’t charged
to expense until sometime after the purchase. These purchased items are
considered to be assets until they’re used (expensed).
»» Paying for expenses that were recorded earlier.
»» Making payments to the government for income tax expense that has already
been recorded.
Only revenue and expenses are reported in the income statement, but the other
transactions change assets and liabilities, and they definitely affect cash flow. See
Book 5, Chapter 2 for more about cash flow.
Reporting Extraordinary Gains and Losses
When accountants refer to extraordinary transactions, they mean activity that’s
not related to your day-to-day business. Suppose that you manufacture blue
jeans. You incur costs to buy denim material. You pay labor costs and collect cash
from sales. If you happened to sell your headquarters building for a gain, that
transaction would be out of the ordinary (extraordinary). After all, you’re in the
business of making blue jeans, not selling real estate. Any profit from the sale of
the building would be an extraordinary gain.
Segregating the income statement
Extraordinary gains and losses require an income statement that’s split into two
distinct sections.
Many businesses report unusual, extraordinary gains and losses in addition to their
usual revenue, income, and expenses.
Recording a gain increases an asset or decreases a liability, and recording a loss
decreases an asset or increases a liability.
CHAPTER 1 Stating Your Income
213
Stating Your Income
before-and-after transactions. These explanations apply to dozens of accounting
entries in your business:
When a business records an extraordinary gain or loss during the period, the firm
reports the activity as a separate component of income from continuing operations. Continuing operations refers to day-to-day activities in a business. A bluejeans manufacturer, for example, would include the profit from blue-jeans sales
in income from continuing operations. All that being said, here’s how the multistep income statement is presented:
»» The first section presents the ordinary, continuing sales, income, and expense
operations of the business for the year, along with extraordinary gains and
losses as a separate component.
»» The second section presents any unusual, and nonrecurring gains and losses
that the business recorded in the year.
Considering business disruptions
The road to profit is anything but smooth and straight. Every business experiences an occasional discontinuity — a serious disruption that comes out of the
blue, doesn’t happen regularly or often, and can dramatically affect bottom-line
profit. In other words, a discontinuity is something that disrupts operations or the
regular flow of profit-making activities.
Here are some examples of discontinuities:
»» Downsizing and restructuring the business: Layoffs may require severance
pay or trigger early-retirement costs; major segments of the business may be
disposed of, causing large losses.
»» Abandoning product lines: When leadership decides to discontinue selling a
line of products, the business loses at least some of the money it paid to
obtain or manufacture the products, because it either sells the products
below cost or writes off products it can’t sell as a loss.
»» Settling lawsuits and other legal actions: Paying damages or fines or
receiving awards from favorable rulings are nonrecurring extraordinary losses
or gains.
»» Writing down (also called writing off) damaged and impaired assets: If
products become damaged and unsellable, or fixed assets need to be
replaced unexpectedly, you need to remove these items from the assets
accounts. Even when certain assets are in good physical condition, if they lose
their ability to generate future sales or other benefits to the business,
accounting rules say that the assets have to be taken off the books or at least
written down to lower book values (see Book 3, Chapter 1).
214
BOOK 4 Preparing Income Statements and Balance Sheets
method for recording revenue and expenses than it did in the past, in some
cases because the accounting rules have changed. Often, the new method
requires a business to record a one-time cumulative effect caused by the
switch in accounting method. These special items can be huge.
»» Correcting errors from previous financial reports: If a business discovers
that a past financial report had an accounting error, it must make a correction
entry, recording a loss or gain that had nothing to do with the performance of
the business in the current year.
According to financial reporting standards, a business must make these one-time
losses and gains very visible in its income statement. In addition to the main part
of the income statement that reports normal profit activities, a business with
unusual, extraordinary losses or gains must add a second layer to the income
statement to disclose these out-of-the-ordinary happenings.
If a business has no unusual gains or losses in the year, its income statement ends
with one bottom line, usually called net income, as shown in figures 1-1 and 1-2
earlier in this chapter. When an income statement includes a second layer, the net
income line becomes net income from continuing operations before unusual gains
and losses. Below this line, each significant, nonrecurring gain or loss appears.
Suppose that a business suffered a relatively minor loss from ending a product
line and a very large loss from a major lawsuit, the verdict of which went against
the business. The second layer of the business’s income statement would look
something like the following:
Net income from continuing operations
$267,000
Discontinued operations, net of income taxes
($20,000)
Earnings before effect of legal verdict
$247,000
Loss due to legal verdict, net of income taxes
($456,000)
Net earnings (loss)
($209,000)
Extraordinary gains and losses, which are reported as a separate component of
income from continuing operations, are generally complex and may be quite difficult to spot. When you’re looking for extraordinary gains or losses, answer the
following questions:
»» Why wasn’t the loss or gain recorded on a more piecemeal and gradual
year-by-year basis instead of as a one-time charge?
CHAPTER 1 Stating Your Income
215
Stating Your Income
»» Changing accounting methods: A business may decide to use a different
»» Was the loss or gain really a surprising and sudden event that couldn’t have
been anticipated?
»» Is such a loss or gain likely to occur again?
Questioning whether activity
is truly unusual
Every company that stays in business for more than a couple of years experiences
a discontinuity of one sort or another. But beware of a business that takes advantage of discontinuities in the following ways:
»» Discontinuities become continuities. A successful business makes consis-
tent profits from continuing operations. It’s the day-to-day business that
drives profit. Beware of a business that makes an extraordinary loss or gain
a regular feature on its income statement. Suppose that every year or so, the
business loses a major lawsuit, abandons product lines, or restructures itself.
It reports “nonrecurring” gains or losses on a recurring basis. You should
question whether the company’s core business could be profitable without
all the unusual transactions.
»» A discontinuity is used as an opportunity to record all sorts of write-
downs and losses. When recording an unusual loss (such as the cost of
settling a lawsuit), the business opts to record other losses at the same time
and writes off everything but the kitchen sink (and sometimes that too).
According to this big-bath strategy, you might as well take a big bath now to
avoid taking little showers in the future. Consider whether all the write-offs
truly relate to the event that occurred or whether the company is taking
advantage of the situation to expense unrelated items.
A business may just have bad (or good) luck regarding extraordinary events that
its managers couldn’t have predicted. If a business is facing a major, unavoidable
expense this year, cleaning out all its expenses in the same year so it can start
fresh next year can be a clever, legitimate accounting tactic. But where do you
draw the line between these accounting manipulations and fraud? Staying alert to
these potential problems is an important first step. The subject of fraud is covered
in Book 9, Chapter 7.
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To wrap up this chapter, consider some misconceptions about profit. It’s critical
that an accountant understand these issues. The first section covers misconceptions generally. The second discussion focuses on your firm’s profit compared
with profit standards in your industry. Finally, you consider an analysis of credit
sales and bad debt.
The purpose of this section is to remind business owners to stop and consider
what their level of profit really means to the business.
Clearing up profit misconceptions
Many accountants find themselves clearing up these misconceptions for other
people in the organization:
»» Profit doesn’t increase cash by the same amount. Most companies use the
accrual method, which matches revenue earned with expenses incurred to
earn the revenue. Using this method, you may post revenue and record
expenses without cash moving in or out of your business. As a result, a
$20,000 profit doesn’t mean your cash account is immediately $20,000 higher.
»» Some revenue and expense entries are based on estimates. Another
misconception about profit is that the numbers reported in the income
statement are precise. Many journal entries are based on estimates, which
require using judgment. Recognizing bad-debt expense, for example, often
requires estimating of the percentage of customers who won’t pay. The
expense may be later, when the actual amount of bad debt is known. (For
more on bad-debt expense, see “Waving the red flag when you see revenue
and credit sales increase” later in this chapter.) Profit calculations are partially
based on estimates.
»» A high level of profit doesn’t mean that the balance sheet is necessarily
attractive to investors. Consider how a company acquires and uses assets
to generate a profit. Suppose that a company borrows heavily to meet high
customer demand. The plan works, and the firm generates a high level of
profit. If sales go down, profit may decline. The business will have less in
revenue to make the larger debt payments. Ramping up spending to meet high
demand may become a drag on profits if sales decline. An investor may shy
away from investing in a company with a high debt load and declining sales.
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Stating Your Income
Correcting Common Misconceptions
about Profit
Comparing with industry standards
When considering your level of profit, comparing your profit with that of other
companies in your industry may be useful. Here are some points to mull over. The
percentages used are profit-margin percentages (net income divided by sales):
»» Reasonableness: Your shop sells sporting goods to hikers, mountain-bike
riders, and other participants in outdoor sports. You earn what you believe to
be an unusually high level of profit of 25 percent for the year. After some
research, you find that similar shops had profits in the same range. It turns
out that great weather increased demand for outdoor sporting goods. You
conclude that the profit — which is higher than you expected — is reasonable,
based on the industry average.
»» Sustainable level of profit: Suppose that your grocery store has a 10 percent
profit for the year. Stores in your industry typically have an annual profit of 2
percent. You do research to determine whether the 10 percent profit is
sustainable. After all, your profits should be in line with the industry’s profit
levels over time. You find that your high profit level was due to more demand,
due to a nearby grocery store’s closing. You decide to plan future sales and
costs based on the industry’s 2 percent profit.
»» Adding a product line: You manage a roofing company, which installs and
repairs roofs for the residential market. You’re considering adding siding
installation to your business. To estimate a profit margin for your new
venture, you can consider the industry profit averages. Assume that your
roofing business generates a 12 percent profit and that the siding industry
averages a 5 percent profit. You can consider how your total company profit
would look after you add the new product line.
Your goal is to plan and manage your business based on a reasonable, sustainable
level of profit. Industry standards should be part of your analysis.
Waving the red flag when you see revenue
and credit sales increase
When comparing income statements from different periods for the same business, watch out for this big, common red flag: an increase in revenue that’s tied
to an increase in credit sales. (See Book 5, Chapter 3 for additional guidance on
analyzing financial statements.)
Credit sales mean that you’re selling a product that will be paid for at a later date.
When a business increases its credit sales, it needs to consider how much of those
sales are credit sales to new customers. New customers, by definition, don’t have
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Here’s an example. You note these results from the previous year:
Previous-year results: Credit sales $1,200,000, bad-debt expense $24,000
(2 percent of credit sales)
The profit on the credit sales includes all expenses — including bad debt expense.
In the current year, you note an increase in credit sales. You also see that bad-debt
expense increased to 3.5 percent of credit sales. Here are the current-year results:
Current-year results: Credit sales $1,500,000, bad-debt expense $52,500
(3.5 percent of credit sales)
Bad-debt expense increases by $28,500 ($52,500 less $24,000). You can see how
this additional expense would eat away at profit. Assuming that everything else
remained the same, this higher bad-debt expense would reduce the profit margin.
Every dollar increase in credit sales generates a higher dollar amount of bad debt
compared with the previous year. If you own or run the business, you must consider whether the new customers are worth the risk of bad debt. Book 3, Chapter 6
has more information on bad-debt expense.
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Stating Your Income
a track record of making timely payments on credit sales. You may find that credit
sales are increasing but that bad-debt expense is increasing even faster. A business needs to perform some analysis to determine whether sales to new customers will be profitable over the long term.
IN THIS CHAPTER
»» Sticking with an asset’s historic cost
»» Listing common current assets
»» Distinguishing between tangible and
intangible assets
»» Preparing the asset section of a
balance sheet
Chapter
2
Balancing Your Sheets
A
balance sheet reports a company’s assets, liabilities (claims against those
assets), and equity (the amount of money left when you sell what you
own and pay what you owe). It is one of the most important reports that
a company produces, providing a snapshot of how a company’s capital is being
managed.
In this chapter we get the party started by focusing on assets. Regardless of how
a company acquired those assets (whether by borrowing money or using their
own), assets include the value of all the stuff they possess. From operating plants
to inoperable pens, and even some things that have no physical existence at all,
this chapter will explain how to play with your assets.
Homing in on Historic Cost
Before exploring typical business assets, you need to understand how the value
of most assets normally shows up on the balance sheet. Most assets are valued
on the balance sheet at their original historic cost — the cost of the item when it
was acquired plus any other costs to prepare the asset for use. Historical cost isn’t
fair market value, which is what a buyer is willing to pay for the asset in an open
marketplace.
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Here’s an example. Suppose that a company buys a building for $200,000 in 1999.
That $200,000 is the building’s historic cost. In 2015, the fair market value of
that building is $400,000, but the value of the asset on the balance sheet stays at
$200,000 — the historical cost. Book value is defined as cost minus accumulated
depreciation. If you consider buying an asset, the “true value” of the asset is its
book value. Check out Book 3, Chapter 1 for more on book value and depreciation.
Record marketable securities — securities that the company purchases to sell in the
short term — at their fair market value. See “Short-term investments” later in
this chapter for details. Keep in mind that some assets, such as marketable securities, use fair market value as the asset’s value on the balance sheet.
Discovering What Makes an Asset Current
Assets are resources a company owns and uses to generate revenue. Businesses
have many types of assets, which are categorized as current or noncurrent. Current assets (such as checking accounts, accounts receivable, and inventory) are
liquid, which means they either are cash or can quickly be turned into cash.
Noncurrent assets aren’t liquid; converting them to cash may take time. Converting these assets to cash may result in a loss or a gain on sale. Examples of noncurrent assets include tangible assets (things you can touch) such as a company’s
cars, computers, office buildings, or factories.
Not every noncurrent asset is tangible. Consider a company’s patents and trademarks, as well as investments that a business makes in other companies, all of
which are intangible assets. Another intangible asset, goodwill, is created when a
business buys another company.
For this book, current assets include cash and any asset that a company anticipates
converting to cash within a 12-month period from the date of the balance sheet.
On the balance sheet, you should list current assets in order of liquidity. Because
cash is the most liquid (it’s already cash), it shows up on the balance sheet first.
Other common current assets are short-term investments, accounts receivable,
notes receivable, inventory, and prepaid expenses. The following sections cover
each type in turn.
Liquidity refers to a firm’s ability to manage current assets and pay current liabilities on time. Managing liquidity is a critically important task for any business.
Refer to Book 5, Chapter 3 for more information.
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Cash
Cash consists of paper bills, coinage, and accounts backed by cash. When you go
to the grocery store and use your debit card to pay for your groceries, that debit
transaction is the same as paying with cash, because when you swipe your card
and enter your personal identification number, you attest to the fact that funds in
your checking account are sufficient and immediately available to cover the cost
of your groceries.
You may be wondering why a company complicates its bookkeeping with different bank accounts to pay expenses and accept revenue. In some cases, having
different bank accounts creates a safer business environment. Having a dedicated
payroll account, for example, allows payroll-disbursing employees to do their job
(processing payroll paper checks and electronic transfers) while having access to
a limited, defined amount of cash.
But with cash accounts, it’s really the Wild West out there in the business world.
Some small businesses have more accounts than they actually need, and some
large businesses have only one.
In terms of the balance sheet, the most important point to remember about cash
accounts is that they’re included in the current section of the balance sheet. But
understanding the business purpose for different types of cash accounts is also
important, so here they are, with brief descriptions:
»» Operating checking account: A business usually earmarks a particular
checking account, which it calls its operating account, to handle business
activities such as depositing revenue and paying bills.
»» Payroll checking account: Many companies have a checking account used
only to pay employees. The company calculates the total dollar amount of
checks or transfers going to pay employees and transfers that amount from
its operating account to cover the payroll checks. Often, businesses hire a
payroll service to perform these tasks. Head to Book 2, Chapters 4 and 5 for
more on payroll.
»» Merchant account: If a business allows customers to pay by credit card, it
probably has a dedicated merchant account into which the only deposits are
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Depending on its size, a business might organize and manage its revenue and bill
paying in one or more types of cash accounts. A retail business probably has a
separate operating account and merchant account (an account where credit card
transactions deposit). A large service business may have a separate operating
account and payroll account. Some companies have cash accounts for which they
earn interest income.
from its merchant provider: the company that helps it process customer credit
card transactions. Normally, withdrawals from this account go to the operating cash account to cover bill-paying withdrawals.
»» Petty cash account: Most companies have a cash box to pay for small daily
expenses. This account is also known as an imprest account, which means that
it always carries the same balance. Any time the cash box is checked, it should
contain cash or receipts equaling the petty-cash fund amount. So if the fund
balance is $300, cash and receipts in the box must equal $300.
»» Sweep account: A sweep account enables a company to earn investment
income automatically. Each evening, any extra cash in the company’s operating account is gathered up and transferred (swept) into investment accounts.
Money from many companies is pooled into a bigger pot, thereby providing
the advantage of a higher rate of return. Then, as the company needs the
money to clear checks and withdrawals, the money is swept back into the
operating account.
A negative (credit) balance in a cash account is considered to be a loan. If you have
a negative balance, your account is overdrawn; you owe the bank money. This
situation requires an adjustment at the end of an accounting period. You should
debit cash (to adjust the account to zero) and credit a loan or payable account. A
credit entry increases a liability account.
Short-term investments
A business may make short-term investments by purchasing securities issued by
other companies to the public. These investments can be equity (stock) and debt
(bond) securities that a company uses to invest any idle cash and earn a return.
Instead of investing idle cash in a bank account, a company invests idle cash in
stocks and bonds.
To classify these investments as short-term (current assets), the company must
be planning to sell them within 12 months of the balance sheet date. Two types
of common short-term investments are trading and available-for-sale securities,
which the following sections describe.
Trading securities
Trading securities are debt and equity securities that a business purchases to sell in
the short term to make a profit. You record trading securities on the balance sheet
initially at cost. Then, as their value fluctuates, you record them at fair market
value, with any unrealized gain or loss going to the income statement. Unrealized
means that the gain or loss is only on paper. You won’t have realized gain or loss
until you sell the securities.
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You must have a buy and a sell to have a realized gain or loss. An unrealized gain
or loss on a security means that a gain or loss would occur if you were to sell the
security. Until you sell the asset, the gain or loss is unrealized. Suppose that your
company buys 100 shares of common stock in ABC Corp. for $1,000. To record this
transaction, the balance sheet’s trading securities account is increased by $1,000,
and cash is decreased by the same amount.
Historic cost isn’t used on the balance sheet when you’re dealing with marketable
securities. In the example of ABC Corp. stock dropping in value, the value of ABC
Corp. stock on the balance sheet is reflected at less than historic cost.
Available-for-sale securities
Available-for-sale securities are debit and equity investments that a company opts
not to classify as trading securities. The difference is important because unrealized fluctuations in the value of available-for-sale securities do not show up on
the income statement as gain or loss. Instead, any changes (net of tax) go on the
balance sheet as accumulated other comprehensive income.
Here’s how to handle an available-for-sale transaction. Suppose that Reeves Corp.
buys 2,000 shares of common stock for $5,000, deciding to classify the stock as
available-for-sale. At the end of the month, the fair value of the shares is $6,000.
Woohoo! That’s an unrealized gain of $1,000.
To record this transaction, you increase (debit) the value of the security on the
balance sheet by $1,000 (from $5,000 to $6,000) and increase (credit) accumulated other comprehensive income by $1,000.
Accounts receivable
Accounts receivable is the amount of money that customers owe a business for merchandise or services they purchased from the business on credit. Many companies
sell products and services on credit, because the practice encourages customers
to do business. As a result, many companies have accounts receivable balances.
Suppose that you perform a service and give a client an invoice for $500. A couple
of weeks later, your client mails you a check for payment in full. In that two-week
period between when you performed the service and received the payment, that
$500 is on your books as an accounts receivable.
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Sadly, at the end of the month after purchase, these 100 shares are now worth
only $900. To adjust the current asset section of the balance sheet, you need to
credit (reduce) trading securities by the $100 drop in value. Then you also debit
(increase) other losses on the income statement by $100.
Unfortunately, some customers who buy on credit don’t pay their bills. Under
generally accepted accounting principles you have to make a valuation adjustment
for such uncollectible accounts, called bad debt. If you determine that a customer
isn’t going to pay, the receivable balance should be recorded as bad-debt expense.
If you extend credit to customers, GAAP requires you to estimate your uncollectible accounts. Companies usually base their estimate on their experiences with
bad debt. A company might find, for example, that 2 percent of all its credit sales
over the past five years were never collected. Those balances were written off as
bad-debt expense. That history of bad debt (2 percent of sales) can be used to estimate bad debt in the current period.
Using the allowance method
for bad-debt expense
The allowance method enables you to estimate the amount of bad-debt expense,
based on some percentage of credit sales. In the preceding example, you estimate
that 2 percent of credit sales will be uncollectible.
Suppose that sales on account are $50,000. Using the 2 percent figure, the estimate for uncollectible accounts is $1,000 ($50,000 × 0.02). The journal entry
to record this amount is to debit (increase) bad-debt expense $1,000. Bad debt
expense is an income statement account. You also credit (increase) allowances for
doubtful accounts $1,000 (allowance for doubtful accounts is considered to be a
contra account).
A contra account carries a balance opposite to the account’s normal balance. Because
the normal balance for an asset is a debit, the normal balance for a contra-asset
account, such as allowance for doubtful accounts, is a credit.
The amount of money you expect to collect from credit sales is defined as net
receivables. Here’s the formula:
Net receivables = Accounts receivable – Allowance for doubtful accounts
Allowance for doubtful accounts tells the financial-statement reader the dollar
amount of credit sales you estimate as bad debt. Until the company is reasonably
sure that a customer on account won’t cough up the cash, the journal entry is just
an estimate, not tied to any particular customer.
When you determine that a particular customer’s account is uncollectible (maybe
the company declares bankruptcy), your next step is removing the amount from
both allowance for doubtful accounts and the customer accounts receivable balance. After all, the mystery is over; you know that the customer won’t be paying.
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Suppose that Newbury Supplies owes you $1,000. You send the company a pastdue notice, which the post office returns as undeliverable with no forwarding
address. After following up, you have no success at locating Newbury. You must
make a journal entry to debit (decrease) allowance for doubtful accounts for
$1,000 and credit (reduce) Accounts Receivable–Newbury Supplies for $1,000.
The allowance method for bad debt adheres to the accounting principle of conservatism. When in doubt, the principle instructs the accountant to err on the side
of conservatism, which means that you should delay recognizing revenue until
you’re certain about your estimate. You should also recognize expenses sooner
rather than later. The principle helps you generate financial statements that
aren’t overly optimistic.
The allowance method posts bad-debt expense early. The bad-debt entry is based
on your estimate of bad debt. When you’re certain that a customer won’t pay, you
reduce (debit) the allowance account and reduce (credit) accounts receivable.
Going over the direct write-off method
Using the direct write-off method, you post bad debt only when you’re certain that
you won’t be paid. This method doesn’t use an allowance account to estimate
uncollectible balances, so it doesn’t meet GAAP requirements. When an account is
determined to be uncollectible, the direct write-off method requires you to debit
(increase) bad-debt expense and credit (reduce) accounts receivable. For more
about the direct write-off method, see Book 3, Chapter 6.
Note the difference between the allowance and direct write-off methods. The
allowance method posts bad debt when you estimate uncollectible balances. The
direct write-off method posts the bad debt only when you’re certain that you
won’t be paid. Because the allowance method posts bad debt sooner, the approach
is more conservative, thus conforming to GAAP.
Notes receivable
A note receivable is a short-term debt that someone owes you, meaning that
it comes due within 12 months of the balance sheet date. In many cases, this
current asset arises from a trade receivable: money your customer owes you for
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Now, what if the owner of Newbury Supplies sends you a check for the $1,000 after
you’ve written off the balance due? You record the payment by debiting cash and
crediting allowance for doubtful accounts. Keep in mind that you already removed
(credited) the receivable when you determined the amount was uncollectible. So
when you collect on a receivable that has been written off, you don’t post an entry
to accounts receivable.
the purchase of goods or services you provided. This situation can arise if the
customer has cash-flow problems that prevent it from paying for a purchase.
The customer goes to its vendor and asks for extended terms in a formal ­written
document, which replaces the less formal agreement to pay for the goods or
­services — the invoice.
A note receivable has three major components:
»» Principal: The amount owed to the company by the debtor.
»» Rate: The amount of interest the debtor pays on the principal. The rate is
almost always stated as an annual rate, even if the note is for a period shorter
than one year.
»» Time: The period in which the debtor has to pay back the note.
If you ever have to convert an accounts receivable to a note receivable, you can
breathe a sigh of relief, because all you do is increase (debit) notes receivable and
decrease (credit) the customer’s accounts receivable.
A note receivable appears in the current asset part of the balance sheet for only the
debt that you anticipate will be paid back within 12 months of the balance sheet
date. Any portion of the note receivable extending past that 12-month period gets
put in the long-term asset section of the balance sheet.
Inventory
Inventory is another current asset you need to account for in the asset section of
the balance sheet. You need to account for two types of inventory. The first is retail
inventory, which is merchandise available for sale in stores and shops. The second,
used by manufacturers, is product inventory, which includes direct materials: work
in process and finished goods.
Book 8, Chapter 2 is devoted entirely to inventory. The following two sections give
you brief descriptions and examples of inventory terms.
Retail (or merchandise) inventory
Accounting for retail inventory is easier than accounting for manufacturing
inventory, because a merchandising company, such as a retail store, has only one
class of inventory to keep track of: goods that the business purchases from various
manufacturers for resale (the goods on the store’s shelves).
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BOOK 4 Preparing Income Statements and Balance Sheets
Here’s an example of how a retailer handles an inventory purchase. The associate in charge lawn-mower inventory at a major home improvement store notices
that the department is running low on a certain type of mower and informs the
department manager. The manager follows the department store’s purchasing
process, and the department receives a shipment of mowers from its vendor. This
transaction is a purchase, which is part of inventory (an asset account). When the
mowers are sold, the inventory is reclassified as cost of goods sold (an expense
account).
Manufacturing inventory
»» Direct material inventory: Also known as raw materials, this inventory
reflects all materials the company owns that it will use to make a product. For
the lawn-mower manufacturer, raw materials include the steel to form the
body, leather or fabric for the seat, and all the other gizmos and parts that
make the mower work. In essence, any materials that you can directly trace
back to making the mower are direct material inventory.
»» Work-in-process inventory: At any point in time during the manufacturing
process, the company probably has items that are in the process of being
made but aren’t yet complete, which is work in process. For a lawn-mower
manufacturer, this category includes any mowers that aren’t completely
assembled at the end of the financial period. The company values its workin-process inventory based on the mower’s percentage of completion. If the
mower is 70 percent complete, the mower’s cost is likely to include 70 percent
of the costs incurred.
»» Finished goods: These costs are associated with goods that are ready for sale
to customers but haven’t yet been sold. For the lawn-mower manufacturer,
this category consists of mowers not yet sold to retailers, such as hardware
stores. Finished goods can end up in two places. If you sell the goods, the cost
is posted to cost of sales (an expense account). If you don’t sell the finished
goods, the cost is included in ending inventory (an asset account).
Companies can use many methods to place a dollar value on ending inventory.
See Book 8, Chapter 2 for details.
Prepaid expenses
Prepaid expenses are expenses that the business pays before they’re due. Many
companies pay six months’ worth of business insurance in advance, for example.
In a similar way, your car insurance policy requires insurance premium payments
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Because a manufacturing company doesn’t simply buy finished goods for resale
to customers, it has a more complicated inventory with three major components:
before your coverage starts. Companies may also pay rent in advance. Prepaid
expenses are considered to be assets because you don’t have to pay them later.
Suppose that a company pays an invoice for $1,200 that covers 12 months of car
insurance for the company vehicle. You originally book this amount as an increase
(debit) to prepaid expense and a credit (reduction) to cash. Then, as each month
goes by, you move the portion of the insurance cost from the balance sheet to the
income statement. Each month, you debit (increase) insurance expense for $100
($1,200/12 months) and credit (reduce) prepaid expense for the same amount. See
Book 3, Chapter 6 for additional coverage of prepaid expenses.
Keeping Track of Noncurrent (Long-Term) Assets
Assets are used to make money in your business, ensuring its solvency. You classify an asset as noncurrent or long-term if the asset will be used up over the
course of more than 12 months after the date of the balance sheet. Any part of
a note receivable that the company expects to receive after the 12-month cutoff
date is classified as noncurrent, for example. Natural resources such as coal, oil,
and timber are also noncurrent assets. So are mineral deposits, such as gold and
diamonds.
Solvency refers to a company’s ability to manage cash inflows and make timely
payments on long-term debt, and every business must manage solvency to maintain a good credit rating. You can read more about solvency in Book 5, Chapter 3.
This section focuses on the most common types of noncurrent assets you’ll
encounter, starting with tangible assets and then moving on to intangibles.
Meeting the tangibles: Property,
plant, and equipment
Tangible assets, also called fixed assets, include property, plant, and equipment
(PP&E) — a category that includes land, buildings, equipment, furniture, and
fixtures. The following sections describe the various tangible assets included in
PP&E.
Land
Land, also called real property, is the earth on which the company’s office buildings or manufacturing facilities sit. The cost of the land plus any improvements
the company has to make to the land to use it for business operations is your total
cost. Land is posted to the balance sheet at historic cost.
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BOOK 4 Preparing Income Statements and Balance Sheets
Four types of costs are included in the land account:
»» Contract price: The purchase price for the land.
»» Closing costs: Expenses to exchange the title of the land from buyer to seller.
These costs include real estate broker commissions, legal fees, and title
insurance.
»» Survey costs: Costs for a land surveyor to give you a professional opinion as
to where the boundaries of the property lie.
use, which include the cost of clearing the land if necessary to build the
manufacturing plant or adding sidewalks and fences to an existing property.
Because land isn’t considered to be “used up” the way that other PP&E is, land is
never depreciated.
If a company buys land as an investment, you record it in the investment section
of the balance sheet rather than PP&E. Do you wonder whether it would go in
the current or long-term section? Well, that classification depends on how long
the company plans on owning the land. If it anticipates selling the land within
12 months of the balance sheet date, it’s a current asset. Otherwise, record it as
noncurrent (long-term).
Buildings
This category covers the company-owned structures in which the company conducts business operations. It includes office buildings, manufacturing facilities,
and retail shops. If the business owns off-site storage facilities or warehouses,
these assets go in the buildings category too.
Unlike land, buildings are depreciable (see Book 3, Chapter 1). Also, when you’re
preparing a balance sheet, make sure that you list land and buildings separately,
because doing so is a GAAP requirement.
To figure out the cost of the land and buildings separately, do one of the following:
»» If the business purchased the land and buildings together, hire an appraiser
to determine the value of the land and the value of the building.
»» If the business purchased a piece of raw land and constructed its own
building, use the purchase agreement to determine the value of the land and
all invoices related to erecting the building to determine its value.
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»» Land improvements: Expenses the company incurs to get the land ready for
Equipment
This category is quite broad, encompassing any equipment a company uses to
make the products it sells to customers. A manufacturing company such as a bread
baker includes all the mixers, ovens, and packaging machines it uses to turn the
yeast and flour into loaves of bread and package them to ship to grocery stores.
A merchandising company (a retailer, which doesn’t make any products) includes
in this category any office computer equipment it owns, plus forklifts or mechanized ladders to move inventory around. Retail shops categorize their cash registers as equipment.
Furniture and fixtures
Last up in the parade of PP&E are furniture and fixtures, which include desks,
chairs, and filing cabinets. Add to these three common examples any other furniture items you see in an office setting, such as credenzas, conference tables, and
area rugs; the list goes on and on.
A merchandiser has fixtures to present wares for sale, such as glass display cases
and display racks. Mannequins are also considered to be fixtures, and depending
on their quality, they can be a very high-dollar item on the balance sheet.
If the company leases any of its PP&E, the leased items may not be considered
company property and don’t show up in the PP&E section of the balance sheet.
If the lease has aspects of ownership that pass the GAAP sniff test, however, you
record the leased asset on the balance sheet as a capitalized lease. For more about
leases, see Book 5, Chapter 4.
Investigating intangible assets
The big difference between tangible and intangible assets is that intangible assets
(usually) don’t have a physical presence. When you really dig into the subject,
you’ll probably find intangibles to be a lot more interesting than steel desks and
swivel chairs. The following sections describe the types of intangible assets and
explain how to write off intangible assets and generate intangible assets internally.
Identifying patents, trademarks,
and other intangible assets
The first type, which is the most common, includes long-lived assets such as patents, trademarks, and copyrights:
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BOOK 4 Preparing Income Statements and Balance Sheets
»» Patents: Patents provide licensing for inventions or other unique processes
and designs. Items that patents can protect run the gamut from pharmaceuticals to automobile circuitry to jewelry designs.
»» Copyrights: Securing a copyright means that someone can’t use the company’s printed work (such as books or articles) or recorded work (such as
musical scores or movies) without permission.
»» Trademarks: When a company has a trademarked name or symbol (such as
Microsoft), no other company can use it without getting permission from the
trademark owner.
Introducing goodwill
The second category of intangibles, goodwill, comes into play only when one
business purchases another for a price greater than the fair market value of the
net assets acquired during the sale. (Net assets are total assets less total liabilities.) Suppose that ABC Corp. buys XYZ Corp. for $250,000. XYZ’s net assets are
$175,000. ABC Corp. acquires $75,000 ($250,000 – $175,000) of goodwill in the
transaction. Goodwill is posted as an asset on ABC’s books.
Consider the logic of paying more than the fair market value of the net assets
when purchasing a company. Net assets represents the true value of the company.
If you sell all the assets and use the cash to pay off all the liabilities, you’re left
with net assets (equity). So consider why someone would pay more than the net
assets.
The buyer — who pays more than the net asset value — believes that the company
has assets or other opportunities not fully valued in the financials. Perhaps the
buyer is willing to pay more for the company’s brand name and reputation in the
marketplace. Maybe the company has a customer list, and the buyer believes
that they can generate more business from that list. Those examples are reasons
to pay more than the value of net assets.
Writing off intangibles by using amortization
Amortization is similar to depreciation (see Book 3, Chapter 1) because you use
amortization to move the cost of intangible assets from the balance sheet to the
income statement. Both amortization and depreciation are expenses.
CHAPTER 2 Balancing Your Sheets
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Balancing Your Sheets
See “Writing off intangibles by using amortization” later in this chapter for
details on how to determine the value of these intangible assets and account for
them on the balance sheet.
Most intangibles are amortized on a straight-line basis, using their expected useful life. The U.S. government grants patent protection for a period of 20 years.
Unless the patent has become obsolete, 20 years probably would be the expected
useful life the business uses for its patent amortization. An obsolete patent has
no value. The cost would be expensed immediately.
What about the balance sheet cost of intangibles? Leasehold improvements are
easy: The amount is the actual cost of any improvements the company makes. The
useful life for leasehold improvements is usually the term of the underlying lease.
Patents, trademarks, and copyrights the business purchases are treated similarly:
You have the cost of purchase as a basis for the amount you amortize.
Generating intangible assets for company use
The cost of developing an intangible asset in-house can be minimal. Maybe some
employees were just spit balling in a meeting and came up with a catchphrase that
eventually became very valuable because of the success of the product associated
with the phrase.
In this case, the company can include the legal costs to file the trademark with
the federal government in a trademark asset account. Legal expenses incurred to
defend the trademark against infringement (unauthorized use) can also be added
to the trademark asset account. Keep in mind, however, that most research and
development costs to create an intangible asset are expensed as incurred. Those
costs aren’t posted to an asset account.
The second category of intangibles, goodwill, is never amortized. Accountants test
goodwill yearly for impairment. The company determines whether any goodwill
has declined in value and writes off (removes) that value from the balance sheet.
Exploring the Asset Section of
the Balance Sheet
To wrap up this chapter, Figure 2-1 shows what the asset section of the balance
sheet looks like. Liabilities and equity are each merely a line item in Figure 2-1.
Current assets are always shown first, in order of liquidity, followed by any
long-term assets, which typically include notes receivable (notes due more than
12 months past the balance sheet date).
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BOOK 4 Preparing Income Statements and Balance Sheets
Balancing Your Sheets
FIGURE 2-1:
The asset
section of a
balance sheet.
John Wiley & Sons, Inc.
The company’s PP&E appears next, with the accumulated and amortization shown
as a separate line item at the bottom of the section. Appearing at the end are any
nonphysical intangibles — usually net of amortization, which means that amortization is subtracted before listing the intangibles’ values on the balance sheet.
CHAPTER 2 Balancing Your Sheets
235
IN THIS CHAPTER
»» Defining current liabilities
»» Understanding the impact of payroll
and taxes
»» Finding out about long-term debt
»» Accounting for bonds
Chapter
3
Digging for Debt in the
Balance Sheet
I
t’s a common misconception that being in debt is a bad thing. If you’re using
the money that you’ve borrowed in some way that generates a profit, though,
then that’s definitely a form of healthy debt. After all, nearly all businesses
need to borrow money in order to acquire assets and fund operations.
This chapter covers both current and long-term debt, collectively known as liabilities. You discover the types of current liabilities that help a business manage its
day-to-day operations. You also find out about long-term debt obligations that
businesses use to acquire assets. Here, we discuss basic long-term debt — such
as mortgages and notes payable — and bonds, focusing on the many facets of this
complicated topic. A third type of liability — loss contingencies — also gets some
space in this chapter. These liabilities aren’t always included in financial accounting reports; you get the lowdown on when and how to include them.
CHAPTER 3 Digging for Debt in the Balance Sheet
237
Seeing How Businesses Account
for Liabilities
Liabilities are claims on company assets (cash) by other businesses or its employees. Because a company uses assets to pay liabilities, accountants refer to liabilities as a claim on assets. Examples include
»» Accounts payable: Money a company owes to its vendors for services and
products it purchased.
»» Unearned revenues: Money received from clients before the business
provides goods or services to the customer. When you pay for a one-year
magazine subscription, your payment is unearned revenue to the magazine
publisher. The revenue isn’t earned until the publisher starts to deliver
magazines to you.
»» Salaries payable: Wages the company owes to employees.
Generally accepted accounting principles dictate that when you prepare the liability section of the balance sheet, any claims against the company have to be
broken out between current and long-term obligations. For this book, the dividing
line between the two is the one-year mark: All liabilities that are due within one
year of the balance sheet date are considered to be current. All others are considered to be long-term.
If a company refinances a current liability, that new liability may be treated as
long-term. A company might replace an accounts payable balance with a note
payable (a formal loan document to pay the balance — possibly owed over several
years).
Book 1, Chapter 1 introduces the fundamental accounting equation, which is
Assets = Liabilities + Owners’ equity
Based on the order of elements in this equation, liabilities show up on the balance
sheet after total assets but before equity accounts, with current liabilities first,
followed by long-term liabilities. (Current and long-term assets receive similar
treatment; see Book 4, Chapter 2.)
Using the accrual method of accounting (explained in Book 1, Chapter 4), all revenue must be matched with expenses incurred during the production of that revenue. So if a company incurs costs, but money doesn’t change hands, a liability
shows up on the balance sheet to reflect the amount that eventually has to be
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BOOK 4 Preparing Income Statements and Balance Sheets
paid. The company might make a purchase from a vendor without paying for it
immediately, for example. That item will appear in accounts payable, which is a
current liability.
Figure 3-1 shows a simple liability section of the balance sheet, with all asset and
equity accounts consolidated to a single line item each (the two shaded lines).
Check out Book 4, Chapter 2 for a more formal presentation of all sections of the
balance sheet. Also note that each account’s chart of account number is included.
(See Book 1, Chapter 2 for more info about the chart of accounts.) A formal balance
sheet usually won’t include chart of account numbers.
© John Wiley & Sons, Inc.
Keeping Current Liabilities under Control
This section introduces nearly every type of current liability you’re likely to
encounter. It even tosses in some journal entries so you can see how the transactions get into the accounting records (see Book 1, Chapter 3). But before you
start, you need to understand the reason why breaking out current from longterm liabilities is so important. GAAP requires the division so that the user of
the financial statements can easily glean the information necessary to compute
several important financial ratios.
Liquidity ratios measure how well a company is prepared to pay short-term liabilities (bills due in less than a year) with assets available in the short term. One
important liquidity ratio is working capital, which is current assets minus current
CHAPTER 3 Digging for Debt in the Balance Sheet
239
Digging for Debt in the
Balance Sheet
FIGURE 3-1:
The liability
section of a
balance sheet.
liabilities. A variation on working capital is the current ratio, which is current
assets divided by current liabilities. These ratios are important to many users
of financial reports, who may be investors, bankers, or anyone else who has an
interest in the company’s financial health.
These financial ratios and tools (spelled out in Book 5, Chapter 3) give the user
specific criteria for deciding how well the company is performing. A bank’s loan
officer who’s deciding whether to loan a business money wants to gauge the
expectation of being paid back on time, for example. Working capital and the
current ratios are very helpful in that arena.
For this reason, netting current assets with current liabilities is rarely okay under
GAAP. Doing so would eliminate the ability to use any sort of ratio analysis involving current asset or liability accounts. If you purchase inventory on account (on
credit), for example, both the inventory and accounts payable accounts increase.
Accounts payable
Accounts payable (A/P) includes money a company owes its vendors for services
and products it has purchased. Accounts payable is a current liability because the
company anticipates paying the liability in the short term. Suppose that the company purchases inventory from a manufacturer. The transaction originally goes
in the purchases journal, which shows purchases on account, with a debit going
to whatever cost or expense account is most applicable and a credit going to A/P.
Per GAAP, A/P is always assumed to be a current liability. But a transaction originally entered as A/P could eventually be reclassified as a long-term debt. This
change may happen if the company couldn’t pay the vendor and the vendor agreed
to convert the short-term A/P to a long-term note (a formal document showing an
amount owed and a mutually acceptable interest rate and payback period spanning more than a year).
Note that the terms accounts payable and trade payables are often used synonymously. But technically, trade payables generally refer to vendors from which a
company buys business supplies and direct materials — items it uses to manufacture products for sale (see Book 7, Chapter 4). Accounts payable includes all
vendors you intend to pay within a year. Some accounting systems may include
both categories simply as accounts payable.
Many vendors selling on credit give a discount to customers who pay their balances early. The terms of a purchase might call for full payment in 30 days but
a discount of 2 percent if the customer pays the bill within 10 days. Accountants
refer to this type of arrangement as 2/10 net 30. If the company got a 1 percent
discount for paying in 15 days with the total amount due in 45 days, it looks like
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BOOK 4 Preparing Income Statements and Balance Sheets
this: 1/15 net 45. The seller is willing to accept a smaller payment (by offering a
discount) to collect the payment sooner. Collecting payments quickly provides the
business more cash to operate. Figure 3-2 illustrates the debiting and crediting
for $1,000 of inventory purchased on account with discount terms of 2/10 net 30
and the subsequent payment.
FIGURE 3-2:
Inventory
­purchase on
account and
payment within
discount period.
© John Wiley & Sons, Inc.
The nature of the beast is that most companies accrue payroll and related payroll taxes. With an accrual, the business recognizes a liability that hasn’t yet
been paid. At the end of many accounting periods, a company may owe payroll
to employees. This concept is easy to understand if you think about the way an
employer has paid you in the past.
Most companies have a built-in lag time between when employees earn their
wages and when the paychecks are cut. Suppose that Penway Manufacturing
pays its employees on the 1st and 15th of every month, with 15 days of wages in
arrears. This means that when the employees get their paychecks on July 15, the
paychecks compensate work they did from June 16 through June 30. The gross
wages earned but not paid as of June 30 have to be added to the balance sheet as
a current liability. You also have to account for any payroll taxes or benefits that
will be deducted from the employees’ paychecks when the checks are finally cut.
Unearned revenue
Unearned revenue is a liability that arises when a company receives payment for
goods or services rendered before it has provided the goods or services. Because
CHAPTER 3 Digging for Debt in the Balance Sheet
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Digging for Debt in the
Balance Sheet
Payroll and taxes
the business has an obligation to deliver the product or service, the unearned
revenue is a liability until the company completes its end of the transaction.
Unearned revenue can be a short-term (a year or less) or a long-term liability.
To be recorded as such, revenue has to be earned and realizable. If the customer
pays in advance, the revenue is realized. But the revenue isn’t earned until the
product or service is delivered to the client.
Suppose that you pay a $1,200 deposit to a cabinetmaker to build customized
cabinets for your office building. Until the cabinetmaker delivers the cabinets to
your office, your payment isn’t 100 percent earned revenue for the cabinetmaker.
The way this process works on the cabinetmaker’s end is that the company debits
cash and credits unearned revenue for your payment of $1,200. After delivering the completed cabinets, the company records revenue by debiting (reducing)
unearned revenue and crediting (increasing) gross sales for $1,200.
Other short-term liabilities
Other short-term liabilities include items such as loan payments that are payable within 12 months. Current debt can originate as short-term bank loans, or
it can be the portion of a long-term debt that’s due within the next 12 months.
Another type of current liability you’re likely to encounter is estimated warranty,
which reflects how much money a company may have to pay to repair or replace
products sold to customers.
Here’s more information on short-term bank loans, current maturities of longterm debt, and estimated warranty expense:
»» Short-term bank loans: When a company takes out a loan, it doesn’t always
have to be for an extensive period (such as a 30-year mortgage). Frequently, a
company anticipates getting paid for a job it has performed and just needs a
brief influx of cash to pay expenses such as payroll.
A good example of this situation is a working-capital loan, which a bank makes
with the expectation that the loan will be paid back from collection of
accounts receivable. As long as the loan is due in full fewer than 12 months
after the balance sheet date, you classify borrowed funds as current liabilities.
Short-term debt is important to examine when determining the financial
health of a company because it indicates whether a cash-flow issue could
arise. If the short-term debt is unreasonably high, the company may not have
the excess money to make the loan payments.
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BOOK 4 Preparing Income Statements and Balance Sheets
A company can also have a revolving line of credit, which is a loan with a preset
limit on how much the company can withdraw at any time. This type of
financing is considered to be a current liability. This sort of current debt is
much more flexible than a loan because the company borrows against it only
when necessary.
»» Current maturities of long-term debt: Suppose that a company has a
30-year mortgage on its land and building, and it’s in the third year of paying
off the loan. To reflect this mortgage properly on the balance sheet the
principal amount the company owes in the next 12 months has to be
recorded as a current liability. The rest of the mortgage payable is a long-term
liability, a subject covered in the next section.
You can use an amortization schedule, which shows how much of each
mortgage payment goes to principal versus interest, to figure out the current
portion of the long-term debt.
»» Estimated warranty liability: Warranties on products may be included in the
•
Provide a disclosure about the warranty in a footnote to its financial
statements (see Book 5, Chapter 4).
•
Calculate and book an estimate of how much it will cost to fulfill the terms
of the warranty.
A popular way to estimate warranty expense is to use a percentage of sales.
Normally, this percentage is figured historically. If in the past the company has
incurred an actual warranty expense of 4 percent, that same percentage
should be the current year’s estimate until the facts change.
Here are the steps for estimating and recording warranty expense:
1.
2.
Compute the total dollar amount of sales under warranty.
Calculate the dollar amount of warranty expense.
Use a percentage of total sales based on your experience with warranty
expenses in past years.
3.
Post an entry to debit estimated warranty expense and credit accrued
warranty liability for the warranty estimate.
CHAPTER 3 Digging for Debt in the Balance Sheet
243
Digging for Debt in the
Balance Sheet
purchase price of a product or something the purchaser elects to buy
separately — usually at the time of purchase. A great example is the guarantee of performance relating to the purchase of a computer from an electronics retail shop. The computer comes with a six-month warranty from the
manufacturer, covering numerous performance and repair issues. If the
computer breaks down within the six-month warranty period, the purchaser
can send it back to be fixed free of charge. The company has to take two steps
in this situation to ensure that its financial reports are complete:
4.
5.
Debit accrued warranty liability and credit cash for actual payments for
warranty expenses.
Compare your estimate of warranty expense with your actual payments
for warranty expenses (cash payments).
Consider whether the warranty estimates should be increased or decreased to
reflect your warranty expenses accurately going forward.
Ready to see how to journalize these transactions? Figure 3-3 gives you the lowdown on the entry to book the estimate and record actual warranty expense.
FIGURE 3-3:
Recording
accrued and
actual warranty
expense.
© John Wiley & Sons, Inc.
Planning for Long-Term Obligations
If you own a car that you financed, you’re probably all too familiar with long-term
debt — a loan that won’t be paid off within the next 12 months. Companies have
long-term debt too. Although a company usually uses current liabilities (loans) as
a vehicle to meet short-term obligations such as payroll, it may incur long-term
debt for the financing of company assets.
Being able to make timely payments on long-term debt is crucial for a business to
remain solvent and maintain a good credit rating. (See Book 5, Chapter 3 to find
out more about solvency.)
Financing asset purchases
with debt versus equity
Corporations raise money to purchase assets in one of two ways: debt or equity.
Debt means that the company borrows money with an obligation to pay the
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BOOK 4 Preparing Income Statements and Balance Sheets
borrowed funds back. Equity means that the company sells shares of its own stock
to investors. If you issue debt, you have creditors. If you issue stock, the purchasers of your stock are owners.
What makes equity investing appealing is that the company may not be under
any obligation to buy back the shares of stock from the investors. It also means
that equity investors have some say in the decisions of your business, including
voting rights on major corporate decisions. Equity investors also want a return on
investment, possibly in the form of a dividend.
Oddly enough, debt can end up making a company money. This situation is called
financial leverage, and it takes place when the borrowed money is expected to earn
a higher return than the cost of interest payable on the debt. Additionally, interest
expense on debt is normally a tax deduction, whereas dividends payable to investors are not.
Managing long-term debt
If the company needs to raise cash and decides to do so by accumulating debt, the
most common types are mortgages, notes payable, capitalized leases, and bonds.
Following is your accounting guide to the first three of these categories of longterm debt. Bonds are a much more complicated subject, covered in “Accounting
for Bond Issuances” later in this chapter.
Any type of debt instrument between a lender and a borrower specifies principal
(the amount borrowed), rate (how much interest the company pays to borrow the
money), and term (the duration of the note). A portion of each payment is applied
to principal and the other portion to interest.
Mortgages
Mortgages are used to finance the purchase of real property assets (building and
land, for example). The property collateralizes the mortgage, which means that the
property is held as security on the mortgage. If the borrower defaults on the mortgage, the lending institution seizes the property and sells it to recoup as much of
the borrowed money as possible.
CHAPTER 3 Digging for Debt in the Balance Sheet
245
Digging for Debt in the
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Here’s an example: You borrow funds at 6 percent to purchase a new machine to
manufacture a product. The new machine operates more efficiently. You incur
less repair and maintenance cost, and you’re able to produce more product each
month. As a result, your company earnings increase by 8 percent. Your 8 percent
growth in earnings more than offsets your 6 percent borrowing cost. Book 8,
Chapter 4 provides more insight on this concept.
Notes payable
Notes payable are formal written documents that spell out how money is being
borrowed. The earlier section “Other short-term liabilities” explains that the part
of a note payable that’s going to be paid off within the 12 months of the balance
sheet date is classified as short-term debt. The remainder of the note is considered to be a long-term debt.
Capitalized leases
Another type of long-term debt involves capitalized leases. A company ­doesn’t
always buy its fixed assets sometimes, it leases those assets. Leasing often
makes sense for any fixed asset that’s replaced frequently. Leasing computers,
for example, makes sense for businesses that need to stay current with computer
technology.
Capital leases have characteristics of ownership, which means that the cost of the
leased capital asset goes on the balance sheet as a depreciable asset.
Anticipating contingent liabilities
A contingent liability is a liability that may cause a future loss depending on
events that may or may not occur. Here are two examples of common contingent
liabilities:
»» Pending litigation: A company is actively involved in a lawsuit that hasn’t
been settled.
»» Guarantee of obligations: A business agrees to step in and satisfy the debt
of another borrower if need be. A company may guarantee the debt of a
supplier if the supplier’s product is critical to the company’s production
process. Perhaps the supplier can’t operate without a loan, and the lender
insists on a co-signer for the loan to be approved.
You typically record contingent liabilities in the footnotes to the financial statements (see Book 5, Chapter 4) rather than as a dollar amount in the financial
statements. If a loss due to a contingent liability meets the following two criteria,
however, it should be accrued and reported in the company’s financial statements
as a dollar amount:
»» The loss event is probable — likely to occur. Consider the guarantee-of-
obligation example: If the debtor business (the supplier) went out of
­business, and the owners disappeared into the night, the lender will
­probably come after the back-up guarantor to pay off the loan balance.
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BOOK 4 Preparing Income Statements and Balance Sheets
»» The amount of the loss can be reasonably estimated, which means that you
can come up with an accurate dollar amount of the loss. Continuing with the
guarantee-of-obligation example, the loss is reasonably estimated because it
should be the remaining balance on the loan, interest owed, and any additional charges tacked on by the lender in accordance with the obligatory note.
If the loss contingency meets these two standards for accrual, the journal entry
involves a debit to a relevant loss account (an expense) and a credit to a liability
account. The company could take the debit to loss on guaranteed debt and to
some sort of liability account such as amount due on guaranteed obligation.
Accounting for Bond Issuances
Bonds are long-term lending agreements between borrowers and lenders. A
municipality (such as a city or village) might issue bonds to finance the building
of new roads or a hospital. Corporations generally issue bonds to raise money for
capital expenditures, operations, and acquisitions.
A bond is either a source of financing or an investment, depending on which side
of the transaction you’re looking at. The company issuing the bond incurs the
long-term liability. The person or company acquiring the bond views it as an
investment; for a business, this investment is an asset.
Mulling over bond basics
Bonds are normally issued at face amount (the principal amount printed on the
bond, as explained in the following list). When a bond is issued, it’s sold to the
public for the first time. After issuance, a bond may be bought and sold between
many investors over time, based on the market price of the bond.
The market price of a bond can be expressed in one of three ways:
»» Face amount (also known as par value): The principal amount printed on the
bond, typically in denominations of $1,000
»» A discount: Less than face value
»» A premium: More than face value
CHAPTER 3 Digging for Debt in the Balance Sheet
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Digging for Debt in the
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The person who purchases a bond receives interest payments at the bond’s stated
interest rate during the bond’s term or for as long as they hold the bond. When the
bond matures (the term of the bond expires), the company pays the bondholder
back the bond’s face value, or principal amount.
When considering bond prices and rates of return, consider the following:
»» Principal repayment: The bond issuer is obligated to repay the face amount
at maturity regardless of the price the investor paid for the bond. If the bond’s
face amount is $1,000, for example, the bond issuer must pay back $1,000.
»» Interest payments: Most bonds pay interest monthly or semiannually (twice
a year). Bonds issued by corporations typically pay interest semiannually.
»» Yield to maturity: An investor has two cash flows that affect their total
return. One cash flow is the interest payments, which are based on the stated,
fixed interest rate. Investors may also have a gain or loss, depending on
whether they bought the bonds at a premium or a discount. The interest
income plus the gain or loss is the yield to maturity. You can view yield to
maturity as being the total return on the bond investment.
Examining sample bond transactions
To get a handle on bond prices and yield to maturity, consider an example of a
bond purchased at a discount; then consider an example of a bond bought at a
premium.
Buying a bond at a discount
A $1,000, 6 percent, 10-year face amount bond is originally issued at $1,000. One
year later, an investor purchases the bond at $920. Because the purchase price is
less than the face amount, the bond is purchased at a discount. That investor has
two cash flows:
»» Annual interest payments of $60 ($1,000 × 6 percent)
»» The principal amount paid at maturity, less the cost of the bond
($1,000 – $920 = $80)
The investor’s yield to maturity (total return) is more than 6 percent because
the investor earns $80 when the bond matures, along with the 6 percent interest
rate. When you buy a bond at a discount, you earn more than the stated interest
rate of the bond.
Investing in a bond at a premium
Using the same numbers, assume that a 6 percent, 10-year face amount bond
is originally issued at $1,000. One year later, an investor purchases the bond at
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BOOK 4 Preparing Income Statements and Balance Sheets
$1,050. Because the purchase price is more than the face amount, the bond is
purchased at a premium. That investor has two cash flows:
»» Annual interest payments of $60 ($1,000 × 6 percent)
»» The principal amount paid at maturity, less the cost of the bond
($1,000 – $1,050 = –$50)
The investor’s yield to maturity (total return) is less than 6 percent because the
investor loses $50 when the bond matures. When you buy a bond at a premium,
you earn less than the stated interest rate of the bond.
Kicking around the logic of paying a premium
Given the fact that paying a premium for a bond reduces the net interest earned,
you may wonder why an investor would pay a premium for a bond. Bonds are
priced at a premium because the stated interest rate on the bond is higher than
the interest rate of bonds currently being issued (for the same maturity and credit
quality).
This discussion also explains why bonds are priced at a discount. If a bond’s stated
interest rate is less than similar bonds currently being issued, the market price of
the bond is less than the face amount. If bonds are being issued at 5 percent, an
existing 4 percent interest rate bond sells at a discount.
Journaling bond transactions
When a company issues a bond and when the bond is purchased (at a premium
or a discount), the company must make a journal entry to record the activity, as
explained in the following sections.
Issuing a bond
Bonds are most often issued at face amount (par value). If a bond is issued at
par value of $1,000, the entry is to debit cash $1,000 and credit bond payable (a
liability account) for $1,000. Issuing a bond means that the company is selling
the bond to an investor. As a result, the company receives cash from the buyer.
Issuing a bond at a premium or discount doesn’t happen often, so you don’t need
to concern yourself with those scenarios.
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Digging for Debt in the
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Consider the example in the preceding section. Assume that 10-year maturity
bonds of similar creditworthiness are being issued at a 5 percent interest rate.
An investor may pay $1,050 for the 6 percent bond because current bonds being
issued have a stated rate of less than 6 percent. The investor is willing to pay an
extra $50 to earn more interest income.
Accounting for a bond purchased at a premium
Suppose that a buyer purchases a $1,000 bond for $1,020. Because the buyer pays
more the $1,000, the bond was purchased at a premium. The buyer debits bond
investment for $1,000 (the face amount). Premium on bond investment is debited
for $20, and cash is credited for $1,020. The premium of $20 is amortized, meaning that the bond premium is moved into an expense account over time until the
bond matures. The premium is an extra cost to the buyer.
Handling a bond purchased at a discount
Suppose that the buyer purchases a $1,000 bond for $980. Because the buyer pays
less than the $1,000, the bond is purchased at a discount. The buyer debits bond
investment for $1,000 (the face amount). Note that the bond investment is debited
for $1,000 whether the bond is bought at a premium or at a discount.
Discount on bond investment is credited for $20, and cash is credited for $980.
The discount of $20 is also amortized. In this case, the bond discount is moved
into an income account over time until the bond matures. The bond discount is
extra income for the buyer.
Considering the bond seller’s entries
Now consider the seller of the bond and the related entries. When selling a bond
at a premium, the seller receives more than the face amount. The premium must
be amortized over time into an income account. On the other hand, when selling
at a discount, the seller receives less than face amount. That discount must be
amortized into an expense account.
What you should notice is that additional expense for the buyer generates income
for the seller. The reverse is also true: Additional income for the buyer results in
more expense for the seller.
Understanding debt and other liabilities is a critical area for a business owner.
Debt is one of the two ways an owner can raise capital to run the business.
A manager needs to understand repayment terms and the total liabilities on the
balance sheet to make well-informed business decisions.
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BOOK 4 Preparing Income Statements and Balance Sheets
IN THIS CHAPTER
»» Meeting the three types of business
entities and two types of stock
ownership
»» Investigating paid-in capital and
retained earnings
»» Checking out reductions in
stockholder’s equity
»» Understanding how corporations pay
their investors
Chapter
4
Explaining Equity
E
quity (also referred to as net assets) is the combined total of each owner’s
investment in the business. Both terms refer to the difference between assets
(resources a company owns) and liabilities (claims against the company).
In this chapter we discuss some of the details regarding the amount of value in a
company that belongs to the shareholders. This part is exciting for many investors because this is the hindsight assessment of how much their investments are
actually worth to them in book value.
Understanding How Owner Equity
Varies among Business Entities
Depending on the type of business entity, the owners’ equity section of the balance sheet can range from bare-boned to quite elaborate, as explained in the following sections.
CHAPTER 4 Explaining Equity
251
Sole proprietorship
Sole proprietorships (one-owner businesses) have an equity account called owner
capital. Cash and other contributions that the owner makes to the business, such
as equipment, increase the owner capital account. Business earnings (net income)
also increase the owner capital account.
The owner draw account shows money and other assets that the owner takes from
the business to convert to personal use. Owner draw reduces the owner capital
account. Although owner draws are accounted for in a unique account, keep in
mind that you need to keep track of owner draw activity to calculate owner capital.
Here’s a formula to calculate an owner’s capital balance:
Owner’s capital balance = Beginning capital balance + Owner capital contributions
+ Year-to-date net income – Capital draws
Figure 4-1 shows the owner’s equity section of the sole proprietorship for Penway
Manufacturing owned by Mike Penway.
FIGURE 4-1:
A statement
of owner’s
equity for a sole
proprietorship.
© John Wiley & Sons, Inc.
Partnership
Partnerships (businesses owned by two or more people) mimic sole proprietorships in that the equity section on the balance sheet has capital and draw accounts.
Figure 4-2 shows the partner equity section of the Double-Trouble Partnership,
whose partners, Tom and Dottie Double, each own 50 percent of the business.
The amount of draws and income distributions a partner is allowed to take can
differ from that person’s partnership interest (ownership interest). So even
though you have two equal partners, that doesn’t mean they have to take the
same draw amount — hence, the differences in beginning and ending partners’
capital accounts between partners in Figure 4-2.
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BOOK 4 Preparing Income Statements and Balance Sheets
FIGURE 4-2:
A statement of
partners’ equity.
© John Wiley & Sons, Inc.
If one 50 percent owner takes a higher draw each year, their capital account
declines faster over time, everything else being equal. That’s why Tom’s capital
account balance is lower than Dottie’s ($12,000 versus $17,000).
Corporation
Unlike sole proprietorships and partnerships, corporations are owned by stockholders. The balance sheet section called stockholders’ equity represents the claim
shareholders of the corporation have to the company’s net assets. Stockholders’
equity is made up of four components: capital stock, paid-in capital, treasury
stock, and retained earnings. Capital stock, paid-in capital, and treasury stock
involve transactions dealing with the corporate stock issuances and repurchases.
Retained earnings contain income and dividend transactions. The sections that
follow give each of these components their due.
It will help you manage capital portfolios to know a little something about the differences in capital stock. To sell ownership in a corporation, the corporation issues
stock that investors can purchase. According to general accepted accounting principles (GAAP), all stock transactions must be reported on the balance sheet. The
following sections describe the types of stock covered in this book (common and
preferred) and show how to record stock transactions on the balance sheet.
CHAPTER 4 Explaining Equity
253
Explaining Equity
Distinguishing between Two Types
of Capital Stock
Looking into preferred stock
Preferred stock has two advantages over common stock:
»» Preferred-stock shareholders receive their dividends before common-stock
shareholders. If earnings are insufficient to pay both common and preferred
dividends, only the preferred dividend is paid. The preferred dividend is a
specific amount, stated as a percentage or a dollar amount.
»» If a corporation sells its assets and closes its doors, preferred shareholders
receive their portion of company assets before common shareholders receive
theirs. In other words, in the event that a company liquidates, and assets
remain on the books, preferred shareholders are more likely to recoup all or a
portion of their investments in the company.
Considering common stock
Common-stock shareholders also may earn a dividend, but the amount of the dividend is at the discretion of the corporation. (The dividend amount isn’t stated.)
The dividend may be higher or lower than last year’s — or even zero for the year.
In the unfortunate event that a corporation is liquidated, common shareholders’ claims on assets come after preferred shareholders’ claims are paid. In fact,
common-stock claims on assets are last in line, after bondholders, creditors, and
preferred stockholders.
Recording stock transactions on the balance sheet
GAAP dictates that you describe stock transactions properly on the balance sheet.
Figure 4-3 shows the proper balance sheet descriptions for common and preferred
stock. Note the following terms:
»» Par value: The value per share that’s posted to the stock account balance.
Note the difference in par values for common and preferred stock. Common
stock has a par value of $5; preferred stock is $200.
»» Authorized shares: The maximum number of shares that the corporation
can issue, according to its articles of incorporation. When a company is
formed, the owners determine how many shares they want to authorize.
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BOOK 4 Preparing Income Statements and Balance Sheets
»» Issued shares: Authorized shares sold to the public.
»» Outstanding shares: Authorized and issued shares held by the public. If the
corporation repurchases issued shares, those shares are considered to be
treasury stock. Treasury stock shares aren’t outstanding. (See “Buying back
shares: Treasury stock” later in this chapter for details.)
»» Dividend: The preferred stock dividend is a stated amount: 5 percent in
this case. The 5 percent is based on the $200 par value. So the dividend is
5 percent × $200, or $10 per share. The common stock doesn’t have a stated
dividend amount.
FIGURE 4-3:
Capital-stock
balance sheet
descriptions.
© John Wiley & Sons, Inc.
Defining Paid-In Capital
Paid-in capital represents money invested in the business (contributed capital).
Paid-in capital has two components:
»» Par value of common or preferred stock: The par value of the stock
issued (either common or preferred) multiplied by the number of shares
issued. If you issue 100 shares of $5 par value common stock, you would
post $500 (100 × $5) to the common stock line in the balance sheet.
pay for the stock above its par value. Additional, in this case refers to more
than par value. Suppose that you spend $700 to buy 100 shares of $5-parvalue common stock, and $500 is posted to common stock. The remaining
$200 ($700 purchase price less $500 par value) is posted to additional paid-in
capital.
CHAPTER 4 Explaining Equity
255
Explaining Equity
»» Additional paid-in capital: Additional paid-in capital is the dollar amount you
Recording Retained Earnings
The retained earnings account lists the sum of all net income earned by the company since inception less all dividends paid to shareholders since the company
opened for business. These transactions change the retained earnings balance:
»» Net income: Net income (profit) for the current year increases retained
earnings. A net loss reduces retained earnings.
»» Dividends: Earnings distributed to shareholders. If a company pays a
dividend, the payment reduces retained earnings.
Consider this formula for year-end retained earnings:
Year-end retained earnings = Beginning retained earnings + Current year net
income – Current year dividends.
Suppose that your company opened its doors on January 2, 2022. On January 2,
retained earnings are 0 because the company didn’t previously exist. From January
2 to December 31, 2022, your company has a net income of $20,000 and pays out
$5,000 in dividends.
On January 1, 2023, the retained earnings amount balance is $15,000 ($20,000 –
$5,000). To compute retained earnings as of December 31, 2023, you start with
$15,000 and add or subtract the amount of income the company made or lost during 2023. You also subtract any dividends paid during the year.
If you discover an accounting error after you close the books and issue the financial statements, post any required adjustment to the income statement to retained
earnings, not to net income. When you close the books, net income is reclassified
into retained earnings, so you must post any correction to net income to retained
earnings. See Book 3, Chapter 4 for more about closing the books.
Spotting Reductions to
Stockholders’ Equity
Three accounting transactions reduce stockholders’ equity: incurring a net loss
(refer to “Recording Retained Earnings” earlier in this chapter), paying dividends,
and repurchasing treasury stock. The following sections explain how paying dividends and repurchasing treasury stock result in reductions of stockholders’ equity.
256
BOOK 4 Preparing Income Statements and Balance Sheets
Paying dividends
Dividends are distributions of company earnings to the shareholders in the form of
cash or additional stock. For most investors, receiving stock dividends isn’t quite
as exciting as getting a check in the mail. But stock dividends can be quite profitable in the long run, especially if the stock’s price rises, because the investor has
more shares to sell.
Companies pay dividends only to shareholders of record — investors who own their
shares on a specific date, referred to as the record date. In other words, an investor
can’t simply purchase stock the day before dividends are paid, collect the dividends the next day, and then sell the stock.
Calculating dividends
Whether your company decides to pay cash dividends or stock dividends, you need
to know how to calculate the amount to pay investors of record. Here’s an explanation of both cash and stock dividend calculations:
»» Cash dividends: Shareholders of record receive cash dividends based upon
how many shares of stock they own. For a company to pay cash dividends,
two conditions have to be met:
•
•
The company has net income for the current period.
The company has enough ready cash to pay the dividends.
Suppose that an investor owns 1,500 shares of common stock in Penway
Manufacturing. Penway has both a surplus of cash and a retained earnings
balance, so the board of directors decides to pay a cash dividend of $12 per
share. The investor’s dividend is $18,000 (1,500 shares × $12).
»» Stock dividends: As the name implies, a stock dividend means that share-
Posting dividends to the accounting records
Now that you know the amount of cash or number of shares paid as a dividend,
you can post journal entries. (Recording the stock dividend is slightly more complex than the cash dividend entry.)
CHAPTER 4 Explaining Equity
257
Explaining Equity
holders of record receive additional shares of stock, not cash. The additional
shares received are based on the number of shares the investor already
owns. This type of dividend is expressed as a percentage rather than a dollar
amount. If an investor receives a stock dividend of 5 percent on 1,500 Penway
shares, they receive an additional 75 shares of stock (1,500 × 0.05).
Dividends are not an expense of doing business. They’re a balance sheet transaction only, serving to reduce both cash (in the case of cash dividends) and retained
earnings.
The reduction to retained earnings for a cash dividend is straightforward: You
reduce (debit) retained earnings by the amount of the dividend and credit cash to
reduce that account for the payment.
Posting the stock dividend is more complex:
1.
Determine the fair market value of the stock on the declaration date.
The declaration date is the date on which the board of directors decides to pay
a dividend.
2.
Calculate the total number of shares to be paid as a stock dividend.
Multiply the stock dividend percentage by the number of shares outstanding.
3.
Multiply the fair market value per share by the number of stock dividend
shares.
This total represents the fair market value of the stock dividend in total dollars.
4.
5.
6.
Debit retained earnings for the fair market value in dollars.
Credit common-stock dividends distributable for the par value of the
stock dividend shares.
Credit additional paid-in capital for the fair market value of the stock
that is greater than the par value.
Here’s an example of a stock dividend transaction:
Penway declares a 5 percent stock dividend at a time when it has 30,000 shares of
$10 par value common stock outstanding. At the date of declaration of the stock
dividend, the fair market value (FMV) of the stock is $15.
The stock dividend totals 1,500 shares (5 percent × 30,000 shares). The net effect
is to decrease retained earnings by $22,500 (1,500 × FMV of $15 per share) and
increase common stock dividends distributable by $15,000 (par value of $10 ×
1,500 shares). Additional paid-in capital increases by the difference between the
two: $7,500. This entry reduces retained earnings and shifts the dollar amount
($22,500) to common stock and paid-in capital.
When Penway issues the stock dividend, common stock increases by $15,000, and
the common-stock dividends distributable is adjusted to zero.
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BOOK 4 Preparing Income Statements and Balance Sheets
Corporations may issue stock dividends when they’re low in operating cash but
still want to throw the investors a bone. The investors stay happy because they
feel that they’re getting more of a return on their investments.
Buying back shares: Treasury stock
Treasury stock represents shares of stock that a corporation issued (sold) to investors and then bought back. You record treasury stock on the balance sheet as a
contra stockholders’ equity account. Contra accounts carry a balance opposite to the
normal account balance. Because equity accounts normally have a credit balance,
a contra equity account weighs in with a debit balance, because company equity is
reduced by treasury stock.
Your journal entry to record the purchase of treasury stock is to debit treasury
stock and credit cash (for payments to the sellers of stock). In accordance with
GAAP, don’t record any gain or loss on treasury stock transactions.
One reason why a corporation buys back shares of its own stock is to prevent a
hostile takeover. The fewer shares are trading in the open market, the smaller the
chance that another company can purchase controlling interest.
Exploring Stock Splits
One other type of stock transaction that doesn’t reduce retained earnings is a
stock split, which increases the number of shares outstanding while decreasing the
price per share proportionally. A company typically performs a stock split when it
believes that the share price is too high to attract investors.
The common-stock caption, which is the descriptive line on the balance sheet,
changes to reflect the split on the books. If the caption originally read “Common
stock, 1,000 shares at $100 par,” now it reads “Common stock, 4,000 shares at
$25 par.” Note that the total dollar value remains the same — $100,000 — with
no reduction of retained earnings.
CHAPTER 4 Explaining Equity
259
Explaining Equity
Suppose that Penway Manufacturing stock is trading for $100, and the company
thinks that the price is too high to attract the average investor. To get the price of
the stock down to $25 per share, the company issues a 4-for-1 split. Every outstanding share now equals four shares, each of which is worth $25. The logic here
is that one share worth $100 is equal to four shares worth $25.
Computing Earnings per Share
Earnings per share (EPS) is calculated as net income divided by shares of common
stock outstanding. (Although variations exist, this basic formula is most often
used to calculate EPS.) Potential investors like to see the EPS calculation so that
they can make educated investment decisions; earnings per common share is a
frequently used measure of profitability. The following sections explain how to
calculate EPS for a simple capital structure and give you basic information on EPS
in a complex capital structure.
Simple capital structure
If a company issues only common stock — or common stock with nonconvertible
preferred stock outstanding — it has a simple capital structure. The following
sections define convertible securities so that you know what nonconvertible stock
is and explain how to calculate the EPS for a corporation that has a simple capital
structure.
Understanding convertible securities
A simple capital structure assumes that the company has no convertible securities outstanding. Convertible securities are those that can be converted to common
stock, such as convertible bonds, convertible preferred stock, stock options, warrants, and rights.
Computing EPS for weighted average shares
To calculate EPS for a corporation with a simple capital structure, divide income
available to common shareholders by the weighted-average number of common
shares outstanding for the period. The weighted-average is figured by multiplying
the number of shares outstanding by the fraction of the period in which they’re
outstanding. If the company has 10,000 shares of stock outstanding in ­January,
February, and March, its weighted average for the year (12 months) is 2,500
(10,000 × 3 ⁄ 12).
Suppose that ABC Manufacturing Corporation has net income of $473,400. During
the year, the corporation has 38,000 outstanding shares of $4.50, $70 par value
preferred stock, and the weighted-average number of common shares outstanding
totals 205,000. The owners of the 38,000 shares of preferred stock get a dividend
of $4.50 per share first, which equals $171,000 (38,000 shares × $4.50 per share).
You have to subtract this figure from net income before figuring the EPS of common stock ($473,400 – $171,000 = $302,400). Dividing $302,400 by the shares of
common stock outstanding (205,000) equals $1.48 EPS of common stock.
260
BOOK 4 Preparing Income Statements and Balance Sheets
If net income includes items such as extraordinary gains or losses, a separate EPS
is required for each major component of income, as well as for net income.
Complex capital structure
If items that could cause a potential dilution to EPS exist, the company’s capital
structure is complex. Dilution refers to the idea that total earnings are spread out
over more shares of stock. Convertible securities are potential sources of dilution.
Accountants say potential source, because the owner of each security can choose to
convert the security to common stock. When the potential for dilution exists, you
have to show both basic and diluted EPS.
To figure diluted EPS, use the number of common shares outstanding that would
be issued if every potentially dilutive share were converted to common stock.
Presenting the diluted EPS gives the user of the financial statements the worstcase scenario for EPS, relating to any exercise of existing options or the conversion of existing securities. In other words, diluted EPS displays the lowest possible
EPS figure.
Check out Figure 4-4 for an abbreviated income statement showing how basic
EPS looks, including extraordinary items. Note that the figure includes a line item
reflecting diluted EPS.
FIGURE 4-4:
Explaining Equity
Showing EPS
and diluted EPS
on the income
statement.
CHAPTER 4 Explaining Equity
261
IN THIS CHAPTER
»» Seeing connections between the
income statement and balance sheet
»» Fitting key pieces into the balance
sheet puzzle with operating ratios
»» Adding assets to the balance sheet
»» Examining debt versus equity on the
balance sheet
Chapter
5
Interpreting Income
Statements and
Balance Sheets
E
very time you record a sale or expense entry by using double-entry accounting, you see the connections between the income statement and balance
sheet. A sale increases an asset or decreases a liability, and an expense
decreases an asset or increases a liability. Therefore, one side of every sales and
expense entry is in the income statement, and the other side is in the balance
sheet. You can’t record a sale or an expense without affecting the balance sheet.
The income statement and balance sheet are inseparable, but they aren’t reported
that way!
To properly interpret financial statements — the income statement, the balance sheet, and the statement of cash flows — you need to understand the links
between the three statements. Unfortunately, the links aren’t obvious. Each
financial statement appears on a separate page in the annual financial report, and
nothing highlights connections between related items on the different statements.
In reading financial reports, nonaccountants — and even some accountants —
usually overlook these connections.
CHAPTER 5 Interpreting Income Statements and Balance Sheets
263
This chapter stitches the income statement and balance together and marks the
connections between sales revenue and expenses (in the income statement) and
their corresponding assets and liabilities (in the balance sheet).
Rejoining the Income Statement
and Balance Sheet
When reading financial statements, you should “see,” in your mind’s eye, lines
connecting related amounts on the income statement and balance sheet. Because
financial reports don’t offer a clue about these connections, actually drawing the
lines, as done in the next section, may help you see the connections.
Seeing connections between accounts
Here’s a quick summary explaining the lines of connection between items on the
income statement and balance sheet, as shown in Figure 5-1, starting from the
top and working down:
»» Making sales (and incurring expenses for making sales) requires a business to
maintain a working cash balance.
»» Making sales on credit generates accounts receivable.
»» Selling products requires the business to carry an inventory (stock) of
products. When inventory is sold, the inventory cost is posted to cost of goods
sold — an expense account.
»» Acquiring inventory items on credit generates accounts payable.
»» Prepaying expenses (such as insurance premiums) creates an asset account
balance.
»» Depreciation expense is recorded for the use of fixed assets (long-term
operating resources).
»» Depreciation is also recorded in the accumulated depreciation contra account
(instead of decreasing the fixed asset account).
»» Amortization expense is recorded for limited-life intangible assets.
»» Operating expenses is a broad category of costs encompassing selling,
general, and administrative expenses:
264
BOOK 4 Preparing Income Statements and Balance Sheets
Some of these operating costs are prepaid before the expense is recorded,
and until the expense is recorded, the cost stays in the prepaid expenses
asset account.
•
Some of these operating costs involve purchases on credit that generate
accounts payable.
•
Some of these operating costs are from recording unpaid expenses in the
accrued expenses payable liability.
»» Borrowing money on notes payable generates interest income for the lender
and interest expense for the borrower.
»» Net income results in income tax expense. A portion of income tax expense
for the year may be unpaid at year-end. The unpaid balance is recorded in the
accrued expenses payable liability.
»» Earning net income increases retained earnings, which also increases the
equity section of the balance sheet.
FIGURE 5-1:
Connections
between income
statement and
balance sheet
accounts.
© John Wiley & Sons, Inc.
CHAPTER 5 Interpreting Income Statements and Balance Sheets
265
Interpreting Income Statements
and Balance Sheets
•
Using transactions to explain
the connections
Figure 5-1 provides a nice visual tool to connect balance sheet and income statement accounts. Keep that tool in mind as you consider some common accounting
transactions, as explained in the following sections.
Estimating a receivable balance at year-end
Figure 5-1 shows how the sales account (in the income statement) is connected to
accounts receivable in the balance sheet. An accountant can use historical trends
in these two accounts to project an accounts receivable balance at year-end.
Suppose that for the year just ended, a business reports $5,200,000 sales revenue, as shown in Figure 5-2. All sales are made on credit (to other businesses).
­Historically, the company’s year-end accounts receivable balance equals about
five weeks of annual sales revenue; in other words, an amount equal to five weeks
of annual sales revenue is not yet collected at the end of the year.
FIGURE 5-2:
Income
s­ tatement of a
business for the
year just ended.
© John Wiley & Sons, Inc.
Sales are level throughout the year. To determine the amount of accounts receivable to expect in the business’s year-end balance sheet, divide the $5,200,000
by 52 weeks to get $100,000 per week. After that, multiply by five weeks to get
$500,000 of sales revenue in accounts receivable.
266
BOOK 4 Preparing Income Statements and Balance Sheets
If historical trends allow you to project accounts receivable, you may also be able
to forecast an ending balance in inventory and a year-end accounts payable figure. Suppose that the same business has an annual cost-of-goods-sold expense
of $3,120,000 (refer to Figure 5-2), and its ending inventory balance historically
equals about 13 weeks of annual sales. You can expect the amount of inventory in
its year-end balance sheet to be: $3,120,000 ÷ 52 weeks = $60,000 average cost of
goods sold per week × 13 weeks = $780,000.
Historically, the business’s accounts payable for inventory purchases equals
about four weeks of annual cost of goods sold.
The accounts payable balance also includes an amount from purchases of supplies
and services on credit, but this example concerns only the amount of accounts
payable from inventory purchases.
Here’s how you calculate the amount of accounts payable for inventory purchases you’d expect to see in its year-end balance sheet: $3,120,000 ÷ 52 weeks =
$60,000 average cost of goods sold per week × 4 weeks = $240,000.
Accruing other year-end expenses
A company has other expenses in addition to cost of goods sold. You may be able to
estimate the amount of other expenses that are accrued at year-end Suppose that
a business has annual operating expenses of $1,378,000 (which excludes depreciation, amortization, interest, and income tax expenses). Historically, its year-end
balance of accrued expenses payable equals about six weeks of its annual operating expenses. Ignoring accrued interest payable and income tax payable, you’d
expect the amount of accrued expenses payable in its year-end balance sheet to
be: $1,378,000 ÷ 52 weeks = $26,500 average operating expenses per week × 6
weeks = $159,000.
For this same business, the average amount borrowed on notes payable during the
year was $1,500,000. The average annual interest rate on these notes was 6.5 percent.
To determine the amount of interest expense you’d find in the business’s income
statement for the year: $1,500,000 average notes payable × 6.5 percent interest
rate = $97,500.
CHAPTER 5 Interpreting Income Statements and Balance Sheets
267
Interpreting Income Statements
and Balance Sheets
Projecting ending inventory balance
and accounts payable
Introducing Operating Ratios
One way to connect a balance sheet account to the income statement is to use a
ratio. Accountants use a variety of ratios to measure financial performance. This
section explains the use of operating ratios.
An operating ratio expresses the size of an asset or liability on the basis of sales
revenue or an expense in the annual income statement. A normative operating
ratio refers to how large an asset or liability should be relative to sales revenue or
its related expense. You can use operating ratios to judge how a business is performing compared to its own past performance and to the performance of other
companies in the same industry.
Comparing expected with
actual operating ratios
To manage businesses, managers compare expected performance with actual
results. As explained previously, a normative operating ratio is a benchmark. It’s
a result that’s expected or planned. Your actual ratio may differ. The process of
evaluating the difference between planned and actual results is called variance
analysis.
Suppose that Company X makes all its sales on credit and offers its customers
one month to pay. Very few customers pay early, and some customers are chronic
late-payers. To encourage repeat sales, the business tolerates some ­late-payers.
As a result, its accounts receivable balance equals five weeks of annual sales
revenue. Thus, its normative operating ratio of accounts receivable to annual
sales revenue is 5 (weeks) divided by 52 weeks, which equals 9.615 percent of
sales revenue.
The 5:52 operating ratio is the normative ratio between accounts receivable and
annual sales revenue; it’s based on the sales credit policies of the business and
how aggressive the business is in collecting receivables when customers don’t pay
on time. When you consider actual results, minor deviations from the normative
ratios are harmless. Significant variances, however, deserve serious management
attention and follow-up.
268
BOOK 4 Preparing Income Statements and Balance Sheets
Figure 5-2 earlier in this chapter presents the annual income statement of Company X. From the sales revenue and expenses reported in the income statement,
you can determine the balances of several asset and liability accounts by using the
normative operating ratios for the business.
Presenting ratios used for balance
sheet calculations
Operating ratios can be expressed in terms of a number of weeks in a 52-week
year or as percentages of annual sales revenue or annual expense. The normative operating ratios for the business whose income statement is presented in
Figure 5-2 are as follows (expressed as weeks in a year):
»» Cash: 7/52 or seven weeks of annual sales revenue
»» Accounts receivable: 5/52 or five weeks of annual sales revenue
»» Inventory: 13/52 or 13 weeks of annual cost of goods sold
»» Prepaid expenses: 4/52 or four weeks of annual selling and general expenses
»» Accounts payable for inventory acquisitions: 4/52 or four weeks of annual
cost of goods sold
»» Accounts payable for supplies and services bought on credit: 4/52 or
four weeks of annual selling and general expenses
»» Accrued expenses payable for operating expenses: 6/52 or six weeks of
annual selling and general expenses
Calculating balance sheet amounts
Using the operating ratios for Company X, whose income statement appears in
Figure 5-2, you can determine the balances for the assets and liabilities driven by
its sales revenue and expenses. Take the following steps:
1.
2.
Determine the revenue or expense account to be used for the
operating ratio.
Divide the revenue or expense dollar amount by 52 weeks to compute a
weekly level of activity.
CHAPTER 5 Interpreting Income Statements and Balance Sheets
269
Interpreting Income Statements
and Balance Sheets
Generating balance sheet
amounts by using ratios
3.
Multiply the fraction you calculated in Step 2 by the total dollar amount
of revenue or expense.
The result is the dollar amount in the balance sheet account.
Using the operating ratios presented in the earlier section “Presenting ratios used
for balance sheet calculations,” you can calculate dollar amounts for the balance
sheet accounts:
Assets
7/52 × $5,200,000 sales revenue = $700,000 Cash
5/52 × $5,200,000 sales revenue = $500,000 Accounts receivable
13/52 × $3,120,000 cost of goods sold = $780,000 Inventory
4/52 × $1,430,000 selling and general expenses = $110,000 Prepaid expenses
Liabilities
(4/52 × $3,120,000 cost of goods sold) + (4/52 × $1,430,000 selling and general
expenses) = $350,000 Accounts payable
6/52 × $1,430,000 selling and general expenses = $165,000 Accrued expenses
payable
These asset and liability balances are normative, not the actual balances that
would be reported in the business’s balance sheet. Refer to “Comparing expected
with actual operating ratios” earlier in this chapter for additional guidance.
Tackling other balance sheet issues
You may find the list of ratios to be straightforward. Calculating other amounts in
the balance sheet requires more explanation. These balance sheet accounts aren’t
typically derived by using an operating ratio. Consider these points:
»» Intangible assets: The business doesn’t own intangible assets and therefore
doesn’t have amortization expense. An intangible asset, such as a patent or
trademark, usually isn’t derived by using an operating ratio.
»» Accrued interest payable: This year-end liability typically is a relatively small
balance compared with the major assets and liabilities of a business. Also, the
expense that drives this balance isn’t an operating expense. The year-end
balance of accrued interest payable depends on the terms for paying interest
on the business’s debt.
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payable. This balance is typically smaller than the other amounts in the
balance sheet. The expense that drives this balance is the income tax status of
the business and its policies regarding making installment payments toward
its annual income tax during the year. Income tax expense isn’t considered to
be an operating expense.
»» Fixed assets: The ratio of annual depreciation expense to the original cost of
fixed assets can’t be normalized. Different fixed assets are depreciated over
different estimated useful life spans. Some fixed assets are depreciated
according to the straight-line method, and others are depreciated according
to an accelerated depreciation method.
FIGURE 5-3:
Partial balance
sheet with asset
and liability
balances.
© John Wiley & Sons, Inc.
FIGURE 5-4:
A partial balance sheet that
includes assets
and liabilities.
© John Wiley & Sons, Inc.
CHAPTER 5 Interpreting Income Statements and Balance Sheets
271
Interpreting Income Statements
and Balance Sheets
»» Accrued income tax payable: Income tax payable is similar to interest
FIGURE 5-5:
Complete
balance sheet
of Company X.
© John Wiley & Sons, Inc.
Adding Fixed Assets, Depreciation,
and Owners’ Equity
One asset is missing in the partial balance sheet shown in Figure 5-3: the fixed
assets of the business. Fixed assets are usually physical, tangible assets you use
to make money in your business. Virtually every business needs these long-lived
economic resources to carry on its profit-making activities. This section adds
fixed assets, depreciation, and owners’ equity to the balance sheet detail.
Dealing with fixed assets and depreciation
Unfortunately, you can’t use an operating ratio method to determine the balance
sheet amount for fixed assets or depreciation expenses for two reasons:
»» Different fixed assets are depreciated over different estimated useful life
spans, using different depreciation methods (such as straight-line and
accelerated), so you can’t simply divide total depreciation expense by the
original costs of the fixed assets to compute a consistent ratio for expensing
fixed assets.
»» Generalizing about the cost of fixed assets relative to annual sales revenue is
very difficult. As a ballpark estimate for this ratio, you could say that annual
sales revenue of a business is generally two to four times the total cost of its
fixed assets, but this ratio varies widely from industry to industry and even
among companies in the same industry.
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BOOK 4 Preparing Income Statements and Balance Sheets
»» The type of depreciation method used
»» When the assets were purchased (recently or many years ago)
»» Whether the business leases or owns these assets
Fitting in fixed assets and depreciation
to the balance sheet
Next, you see where fixed assets and depreciation fit into the balance sheet. Take a
look at the partial balance sheet shown in Figure 5-4. Notice the following:
»» The total current asset number ($2,090,000) is the same number you see in
Figure 5-3.
»» Figure 5-4 adds three numbers to the asset column. Note that these three
numbers are below current assets, which means that the added numbers are
long-term assets — assets that will be used over several years.
»» Total assets in Figure 5-4 are $3,855,000. Note that this total doesn’t balance
with total liabilities and equity ($350,000 + $165,000). In fact, the right column
doesn’t list any equity. That issue is addressed in “Tacking on owners’ equity”
later in the chapter.
»» Book 1, Chapter 1 explains the fundamental accounting equation, which
dictates that Assets = Liabilities + Owners’ equity. Because that isn’t the case in
Figure 5-4, this balance sheet is incomplete. You fill in the remaining balance
sheet numbers as you move through the chapter.
Calculating depreciation
Now that you see where fixed assets and depreciation show up in the balance
sheet, you can go over the calculation of depreciation.
Here are the accounts related to fixed assets in Figure 5-4:
$2,450,000 property, plant, and equipment – $685,000 accumulated depreciation =
$1,765,000 cost less depreciation
Accumulated depreciation is the total of all depreciation expense since the asset
was purchased. Property, plant, and equipment (PP&E) is a common term for
fixed assets.
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Interpreting Income Statements
and Balance Sheets
The cost and accumulated depreciation of a business’s fixed assets depend on
these factors:
If all the assets were bought on the same day, and the accumulated depreciation
was zero, the total property, plant, and equipment balance would be ($2,450,000
+ $685,000 = $3,135,000). As you see in the earlier section “Dealing with fixed
assets and depreciation,” there is no single method for calculating depreciation,
so the $685,000 is a combination of different depreciation methods. Some methods recognize depreciation evenly each year; others record more depreciation
expense in the early years. For this chapter, assume that the $685,000 accumulated depreciation is a combination of methods.
Tacking on owners’ equity
In the right column of the figure, you see two liability numbers but no data for
owners’ equity.
You can use the fundamental accounting equation to calculate total equity. As
explained in Book 1, Chapter 1, the fundamental accounting equation looks like
this:
Assets = Liabilities + Owners’ equity
or
Assets – Liabilities = Owners’ equity
Using the numbers from the balance sheet shown in Figure 5-4, you can calculate
owners’ equity.
$3,855,000 assets – $515,000 liabilities = $3,340,000 owners’ equity
Completing the Balance Sheet with Debt
If you own Company X, whose balance sheet is depicted in Figure 5-4, how should
you raise the $3,340,000 in capital? You can debate this question until the cows
come home, because no answer is right or best. The two basic sources of business capital are interest-bearing debt and equity (more precisely, owners’ equity).
Company management decides what percent of capital is raised by using debt, and
how much from equity.
Many businesses use debt for part of their capital needs. This practice makes
sense as long as the business doesn’t overextend its debt obligations.
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Figure 5-5 presents the complete balance sheet for Company X, including its debt
and owners’ equity accounts. These are the final pieces of the balance sheet puzzle
(if you start at the beginning of this chapter, this is what you’re working toward).
The business has borrowed $500,000 on short-term notes payable (due in one
year or less) and $1,000,000 on long-term notes payable (due in more than one
year). Interest rates and other relevant details of debt contracts are disclosed in
the footnotes to the financial statements. Debt covenants (conditions prescribed
by the debt contract), for example, may limit the amount of cash dividends the
business can pay to its shareholders.
Tying in the new equity section
Note that Figure 5-5 displays a more detailed equity section than the simple
equity total presented in Figure 5-4. The following sections describe the sources
of these details.
Bringing up common stock
The shareowners in Company X invested $750,000, for which they received 10,000
shares of capital stock. Typically, a footnote is necessary to fully explain the ownership structure of a business corporation.
As a general rule, private business corporations don’t have to disclose owners —
the owners of their capital stock. By contrast, public business corporations are
subject to many disclosure rules regarding the stock ownership, stock options,
and other stock-based compensation benefits of their officers and top-level
managers.
Addressing retained earnings
Retained earnings represent the sum of all net income earned by the company
since inception, less all dividends paid to shareholders since the business started.
Over the years, the business in this scenario retained $1,090,000 of its yearly
profits (see retained earnings in Figure 5-5). Two details aren’t explained in the
retained earnings line item:
»» You can’t determine how much of the cumulative total is from any single
year’s net income.
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Interpreting Income Statements
and Balance Sheets
Going over the debt section
of the balance sheet
»» Retained earnings don’t reveal how much of the company’s $255,125 profit
for the year just ended (see Figure 5-2) was distributed as a cash dividend to
shareowners during the year just ended.
One purpose of the statement of cash flows (explained in Book 5, Chapter 2) is to
report the cash dividends paid from net income to shareowners during the year.
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5
Reporting Your
Statements
Contents at a Glance
CHAPTER 1:
Valuating Finances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
Clarifying the Values of Assets in Balance Sheets. . . . . . . . . . . . . . . 280
Introducing Business Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
Comparing Business Valuation Methods. . . . . . . . . . . . . . . . . . . . . . 285
CHAPTER 2:
Watching Cash Flow and Equity. . . . . . . . . . . . . . . . . . . 289
Understanding the Difference between Cash and Profit . . . . . . . . 290
Flowing Through Cash Transactions. . . . . . . . . . . . . . . . . . . . . . . . . . 291
Navigating the Three Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 292
Preparing the Statement of Cash Flows. . . . . . . . . . . . . . . . . . . . . . . 298
Interpreting the Statement of Cash Flows. . . . . . . . . . . . . . . . . . . . . 301
Stating Changes in Stockholders’ Equity . . . . . . . . . . . . . . . . . . . . . . 302
CHAPTER 3:
Analyzing Financial Statements. . . . . . . . . . . . . . . . . . . 305
Judging Solvency and Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306
Driving the Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
Measuring Profitability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
Exploring Activity Measures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
Comparing Horizontal and Vertical Analysis. . . . . . . . . . . . . . . . . . . 317
Using Common Size Financial Statements. . . . . . . . . . . . . . . . . . . . 320
CHAPTER 4:
Explaining Disclosures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
Questioning Self-Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
Identifying Corporate Characteristics. . . . . . . . . . . . . . . . . . . . . . . . . 322
Reviewing Common Explanatory Notes. . . . . . . . . . . . . . . . . . . . . . . 324
Putting the Onus on the Preparer. . . . . . . . . . . . . . . . . . . . . . . . . . . 333
CHAPTER 5:
Sharing Public Reports. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
Differentiating between Private and Public Companies . . . . . . . . . 336
Finding Purpose in Reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
Reading the Annual Report to Shareholders. . . . . . . . . . . . . . . . . . . 338
Walking through Form 10-K. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
IN THIS CHAPTER
»» Valuing assets in balance sheets
»» Using the balance sheet to estimate
the value of a business
»» Considering methods to value an
entire business
Chapter
1
Valuating Finances
T
he balance sheet, also called the statement of financial condition, gives a
snapshot of a business’s capital management during a given point in time.
It presents the assets of a business on the one hand and the sources of
capital used to acquire those assets (liabilities and/or equity) of the business on
the other hand, reflecting the balance sheet equation:
Assets = Liabilities + Equity
This chapter considers how to value (estimate the monetary worth of) the assets
and liabilities in the balance sheet. Traditionally, a business values assets at historical cost. In this chapter, you find out how to use other methods to value assets
and how to compute a valuation for an entire business.
This chapter also explores the various uses for valuations and touches on the field
of performing valuations as an occupation. The chapter ends with a discussion of
business valuations based on earnings and cash flow.
CHAPTER 1 Valuating Finances
279
Clarifying the Values of Assets
in Balance Sheets
The evidence is pretty strong that readers of financial reports aren’t entirely
clear about the dollar amounts reported for assets in a balance sheet. Other than
cash — the value of which is clear — the amounts reported for assets in a balance sheet aren’t at all obvious to nonaccountants. Accountants should be clear, of
course, about the valuation of every asset reported in the balance sheet. In preparing a year-end balance sheet, an accountant should do a valuation check on every
asset. Recent authoritative pronouncements on financial accounting standards
have been moving in this direction.
Accountants now must check at the end of the accounting year to see whether the
value of any asset has been impaired (diminished in economic value to the business) and, if so, write down (decrease) the book value of the asset. Book value is
the cost of the asset less accumulated depreciation. Head over to Book 3, Chapter 1
for more on depreciation.
Considering options for balance
sheet valuation
If you need to value assets in the balance sheet, you may consider using historical
cost, a value below cost, or a balance sheet value above cost:
»» Historical cost: Most of the assets in a typical balance sheet are valued at
historical cost (original cost). That value should be your starting point.
»» Impairment: Accountants are required to write down impaired assets. The
value of an impaired asset is typically below cost.
»» Increase in market value of asset: In some cases, the value of the asset is above
cost. Short-term investments in marketable securities held for sale may have an
adjusted value above cost. The recorded values of nearly all other assets aren’t
written up (increased) to recognize appreciation in the replacement value or
market value of the asset. One reason is because assets you use in your business
(buildings, equipment) aren’t held for sale. Also, these assets are likely to be used
for many years. It’s not your intention to sell assets you use in your business.
Looking at balance sheet valuation entries
The dollar amounts reported for assets in a balance sheet are the amounts that
were recorded in the original journal entries made when recording the asset
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transactions. These journal entries could have been recorded last week, last
month, last year, or 20 years ago for some assets. Here are some examples:
»» The balance of the asset accounts receivable is from amounts entered in the
asset account when credit sales were recorded. These sales are recent,
probably within the few weeks before the end of the year.
»» The balance in the inventory asset account is from the costs of manufacturing
or purchasing products. These costs could be from the past two or three
months.
account in the balance sheet may go back five, ten, or more years. These
economic resources are used for a long time.
Connecting balance sheet values and expenses
Most balance sheet assets are valued at historical cost. The amount of cost used to
value the asset depends partly on how expenses are treated.
Merchandisers (retailers) purchase inventory and sell those goods to the public.
Inventory is an asset. Accounting rules dictate that the cost of inventory should
be the price paid for the asset plus any other costs incurred to prepare the goods
for sale. Those other costs may include shipping, storage, and even costs to build
display racks.
The additional costs to prepare the good for sale are not expensed immediately.
Instead, the costs are posted to inventory, and those costs become expenses when
the inventory item is sold. At that point, all the costs are posted to cost of sales (or
cost of goods sold).
If you buy jeans for your retail shop, for example, the shipping costs you pay to get
the jeans to your shop are considered to be part of inventory. If you need to build
displays racks by the front window, those costs are part of inventory too.
Another example of connecting expenses with balance sheet values falls in the
category of leasehold improvements — changes made to a leased space to meet a
tenant’s needs. Instead of expensing this amount immediately, accountants capitalize the cost as an asset. The asset is usually depreciated over the remaining
life of the lease. Suppose that you lease a factory building to a manufacturer. To
accommodate truck shipments for the manufacturer/tenant, you need to widen
the road approaching the factory. The spending on the road isn’t expensed immediately. Instead, the cost is posted to an asset account called leasehold improvements. (See Book 5, Chapter 4 for more about lease-related financial disclosures.)
CHAPTER 1 Valuating Finances
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Valuating Finances
»» The costs of fixed assets reported in the property, plant, and equipment asset
Comparing two balance sheet valuations
Consider two different valuations for the same asset to see how the difference
affects the balance sheet, as shown in Figure 1-1. The business uses the straightline depreciation method, by which an equal amount of depreciation is allocated to
each year of a fixed asset’s estimated useful life. (See Book 3, Chapter 1 for more
about depreciation methods.).
FIGURE 1-1:
Balance sheet for
a company that
uses straight-line
depreciation.
© John Wiley & Sons, Inc.
Suppose that the business used an accelerated depreciation method for its fixed
assets instead. In this case, $700,000 more in depreciation would be expensed,
using the accelerated method. The change in depreciation method results in several changes in the balance sheet, as shown in Figure 1-2:
»» Depreciation expense over the years would be $700,000 higher. As a result,
accumulated depreciation is $700,000 higher ($2,100,000 versus $1,400,000 in
Figure 1-1).
»» Using accelerated depreciation reduces the total value of assets. With that
method, total assets are $7,300,000, compared with $8,000,000 total assets
under straight-line depreciation.
»» The higher amounts of depreciation expense reduce cumulative net income
by $700,000. Lower net income means that retained earnings is also lower
($1,500,000 versus $2,200,000 in Figure 1-1).
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© John Wiley & Sons, Inc.
Introducing Business Valuation
You can also use different valuation methods to estimate the dollar worth of the
entire company.
The following sections present the uses of business valuations and explain the
Certified Valuation Analyst (CVA) designation for anyone who’s interested in
making a career of performing business valuations.
Grasping the practical applications
of business valuations
Accountants don’t perform business valuations simply to stick a dollar figure on
a business; they do valuations for clients who need a general idea of how much
money a business is worth to make well-informed decisions regarding that business. The following sections introduce a few practical applications of business
valuations.
Negotiating a business purchase
The most basic reason to place a dollar figure on a business is to help sellers or
buyers determine what they think is a reasonable price for the business. If you were
considering buying a pizza restaurant, for example, you’d probably want to take
CHAPTER 1 Valuating Finances
283
Valuating Finances
FIGURE 1-2:
Balance sheet
for the same
company, using
accelerated
depreciation.
a look at the ovens, equipment, and furniture, and you’d consider how soon those
fixed assets would need to be replaced. That analysis would help you determine
what the business is truly worth to you and how much you’d be willing to pay for it.
Securing a bank loan
Commercial loan officers work with loans to businesses. The loan officer is concerned about the company’s ability to generate enough earnings to make the
interest payments on the loan and repay the principal amount borrowed. If a valuation based on earnings shows that the company’s earnings are trending higher,
the business is likely to be in a better position to make loan payments in the
future. Suppose that your firm has a $2,000 monthly interest payment on a loan.
The interest payment would be less of a burden if your earnings were $50,000 a
month versus $5,000 a month. See the later section “Using future earnings and
cash flow” to find out more about business valuations based on earnings.
Explaining a company’s value to investors
Businesses often raise money by selling shares of the business to investors who
want to know what they’re getting for their money. Unfortunately, the balance
sheet may fail to reflect the true value of a particular asset or exclude the value
of certain assets. Suppose that a company purchases a time-saving machine that
will eventually save it far more than the cost of that machine; the machine is
worth more than the dollar amount the company paid for it. Also, customers and
clients are assets that don’t even appear on the balance sheet. A business may
have strong long-term relationships with certain clients that generate significant
sales and earnings, but the value can’t be posted to the balance sheet as an asset.
A business valuation takes this important asset into account.
Getting CVA-certified
The demand for business valuations and valuation analysis has resulted in a designation called a Certified Valuation Analyst (CVA). If you find business valuation
fascinating and want to pursue it as a career, you may want to consider getting
your CVA designation. The following sections show you how to get started and
highlight other professions that do business valuations.
Visiting the NACVA website
The CVA designation is offered through the National Association of Certified
Valuators and Analysts (NACVA), which you can find on the web at www.nacva.
com. NACVA trains and certifies Certified Valuators and Analysts. The website
explains that a primary requirement to become a CVA is to hold a valid license as
a certified public accountant.
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Understanding other professionals
and valuations
Many other professionals perform work that may be classified as business valuation, even though the work they produce isn’t considered to be certified valuation.
When a business is subject to litigation, an attorney may perform some analysis
on a firm’s balance sheet and income statement. If the owners of a firm are in a
legal dispute about the value of each owner’s share of the business, for example,
an attorney may perform an analysis. Appraisers perform value analysis of commercial property to estimate its current worth.
Comparing Business Valuation Methods
Just as you can use different valuations to estimate the dollar value of assets listed
on the balance sheet, you can use different methods to perform business valuations, and different methods lead to different conclusions. Keep in mind, however,
that the values calculated for a valuation may not be the amounts listed on the
balance sheet. A valuation may use concepts that are inconsistent with generally
accepted accounting principles (GAAP).
Whether determining the market value of a business is more an art or a science is
open to debate. One school of thought is that business valuation should be based
on a complicated, multifactor, formula-driven model — a scientific approach in
which a business’s dollar value can be quantified. The opposite camp argues that
in buying a business, you’re buying a future stream of earnings, not merely a
collection of assets. Their argument is that you’re just as well off using a simple
method, but this simple method requires forecasting future earnings, which is
notoriously difficult, not to mention unreliable.
Both sides agree on one point: The profit performance track record of the business (reported in its recent income statements) and its current financial condition
(reported in its latest balance sheet) are absolutely essential for the valuation of a
business. The debate concerns how you should analyze and use that information.
The following sections present two common approaches to performing business
valuations.
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Valuating Finances
Although other professionals may perform similar analysis, a CVA may be brought
in to perform a certified valuation. Your accounting skills, along with CVA training
and designation, ensure that you’re up to the task.
Replacing values
One measurement of a business’s worth in dollars is its book value — the cost of all
assets less all accumulated depreciation. The following sections consider the cost
of replacing assets used in a business.
Pairing fixed asset accounts
Most companies pair each fixed asset account with its own accumulated depreciation account, both of which are included in the company’s chart of accounts.
Your office-furniture asset account, for example, is paired with an account called
Accumulated depreciation–office furniture. The asset account less the accumulated depreciation equals the office furniture’s book value.
Accounting systems commonly give each fixed asset account its own accumulated
depreciation account; those account titles usually include a dash, like the one in
Accumulated depreciation–office furniture.
Forecasting spending on fixed assets
Suppose that you’re in the market for a car repair shop. The big assets on the
books are large pieces of equipment, such as hydraulic lifts for vehicles, and lots
of other tools and equipment. All these items are listed as fixed assets on the balance sheet, each with its own accumulated depreciation account.
A potential buyer most likely wants to buy the business and use it to generate
earnings over many years. Big considerations include when each asset needs to
be replaced and how much the replacement asset will cost. The prospective buyer
can scan the fixed asset listing and make a judgment on each asset. Assets with
a large amount of cost posted to accumulated depreciation probably need to be
replaced soon.
An analyst can estimate each asset’s replacement cost and the year of replacement. That list represents the required cash flow to maintain the assets needed to
operate the business. The listing’s total dollar amount, plus the initial purchase
price of the business, is the total investment required to buy and maintain the
business. At that point, the investor can decide whether the business is worth the
investment.
Using future earnings and cash flow
Although asset value provides a snapshot of a company’s current value, it doesn’t
provide much insight into the company’s potential future value. Taking into
account the replacement value of assets, as explained in “Forecasting spending
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on fixed assets” earlier in this chapter, is one way to project the company’s future
value. Another approach is to look at the company’s ability to produce earnings
and cash flow into the future. Several tools are available for measuring a company’s potential profit.
Nearly all companies use the accrual method, which requires them to recognize
revenue when it’s earned rather than when they receive payment. The accrual
method also posts expenses when they’re incurred instead of waiting until the
bills are paid. As a result, earnings under the accrual method differ from those
under the cash method.
Your first approach in determining future value may be potential earnings. Take
a look at the firm’s past financial performance. Next, consider how your industry
knowledge could help increase sales. Mull over the firm’s reputation and customer list.
Maybe you’re considering buying an ad agency. The firm has a stable group
of clients that have used the company for advertising for years. Your purchase
price includes retention bonuses to motivate current key employees to stay with
the company. Based on your long experience in the industry, you conclude that
you can generate a 15 percent profit margin — or a 15-cent profit on every dollar
in sales.
Every investment has an opportunity cost associated with it. Opportunity cost is
cash you invest in the purchase that you can’t use for some other purpose. Suppose
that you invest $500,000 in a greeting-card shop instead of investing the same
amount in a convenience store. The profit earned by the convenience-store owner
is given up; that’s the opportunity cost of investing in the greeting-card shop.
Moving to cash flow
Earnings are important, but a better measure of a company’s value may be the
cash flow it generates. If you decide to invest in a company, you use cash. That
cash has to come from somewhere. Consider these points:
»» If you borrow funds, you stand to pay interest expense on the loan.
»» Investors that purchase stock expect a return on their investment, possibly in
the form of a dividend.
»» If you use cash from your existing company’s operations, you’ll have a tougher
time meeting the cash-flow needs of your business.
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Evaluating earnings first
A business needs to recover its cash investment as soon as possible. Given these
considerations, a potential buyer may look at future cash flows of the new business to determine a company’s value. Suppose that you’re looking at a $600,000
investment in a bookstore. Based on your analysis, you determine that the business will generate $100,000 in cash inflow per year. The calculation you need to
use is payback period:
Payback period = Initial investment ÷ Cash inflow per period
In this case, the payback period is 6 years ($600,000 ÷ $100,000). You can make a
judgment as to whether 6 years is a reasonable period to recover your original cash
investment. See Book 8, Chapter 4 for more about making purchase decisions.
Putting a present value on cash flows
Many analysts add a present value assumption to cash-flow analysis because of
inflation, which is broadly defined as a rise in the general level of prices for goods
and services. In other words, today’s dollar is likely to buy you more than a dollar
will buy you five years from today.
Inflation affects the value of the cash flows you receive from the business you
purchase. The cash inflows should be adjusted to their present value (the current
worth of a future sum of money). You should consider the present value of the
cash flows you receive, because that amount represents the current purchasing
power of those dollars.
If your annual cash inflows is $100,000 per year. Assume a 3 percent inflation
rate. You’re interested in the present value of the payment received at the end of
year 5. You need to multiply the cash inflow by a present value factor of 3 percent
per period for 5 periods. You can find numerous versions of present value tables
online.
When you find a table, the period n is 5 (five years). After you find the n value for
5, scroll over to the 3 percent column. The table should show 0.863 (depending
on rounding in your table). You can multiply this present value factor by the cash
inflow amount:
Present value of $100,000 at 3 percent, end of year 5 = $100,000 × 0.863 = $86,300
If you find a present value factor for all payments, you can compute the present
value of all cash inflows. Use the sum of the cash inflows to judge the value of the
business.
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IN THIS CHAPTER
»» Separating cash from profit
»» Connecting the dots with the
statement of cash flows
»» Presenting cash flow by using the
direct and indirect methods
»» Summarizing changes in
stockholders’ equity
Chapter
2
Watching Cash Flow
and Equity
A
lthough accounting is all about the accrual method, which means that
revenue is recorded when it’s earned and expenses are recorded when
they’re incurred, the missing piece of the puzzle is cash changing hands.
For the users of financial statements to get a total picture of the health of the
business, cash payments and receipts have to be reconciled with accrual transactions. You accomplish this reconciliation by preparing a statement of cash flows.
In this chapter, you find out about the three sections of the statement of cash
flows — operating, investing, and financing — and what types of accounting
information are reported in each section. This chapter also brings you up to speed
on the two acceptable ways to prepare the statement of cash flows — the direct
and indirect methods — and concludes with a brief explanation of the statement
of changes in stockholders’ equity.
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Understanding the Difference between
Cash and Profit
As explained in Book 1, Chapter 4, the accrual method records revenue when it’s
earned, regardless of whether money changes hands. You also record expenses
when you incur them, regardless of whether they’re paid. Book 1, Chapter 4 also
introduces another accounting method: the cash method, which uses the criteria
of cash changing hands to determine when revenue and expense transactions are
recorded. The cash method is posting revenue and expenses by using your checkbook checks, debits, and deposits.
Recognizing accounting transactions by using the accrual method doesn’t hinge
on the exchange of cash. As a result, you can expect to see a difference between
a company’s cash balances and profit shown on the income statement. Not all
costs are immediately expenses, and until a cost is an expense, it doesn’t appear
on the income statement. In the same way, not all cash receipts are immediately
revenue. If a customer pays you in advance, you don’t recognize revenue until
you provide the product or service to the client. This section first shows you how
noncash transactions influence a company’s net income and then illustrates the
difference between costs and expenses.
Seeing how noncash transactions
affect profit
The statement of cash flows homes in on the difference between two amounts:
»» Ending balance in cash for the period
»» Net income for the period
Differences exist because net income factors in revenue earned but not yet collected from customers and expenses incurred but not yet paid, rather than
reflecting only transactions involving cash. In other words, net income is computed by using the accrual method of accounting. The accrual method means that
a business is likely to have a balance in accounts receivable (for credit sales) and
accounts payable (for purchases it hasn’t yet paid for). Suppose that in June, a
company deposits $2,000 in its checking account and writes checks to pay bills
for $1,800. If you look only at the cash flowing in and out of the business, the
company spent $200 less than it brought in, so it shows a profit of $200. But
what if in June, the company also used a credit card that it doesn’t intend to
pay for until August? Taking this transaction into account, the company actually
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spent more than it made, resulting in a loss of $800 ($2,000 in deposits less
$2,800 in checks and credit card use).
Distinguishing costs from expenses
When you use the accrual method of accounting, one of the big distinctions you
need to make (and keep in mind) is that costs aren’t the same as expenses. Take
a look at the differences:
»» Costs: A cost is the money the company uses to produce or buy something —
money that’s not available to use anymore. Costs are a use of company cash,
be it to purchase inventory, make investments, or pay back debt.
»» Expenses: Expenses are costs directly applied to revenue-producing activities
during a financial period. When spending is applied (or matched) with
revenue, the spending becomes an expense.
The statement of cash flows is important because it ties together the costs shown
on the balance sheet with the expenses shown on the income statement.
Flowing Through Cash Transactions
The primary purpose of the statement of cash flows is to show a company’s cash
sources and uses during the financial period. Although cash can come from many
sources — such as customer payments, loans, and sales of assets — uses of cash
trace back directly to costs. This information is interesting to the external users
of the company’s financial statements, who aren’t privy to the day-to-day operations of the business, because it provides a basis for understanding how wisely
a company manages its cash.
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Suppose that a company buys a shipment of aluminum for $25,000 cash to manufacture lawn mowers to sell to customers. The aluminum is a raw material,
which appears on the balance sheet as an inventory account. When the company
buys the aluminum, the price it pays (or promises to pay) is a cost. The company
uses the aluminum to manufacture lawn mowers. When a lawn mower is sold,
the cost of the aluminum used is reclassified as an expense (cost of goods sold).
If the company uses half of the aluminum in production during the accounting period, and all the lawn mowers produced are sold, the cost is $25,000, but
the expense is only $12,500. The remaining $12,500 stays in inventory until it’s
needed to produce the product and the product is sold.
A company can be a real go-getter in the business world, but if it throws cash
around like chewing gum, it may not be able to give prospective investors a reasonable return on their investment. Also, poor cash management may hinder a
company’s ability to make timely payments of principal and interest on a loan.
The statement of cash flows provides guidance for the following questions:
»» Does the company have the ability to generate positive cash flow in the
future? You don’t want to invest in a one-hit wonder. Viewing a current
statement of cash flows gives a hint about the company’s future prospects.
Investors look for companies that can generate positive cash flow year
after year.
»» Does the company have enough cash to make loan or dividend pay-
ments? If you’re a potential investor or lender for a corporation, letting the
business use your money for free probably isn’t very smart. You want to check
out the statement of cash flows to see how the business manages its money
and gauge the probability that the company will have enough cash to satisfy
its loan obligations and pay dividends.
»» Does the reason for the difference between net income and cash
transactions indicate a healthy business? All cash is not created equal.
Cash that a company brings in from gross receipts is a lot more exciting to a
potential investor than cash that the company has left over because it sold
some assets. After all, the business can own only a finite number of assets,
whereas the sky’s the limit for bringing in revenue from operations, assuming
that the business is managed well.
You ferret out this information by reviewing the statement of cash flows. Each
section ties back to how accounting transactions affect the income statement and
balance sheet. So you’re not looking at new information; instead, you’re looking
at the same information presented in a different way.
Navigating the Three Flows
A statement of cash flows has the following three sections:
»» Operating: The sources and uses of cash in this section come from day-to-
day business operations: cash received from sales to customers and cash paid
out for payroll, inventory, and other common costs.
»» Investing: The investing section is about buying and selling assets. This
section shows sources and uses of cash from investment purchases and sales.
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The section also includes purchases and sales of property, plant, and equipment (PP&E).
»» Financing: This section involves raising money to run a business and paying it
back. This section includes cash inflows from loans and cash outflows for
principal payments. It also includes equity related items (the sale of company
stock and payment of dividends).
If some of these terms are unfamiliar to you, don’t worry. By the time you finish
reading the rest of this section, you’ll be an old pro on cash flow.
Most of a company’s cash transactions are in the operating section of the cashflow statement because operations represent the common, day-to-day activity of
the business. If you’re reviewing cash activity, find the investing and financing
transactions first. When you finish, any cash activity that remains unassigned
should be posted to the operating section.
Figuring cash operating results
Operating sources of cash
Here are examples of operating sources of cash:
»» Cash receipts from the sale of goods or services: This source is the cash
that customers pay the company when the sale occurs. When the company
collects cash from accounts receivable, that cash inflow is also from operations. When you go into a store and buy a new phone for $65, for example,
you fork over the cost of the purchase plus sales tax in cash. Target records
this receipt as a source of cash.
On the flip side, suppose that on October 12, you go to an appliance warehouse to buy a new washer and dryer. The warehouse is holding a “90 days
same as cash” promotion, which means that as long as you cough up the cash
for the washer and dryer within 90 days, you pay no interest. On October 12,
the appliance warehouse has no cash source from you, and it won’t have that
source until you pay for your purchase on or before January 12. The appliance
warehouse can’t record the sale as a source of cash until it receives your
payment.
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Generally accepted accounting principles (GAAP) provide a guide to what shows
up in the operating section: The operating section contains transactions that
aren’t listed as investing or financing transactions. The following sections offer
examples of operating sources and uses of cash.
»» Trading portfolio sales: Trading securities are assets that a business pur-
chases to make a profit in the short term. The intention is to trade the
securities (buy and sell them). Suppose that a business has spare cash lying
around and it need access to that cash in the immediate future. Rather than
leave the cash in the bank to earn little or no interest, the company buys highly
liquid (easily convertible to cash) stocks, bonds, or loans.
The business tries to invest in something that won’t drop in value during the
holding period. Then, when the company sells the investment, the cash it
receives goes on the statement of cash flows in the operating section rather
than the investing section because that investment is short-term.
»» Interest and dividends: If the company makes loans to other businesses or
people, any interest income it receives on those loans goes in the operating
section. An example is a loan to a shareholder who is also an employee and
needs cash beyond what they’re receiving in their paycheck. This situation
happens often in a closely held corporation.
Also, some companies make loans to key vendors that need a short-term
infusion of cash to keep their doors open. A company takes this step if it’s in
the company’s best interest to keep an essential vendor in business. After all,
if you like to buy your widgets from Joe’s Widget Shop, and Joe goes out of
business, you’ll have to find another widget vendor, and maybe you won’t like
working with that vendor (or paying its prices) as much as you liked working
with Joe.
As reported on the income statement, dividends are income paid to shareholders based on their proportional ownership of the corporation. Suppose
that ABC Corp. owns 2,000 shares of XYZ Inc. stock. ABC receives dividends
from XYZ at $2 per share totaling $4,000 ($2 × 2,000 shares); this amount is
posted to the operating section as a source of cash.
Operating uses of cash
Cash uses also show up in the operating section of a statement of cash flows. The
cash outflows are kind of the flip side of the cash inflows. Accounts receivable
from customers is an inflow, for example, and accounts payable paid to vendors
is an outflow.
Here are the operating cash outflows you’re likely to encounter:
»» Satisfying accounts payable: Accounts payable is the amount a company
owes vendors for services and products purchased. When the original
purchase takes place, no money changes hands between the customer and
the supplier. Rather, the transaction contains a promise to pay within a certain
amount of time.
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Suppose that you order $500 worth of office supplies from Folders Office
Supply, and Folders immediately invoices your company for $500. Your
company doesn’t record this amount as a cash outlay, because Folders hasn’t
been paid yet; it merely has your promise to pay within 10 days (or 30 days, or
whatever). This $500 becomes a cash outlay only after you sign and mail the
payment check to Folders.
»» Trading portfolio purchases: Just as sales of trading securities are a cash
source, the amount of money the company pays to buy any trading security is
a use of cash. No securities other than trading securities go in the operating
section of the statement of cash flows. Again, the key to operating-section
placement is that the investment is short-term.
»» Payments for other business expenses: This category includes any cash
outlays to buy inventory, pay employees, remit income taxes due, or pay any
other suppliers (such as utility providers or the telephone company).
»» Interest payments: Any cash paid to lenders in the form of interest also goes
When a company borrows funds to operate, the cash inflow from the loan represents cash flow from financing. Interest payments on the loan, however, are an
operating activity.
The main thrust of the operating section of the statement of cash flows is to
reconcile the cash versus accrual treatment of income statement items. Because
paying dividends to shareholders isn’t a business expense, dividend payments
don’t show up on the income statement, so they’re not an operating use of cash.
Showing cash investing transactions
Investing transactions involve the purchase and sale of noncurrent assets.
Noncurrent assets are assets the company anticipates owning for more than one
year past the date of the balance sheet. Examples of noncurrent assets are longterm debt and equity investments, PP&E, and intangible assets such as patents
and copyrights.
Here are some typical types of debt and equity investments:
»» Common stock is an example of an equity investment. Equity refers to
ownership in a company. Suppose that you buy AT&T common stock. As a
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in the operating section. The purpose or source of the loan doesn’t make any
difference. So interest paid to a related party, such as a shareholder, for an
operating capital loan (cash made available for day-to-day business functions)
is treated the same as interest paid to a financing company for the note on
the company car.
shareholder, you’re an investor who gets paid back for the purchase of the
stock only if you sell it to someone else.
»» Bonds are debt investments. Corporations generally issue bonds to raise
money for capital expenditures, operating expenses, and acquisitions.
Because the investors are owed the principal amount they invest with the
company, they’re company creditors. A municipality sells bonds to the public
for the purpose of financing a new hospital, for example. Bondholders receive
interest payments at the bond’s stated interest rate. When the bond matures,
the company pays the bondholders the face amount of the bond.
Investing sources of cash
Investing transactions show up as sources of cash in the following ways:
»» Long-term debt sales and collection: A company’s investments in debt may
fall into three categories: loans, held-to-maturity debt investments, and
available-for-sale debt portfolios. Here’s how they differ:
•
Loans are easy to understand; they’re merely money the company loans to
others that won’t be repaid within 12 months of the balance sheet date.
You know from your own personal debts (such as car loans) that when you
owe money, you periodically have to make payments on the principal
portion of the loan. The same holds true with businesses. So any collection
of principal on loans is a cash source for the company lending the money.
•
Held-to-maturity debt investments are those the company anticipates
holding on to until the debt matures. Suppose that ABC Corp. buys
five-year bonds issued by the city of Orlando to build a new sports arena.
When the bonds mature, the cash proceeds go in the investing section.
•
Available-for-sale debt investments are one of those accounting topics
defined by what they aren’t rather than what they are. They don’t fall into
the held-to-maturity or trading category. As with held-to-maturity investments, however, any cash that the company receives from the sale or
collection of principal at maturity is reflected as a cash source in the
investing section of the statement of cash flows.
»» Sales of equity investments: If the company sells stock that it owns in other
corporations, the cash it receives is an investing source. If your company owns
500 shares of ABC Corp. common stock, and you decide to sell all 500 shares,
any money you receive for the sale of your shares goes in the investing
section.
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»» Sales of PP&E and intangibles: The cash proceeds from any PP&E the
corporation sells (such as cars, buildings, and equipment) is an investing
source of cash. The same is true if the company sells an intangible asset such
as a patent (which provides licensing for inventions or other unique processes
and designs).
Investing uses of cash
Here are the potential uses of cash that appear in the investing section of the
statement of cash flows:
»» Loans and debt purchases: Any cash the company loans to another company is a cash outlay; so is any cash that the company uses to buy bonds.
»» Purchase of equity investments: This category includes any cash the
company uses to buy stock in another corporation.
»» Purchase of PP&E: If the business pays cash for any fixed asset acquisition or
an intangible asset, this outlay of cash must appear in the investing section.
Financing activities show transactions with lenders such as long-term liabilities
(paying or securing loans beyond a period of 12 months from the balance sheet
date) and equity items (the sale of company stock and payment of dividends).
Sound familiar?
The one main financing cash source is cash proceeds if a business issues its own
stock or debt. If ABC Corp. sells $3,000 of its own stock to XYZ Inc., the cash
ABC receives from XYZ for this transaction is a financing source of cash on ABC’s
statement of cash flows.
Short-term and long-term debt that the company issues is included in the financing section. How long the creditor plans to hold the debt determines whether it’s
recorded on the creditor’s books as short- or long-term debt. Here are the uses
of cash that would appear in the financing section of the statement of cash flows:
»» Treasury stock transactions: Treasury stocks are shares of corporate stock
that were previously sold and have since been bought back by the issuing
corporation. The use of the cash is to buy back stock from shareholders.
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Accounting for financing activities
»» Cash dividend payments: Cash dividends are earnings paid to shareholders
based on the number of shares they own. Dividends can also come in the
form of stock dividends, which don’t involve cash changing hands. Only cash
dividends go in the financing section.
»» Paying back debt: Any principal payment that a company makes on bonds or
loans is a financing activity.
Preparing the Statement of Cash Flows
Two methods are available to prepare a statement of cash flows: the indirect
method and the direct method. The Financial Accounting Standards Board (FASB)
prefers the direct method, whereas many businesses prefer the indirect method.
Regardless of which method you use, the bottom-line cash balance is the same,
and it has to equal the amount of cash you show on the balance sheet.
The last step in compiling the statement of cash flows is to verify that the ending
balance in the cash-flow statement equals the ending balance in the cash account
on the balance sheet. If those figures don’t agree, there must be a mistake or
missing cash transactions in the cash-flow statement. This process is used for
both the direct and indirect methods.
The following figures show you what the statement of cash flows looks like when
you use both the direct and indirect methods of preparation. Figure 2-1 is the
statement of cash flows under the direct method, and Figure 2-2 is the statement
of cash flows under the indirect method. As you look at both figures, note that the
cash balance on December 31 is the same.
Using the direct method
The direct method of preparing the statement of cash flows shows the net cash
from operating activities. This section shows all operating cash receipts and payments. Some examples of cash receipts you use for the direct method are cash
collected from customers, as well as interest and dividends the company receives.
Examples of cash payments are cash paid to employees and other suppliers and
interest paid on notes payable or other loans.
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Watching Cash Flow
and Equity
FIGURE 2-1:
A direct-method
statement of
cash flows.
© John Wiley & Sons, Inc.
CHAPTER 2 Watching Cash Flow and Equity
299
FIGURE 2-2:
An indirectmethod
statement of
cash flows.
© John Wiley & Sons, Inc.
Here are three key facts to remember about the direct method:
»» You present cash received and paid — not net income or loss as shown on the
income statement.
»» Any differences between the direct versus the indirect method are located in
the operating section of the statement of cash flows. The financing and
investing sections are the same regardless of which method you use.
»» The FASB prefers the direct method because it believes that it gives users of
the financial statements a more complete picture of the health of the
business.
Starting indirectly with net income
When you use the indirect method of preparing the statement of cash flows, the
operating section starts with net income from the income statement. Then you
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adjust net income for any noncash items. One typical adjustment is for depreciation, which is a noncash transaction.
Other common items requiring adjustment are gains and losses from the sale of
assets), because the gains or losses shown on the income statement for the sale
rarely, if ever, equal the cash that a company receives. In other words, gain or loss
is based on the difference between the asset’s net book value, which is cost less
accumulated depreciation, and the amount the item sold for — not how much
cash the buyer hands over to the seller. Suppose that a business has a machine it
no longer uses. Because it no longer needs the machine, the business sells it to
another company for $1,500. The cash received is $1,500, but what about gain or
loss on disposal? Consider these facts:
»» The company originally paid $3,000 to purchase and install the machine.
»» The asset was depreciated, meaning that the asset’s cost was gradually posted
to depreciation expense over the machine’s useful life. The total amount
depreciated over time (accumulated depreciation) was $2,000.
»» Book value for the machine on the date of sale was $1,000 ($3,000 cost –
$2,000 accumulated depreciation).
Watching Cash Flow
and Equity
»» The company debits (increases) cash for $1,500 and debits (reduces) accumulated depreciation for $2,000. When the asset is sold, the accumulated
depreciation account is adjusted to zero. Debits total $3,500.
»» The asset is credited (reduced) by $3,000, which is the original cost.
»» Gain on disposal is a credit for $500, which is the difference between $3,500
total debit and the $3,000 credit. After the gain is posted, total debits and
credits both equal $3,500.
Look at that: The cash received ($1,500) differs from the gain on disposal ($500).
These types of transactions are reconciled in the statement of cash flows. The net
income change ($500 gain) doesn’t match the $1,500 cash inflow.
Interpreting the Statement of Cash Flows
Users of the statement of cash flows are interested primarily in whether the
company has positive cash flows from operations. As a general rule, a company
should be covering its costs with the cash it brings in from the day-to-day running of the business rather than from borrowed funds.
A potential investor or creditor wants to see that the cash the company brings in
through operations exceeds any cash brought in by selling assets or borrowing
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301
money. Selling assets or borrowing money can never be construed as a continuing
event, such as bringing in cash from selling goods or services.
A company may issue stock or bonds to expand its operations. On a nonrecurring
basis, that situation can be okay because successful expansion is a good thing
for investors and creditors. Successful expansion leads to more sales and higher
overall profits. But unless cash from operations exceeds cash from other sources
with some consistency, a company will be paying back debt with more debt or by
issuing equity, which is decidedly not a good thing.
Here’s how investors and lenders use the statement of cash flows:
»» Investor: An investor wants to make sure the corporation has enough cash
flow to pay an adequate return on investment. In other words, can the
investor anticipate getting a cash dividend each year? Also important is using
the statement of cash flows to evaluate how well the company is managing its
cash, because investors may eventually sell their shares of stock. If the
company mismanages its cash to such a point that it goes out of business,
there won’t be any buyers for the company’s stock; the stock may be
worthless.
»» Creditor: The creditor also has a vested interest in making sure that the
company has sound cash management. After all, in addition to the interest
expense the debtor pays for the use of the loan, the creditor wants to make
sure that it gets paid back the principal portion of the loan. It’s never a good
sign if a business is paying back debt by assuming more debt or issuing
more equity.
Stating Changes in Stockholders’ Equity
Larger businesses generally have more complicated ownership structures than
smaller and medium-size companies do. Larger businesses are most often organized as a corporation in contrast to other forms of legal structures. (See Book 6,
Chapter 2 for more about the legal structure of a business.)
Corporations can issue more than one class of stock shares, and many do. One
class, preferred stock, has certain perks that the other class, called common stock,
doesn’t. Also, a corporation may have both voting and nonvoting stock shares.
And corporations can buy back their own stock shares (treasury stock) for a
variety of reasons.
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The point is that many businesses, especially larger public companies, engage
in activities that change their owners’ equity components. These owners’ equity
activities tend to get lost from view in a comparative balance sheet and in the
statement of cash flows. Yet the activities can be important. Therefore, the business prepares a separate statement of changes in stockholders’ equity covering
the same period as its income statements. The statement of changes in stockholders’ equity is where you find certain technical gains and losses that increase
or decrease owners’ equity but that are not reported in the income statement. You
have to read this summary of changes in the owners’ equity accounts to find out
whether the business had any such gains or losses. Look in a column titled Comprehensive Income for these gains and losses, which are very technical.
The general format of the statement of changes in stockholders’ equity includes
columns for each class of stock, additional paid in capital, treasury stock, retained
earnings, and the comprehensive income element of owners’ equity. Professional
stock analysts have to pore over these statements. Average readers of financial
reports probably quickly turn the page when they see this statement, but it’s
worth taking a glance at, if nothing else.
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Many financial reports include a statement of changes in stockholders’ equity
in addition to their three primary financial statements. This statement isn’t a
full-fledged financial statement; rather, it serves as a columnar footnote for the
various owners’ equity accounts in the balance sheet.
IN THIS CHAPTER
»» Evaluating a business’s financial
health
»» Categorizing business transactions
»» Connecting revenue and expenses
with assets and liabilities
»» Focusing on profitability and activity
measures
»» Assessing quality of profits
»» Preparing vertical and horizontal
analyses
Chapter
3
Analyzing Financial
Statements
S
takeholders in a business are naturally curious about the financial condition
of a company, as reported in its financial statements. Stakeholders include
everyone who may be affected by the financial success or failure of the business: owners, investors, lenders, the chief executive officer and other executives,
managers, employees, and even vendors.
This chapter offers practical tips to help investors, lenders, and anyone else
who has a financial stake in a business glean important insights from financial
statements. These tips also help anyone else who has an interest in the financial
condition of a business.
CHAPTER 3 Analyzing Financial Statements
305
Judging Solvency and Liquidity
Solvency and liquidity both measure the ability of an entity to pay its debts. Solvency
has a long-term focus, whereas liquidity addresses short-term payments.
Solvency refers to the ability of a business to pay its liabilities on time. Solvency
measures whether a company is viable — whether it can generate sufficient cash
flow to operate over the long term (multiple years).
Liquidity, on the other hand, refers to the ability of a business to keep its cash
balance and cash flows at adequate levels so that operations aren’t disrupted by
cash shortfalls. When you’re considering liquidity, focus on the next six months
or the next year.
Understanding the risks of late payments
Delays in paying liabilities on time can cause serious problems for a business.
Customers may shy away from doing business with a company that has financial
problems. Vendors may not be willing to sell the company product because of the
risk of not being paid. Customers and vendors may hear about a company’s financial issues through media reports.
In extreme cases, a business can be thrown into involuntary bankruptcy. In a
bankruptcy, a court-appointed trustee may take substantial control of the business and its decisions about debt payment. Even the threat of bankruptcy can
cause serious disruptions in the normal operations of a business.
Recognizing current assets and liabilities
Short-term, or current, assets include the following:
»» Cash
»» Marketable securities that can be converted to cash immediately
»» Assets expected to be converted to cash within one year
The operating cycle is the process of converting current assets (largely inventory
and accounts receivable) to cash. The term operating cycle refers to the repetitive
process of putting cash in inventory, holding products in inventory until they’re
sold, selling products on credit (which generates accounts receivable), and collecting the receivables in cash. In other words, the operating cycle is the “from
cash through inventory and accounts receivable and back to cash” sequence. The
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operating cycles of businesses vary from a few weeks to several months, depending on how long inventory is held before being sold and how long it takes to collect
cash from sales made on credit.
Short-term, or current, liabilities include non-interest-bearing liabilities that arise
from the operating (sales and expense) activities of the business. A typical business keeps many accounts for these liabilities, such as a separate account for each
vendor. In an external balance sheet, you usually find only three or four operating
liabilities. It’s assumed that the reader knows that these operating liabilities don’t
bear interest (unless the liability is seriously overdue and the creditor has started
charging interest because of the delay in paying the liability).
The balance sheet example shown in Figure 3-1 discloses three operating
liabilities: accounts payable, accrued expenses payable, and income tax payable.
The terminology for these short-term operating liabilities varies from business
to business.
In addition to operating liabilities, interest-bearing notes payable that have
maturity dates one year or less from the balance sheet date are included in the
current liabilities section. (See short-term notes payable in Figure 3-1.) The current liabilities section may also include certain other liabilities that must be paid
in the short run; these items are too varied and technical to discuss here.
Notice the following points in Figure 3-1 (dollar amounts refer to year-end 2018):
»» The first four asset accounts (cash, accounts receivable, inventory, and
prepaid expenses) are added to give the $8,815,000 subtotal for current assets.
»» The first four liability accounts (accounts payable, accrued expenses payable,
income tax payable, and short-term notes payable) are added to give the
$4.03 million subtotal for current liabilities.
»» The total interest-bearing debt of the business is separated between
Analyzing Financial
Statements
$2.25 million in short-term notes payable (those due in one year or sooner)
and $4 million in long-term notes payable (those due after one year).
Brushing up on current and quick ratios
If current liabilities become too high relative to current assets, which constitute the first line of defense for paying current liabilities, managers should move
quickly to resolve the problem. A perceived shortage of current assets relative to
current liabilities could sound sirens in the minds of the company’s creditors and
owners. The current and quick ratios measure this risk.
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FIGURE 3-1:
Typical
comparative
balance sheet
for a product
business at the
end of its two
most recent years
(in vertical, or
portrait, format).
© John Wiley & Sons, Inc.
Making a judgment about the ratios you compute depends on your industry.
A current ratio of at least 1.0, however, is considered to be a minimum expectation
for company liquidity. At that ratio, you have at least $1 in current assets to pay
each dollar of current liabilities.
Business managers know that acceptable ratios also depend on general practices
in the industry for short-term borrowing. Some businesses do well with current
ratios less than 2.0 and quick ratios less than 1.0, so take these benchmarks with a
grain of salt. Lower ratios don’t necessarily mean that the business won’t be able
to pay its short-term (current) liabilities on time.
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Applying the current ratio
Current assets are the first source of money to pay current liabilities when these
liabilities come due. Current assets consist of cash and assets that will be converted to cash in the short run. Ideally, a company will use current assets as a
payment source, rather than borrowing or obtaining other financing.
To size up current assets against total current liabilities, the current ratio is calculated. Using information from the company’s balance sheet (refer to Figure 3-1),
you compute its year-end 2018 current ratio as follows:
$8,815,000 current assets ÷ $4,030,000 current liabilities = 2.2 current ratio
Generally, businesses don’t provide their current ratio on the face of their balance
sheets or in the footnotes to their financial statements; they leave it to the reader
to calculate this number. On the other hand, many businesses present a financial
highlights section in their financial report, often including several financial ratios.
Moving to the quick ratio
The quick ratio is more restrictive than the current ratio. Only cash and assets that
can be immediately converted to cash are included, which excludes inventory. In
some businesses, it may take many months to sell inventory. Here is the adjusted
asset number you use for the quick ratio (refer to Figure 3-1):
$8,815,000 current assets – $3,450,000 inventory = $5,365,000 assets for quick ratio
You compute the quick ratio as follows:
$5,365,000 assets for quick ratio ÷ $4,030,000 current liabilities = 1.3 quick ratio
Wrapping up with working capital
Working capital = Current assets – Current liabilities
A current ratio of at least 1.0 is considered to be reasonable for liquidity purposes
because the ratio displays at least $1 in current assets for each dollar of current
liabilities. Suppose that current assets and current liabilities each total $1,500,000.
The current ratio is 1.0 ($1,500,000 ÷ $1,500,000). Put the same data in the working capital formula. Working capital would be zero ($1,500,000 less $1,500,000).
Negative working capital would mean that current assets are less than current
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The same data used to calculate current and quick ratios is used to compute
working capital. Here’s the formula:
liabilities. So the minimum expectation of 1.0 for a current ratio is the same as a
$0 working capital calculation.
Driving the Balance Sheet
A balance sheet is a snapshot of the financial condition of a business at an instant
in time. If the fiscal (accounting) year of a business ends on December 31, its
balance sheet is prepared at the close of business at midnight December 31.
(A company should end its fiscal year at the close of its natural business year or
at the close of a calendar quarter, such as September 30.) This freeze-frame
nature of a balance sheet may make it appear that a balance sheet is static.
Nothing is further from the truth. A business doesn’t shut down to prepare
its balance sheet. The financial condition of a business is in constant motion
because the activities of the business go on nonstop.
Analyzing three types of balance
sheet transactions
Transactions change the makeup of a company’s balance sheet — that is, its
assets, liabilities, and owners’ equity. The transactions of a business fall into
three basic types. Notice that these three types match the three categories of cash
flow in the statement of cash flows (see Book 5, Chapter 2):
»» Operating activities: This category refers to making sales and incurring
expenses; it also includes accompanying transactions that relate to the
recording of sales and expenses. A business records sales revenue when sales
are made on credit, for example; later, it records cash collections from
customers. The transaction of collecting cash is the indispensable follow-up to
making the sale on credit. As another example, a business purchases products that are placed in its inventory (its stock of products awaiting sale), at
which time it records an entry for the purchase. The expense (the cost of goods
sold) isn’t recorded until the products are sold to customers. Keep in mind
that the term operating activities includes the associated transactions that
precede or follow the recording of sales and expense transactions.
»» Investing activities: This term refers to making investments in assets and
(eventually) disposing of the assets when the business no longer needs them.
The primary examples of investing activities for businesses that sell products
and services are capital expenditures — amounts spent to modernize, expand,
or replace the long-term operating assets of a business. A business may also
invest in financial assets, such as bonds, stocks, and other types of debt and
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equity instruments. Purchases and sales of financial assets are also included
in this category of transactions.
»» Financing activities: These activities include securing money from debt and
equity sources of capital, returning capital to these sources, and distributing
profit to owners. When a business pays cash dividends to its stockholders, for
example, the distribution is treated as a financing transaction. The decision on
whether to distribute some profit depends on whether the earnings generated are needed to operate the business. If the company distributes earnings
by paying a dividend, the equity section of the balance sheet is reduced.
(See Book 8, Chapter 1 for more about accounting for financing activities.)
Reviewing changes in balance
sheet accounts
Figure 3-2 presents a summary of changes in assets, liabilities, and owners’
equity during the year. Notice the middle three columns in Figure 3-2, for each
of the three basic types of business transactions discussed in the prior section.
One column is for changes caused by revenue and expenses and their connected
transactions during the year, which collectively are called operating activities. The
second column is for changes caused by investing activities during the year. The
third column is for the changes caused by financing activities.
Figure 3-2 doesn’t include subtotals for current assets and liabilities. (The formal
balance sheet for this business is presented in Figure 3-1 earlier in this chapter.)
The summary of changes in assets, liabilities, and owners’ equity isn’t a required
financial statement for external users (stakeholders). The purpose of Figure 3-2
is to demonstrate how the three major types of transactions change the assets,
liabilities, and owners’ equity accounts during the year.
Figure 3-2 lists a $1.69 million increase in the Owners’ Equity – Retained Earnings account. See the Operating Activities column. The increase represents net
income earned for the year.
The Operating Activities column in Figure 3-2 is worth lingering over for a few
moments because the financial outcomes of making profit appear in this column.
Most people see a profit number, such as the $1.69 million in this example, and
stop thinking any further about the financial outcomes of making the profit. This
scenario is like going to a movie because you like its title but don’t know anything
about the plot and characters. You probably noticed that the $1,515,000 increase
in cash in this column differs from the $1,690,000 net income figure for the year.
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Tying in profit
The cash effect of making profit (which includes the associated transactions
connected with sales and expenses) almost always differs from the net income
amount for the year. Book 5, Chapter 2 explains this difference.
FIGURE 3-2:
Summary of
changes in assets,
liabilities, and
owners’ equity
during the year
according to
basic types of
transactions.
© John Wiley & Sons, Inc.
Managing balance sheet activity
The summary of changes presented in Figure 3-2 gives a sense of the balance
sheet in motion — how the business got from the start of the year to the end of the
year. Having a good sense of how transactions propel the balance sheet is important. A summary of balance sheet changes, such as those shown in Figure 3-2,
can be helpful to business managers who plan and control changes in the assets
and liabilities of the business; they need a clear understanding of how the three
basic types of transactions change assets and liabilities. Also, Figure 3-2 provides
a useful platform for the statement of cash flows explained in Book 5, Chapter 2.
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Measuring Profitability
In addition to having a handle on how well a company covers its current debt with
current assets, just about all financial statement users want to be able to evaluate
the relative robustness of a company’s income over a series of years or financial
periods. Looking at a company’s performance over a long period of time is called
trend analysis.
This section explains how trend analysis works and why it’s so important when
evaluating profitability. Then it moves on to explain two profitability measures:
return on investment and return on equity.
Understanding trend analysis
A single profitability measure standing alone doesn’t really tell you much about
a company or how it’s performing compared to its competitors, for two reasons:
»» The company may have had an exceptionally good or bad year. Unless a
company’s performance is static from year to year, looking at only one year of
financial statement results is misleading. The statement user sees an inaccurate vision of the company’s performance over time.
Consider a personal example. Suppose that you win $50,000 in the lottery this
year, making your total income (after adding your earnings from your
part-time job) $62,000. The next year and the year after that, you don’t have
any winning lottery tickets (darn it!), and your average income is $33,000 per
year. Clearly, looking at your income for only the year you won the lottery
gives an inaccurate indication of your typical annual income, because that
year’s income includes an unusual, nonrepeating event.
»» Under generally accepted accounting principles (GAAP), companies are
Two equally profitable companies using different inventory valuation methods (see Book 8, Chapter 2 may report big differences in net income). The
same holds true for depreciation of long-term assets, discussed in Book 3,
Chapter 1. Different options are also available for booking an estimate for
bad-debt expense, which is the money that the company reckons it won’t be
able to collect from credit customers (see Book 3, Chapter 6). Many more
differences may arise under allowable GAAP methods, but you get the picture.
Trend analysis provides much more meaningful information to the financialstatement user because differences in accounting methods tend to smooth
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allowed to use various methods to estimate some expenses. If a financialstatement user is trying to compare Company A to Company B by applying a
single set of profitability ratios, they’re not going to see the whole picture.
out over time. Although the method that a company uses for depreciation
affects the amount of depreciation expense by year, for example, it never
affects original cost. In other words, an asset that cost $1,000 can never be
depreciated for more than $1,000. After the asset is fully depreciated, total
depreciation expense is the same regardless of the method used. Analyzing
ratios over a period of several years should be somewhat consistent, which
permits the financial-statement user to make some useful trend comparisons.
Using trend analysis means looking at profitability ratios over several years, which
is usually more helpful to the financial-statement user than any single ratio is
because everything is relative. Seeing how profitability ratios go up and down
(when comparing current performance to past performance and when comparing the company with other companies in the same industry) is more meaningful
than looking at one stand-alone ratio. Most investors consider at least five years
and sometimes up to ten.
Focusing on return on investment
Return on investment (ROI) is a measuring tool investors use to see how well their
investment in a particular company is faring and to help them make that important decision to sell a stock and move on or to stick with it. Potential investors
also use ROI when trying to choose companies in which to plunk their spare cash.
An investor wants to see how well management is using the company assets to
make money. This information gives the investor some idea of the competence of
management and the relative profitability of a business compared with others the
investor is considering.
Investors can calculate ROI, which is expressed as a percentage, in a few ways. All
the methods involve using some form of comparing income to assets. Here are
two common methods:
»» Net income divided by average total assets: Net income (see Book 8,
Chapter 1) is the bottom-line total of what’s left over after you deduct all
business expenses and losses from all revenue and gains for the same
financial period. Assets are all the resources a company owns. So if a company
has net income of $100,000 and average total assets of $2,700,000, its ROI is
3.7 percent ($100,000 ÷ $2,700,000).
To determine the average of any account, add the account balance at the
beginning of the financial period to the ending balance and divide that figure
by two. So if total liabilities are $50,000 on January 1 and $75,000 on
December 31, average total liabilities is $125,000 ÷ 2 = $62,500.
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»» Operating income divided by average operating assets: This form of ROI
calculation starts with income before income taxes and interest and divides it
by average operating assets, which are long-lived assets such as property,
plant, and equipment. So if a company’s operating income is $82,000, and its
average operating assets are $1,200,000, ROI using this method is 6.83
percent ($82,000 ÷ $1,200,000).
In real life, it doesn’t make any difference which method an investor uses. As
long as the chosen method is used consistently, trend analysis using any ROI
method will give the investor a significant resource for deciding which company
to invest in.
Homing in on return on equity
ROI measures how well you generate profits from company assets. Return on equity
(ROE) measures the profit earned for each dollar invested in a company’s stock.
You figure it by dividing net income by average owners’ equity), which is what’s
left over in the business after all liabilities are subtracted from all assets.
The higher the ROE ratio is, the more efficient management is at using its equity
base. This measurement is important to stockholders and potential investors
because it compares earnings with owners’ investments (equity). Because this
calculation takes into account retained earnings — the company’s cumulative net
income less dividends — it gives the investors much-needed data on how effectively their capital is being used. Having net income grow in relation to increases
in equity presents a picture of a well-run business.
Exploring Activity Measures
This section discusses activity measures that quantify the relationship between a
company’s assets and sales. Accounting textbooks usually mention a few activity measures. This section discusses the most common ones: those that measure
accounts receivable and inventory activity.
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Take a walk through a quick calculation. If a company’s net income is $35,000,
and average owners’ equity is $250,000, ROE is 14 percent ($35,000 ÷ $250,000).
Once again, to make wise investment decisions, users of this information look
at ROE as it trends over a series of years and compare it with the ROE of other
companies.
For many companies, accounts receivable and inventory represent the largest
account balances in the balance sheet. As a result, performing analysis on these
accounts is an important indicator of financial performance.
Ratio analysis that studies activity shows you how well a company is using its
assets to make money. This calculation is an expansion of the ROI measurement.
The premise is that how well a company uses its assets to generate revenue goes
a long way toward telling the tale of its overall profitability. Presumably, a business that’s operated effectively and efficiently, which activity measures show, will
generally be more successful than its less-effective and less-efficient competitors.
Asset turnover analysis shows how well you use assets to generate sales. A higher
ratio means more sales per dollar of assets, which is the goal. In other words,
efficiently turning over assets indicates a well-run business. The basic formula to
calculate asset turnover is
Asset turnover = Sales ÷ Average assets
The two most important current assets for the majority of businesses are accounts
receivable and inventory. The following sections explain each turnover ratio.
Accounts receivable turnover
Accounts receivable turnover shows the average number of times accounts receivable is turned over during the financial period. In this case, turned over means
how often a receivable is posted to the books and then received in cash. Here’s
the formula:
Accounts receivable turnover = Net credit sales ÷ Average accounts receivable
Net credit sales represent sales made on credit, less any sales returns and discounts.
(See Book 1, Chapter 3 for more detail on receivables.) Average accounts receivable
is the beginning receivable balance for the period plus the ending receivable balance divided by two. Refer to “Focusing on return on investment” earlier in this
chapter for instructions on computing an average balance.
The sooner a company collects receivables from its customers, the sooner the cash
is available to take care of the needs of the business. This turnover rate is a big
deal, because the more cash the company brings in from operations, the less it has
to borrow for timely payment of its liabilities.
Here’s an example of figuring accounts receivable turnover. Village Shipping has
net credit sales of $35,000 for the year. Accounts receivable (A/R) was $2,500 at
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January 1 and $1,500 at December 31. The average A/R is ($2,500 + $1,500) ÷ 2 =
$2,000. The A/R turnover is $35,000 ÷ $2,000 = 17.5, or 17.5 times.
Another often-used A/R activity measure is the average collection period for A/R,
also called day’s sales outstanding. This measure calculates the average number
of days that credit sales remain in A/R — a valuable aid in helping companies
develop credit and collection policies. The average collection period for A/R is figured by dividing A/R as of the last day of the financial period by the average day’s
sales (all sales in the financial period divided by 365 days or 366 days in a leap
year). This calculation assumes that a business is open each day of the year; it may
not be realistic, but it allows the formula to be used to compare businesses.
Inventory turnover
Inventory turnover shows how efficiently the company is handling inventory management and replenishment. The less inventory a company keeps on hand, the
lower the costs are to store and hold it, thus lowering the cost of inventory that
has to be financed by taking on debt or selling equity to investors. Keep in mind,
however, that running out of inventory hurts business. Low inventory levels can
cause lost sales and late deliveries, and perhaps strain the company’s relationship
with its customers. Also, running low on inventory may cause the company to
panic and buy the same inventory for a higher price to get it right now. Too much
of that sort of mismanagement can play havoc with the bottom line.
Here’s the formula for inventory turnover:
Inventory turnover = Cost of goods sold ÷ Average inventory value
You calculate average inventory the same way you compute the average for A/R. If
cost of goods sold are $35,000 and average inventory is $8,500, inventory turnover is $35,000 ÷ $8,500 = 4.12, or 4.12 times.
Analyzing Financial
Statements
Comparing Horizontal and
Vertical Analysis
A good way to do some ratio and trend analysis work is to prepare both horizontal
and vertical analyses of the income statement. Both analyses involve comparing
income statement accounts in dollars and in percentages.
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Understanding horizontal and vertical analysis is essential for managerial
accounting, because these types of analyses are useful to internal users of the
financial statements (such as company management), as well as external users. If
analysis reveals any unexpected differences in income-statement accounts, management and accounting staff at the company should isolate the reasons and take
action to fix the problem(s).
You can do the same types of analyses for balance sheet accounts. For a horizontal
analysis, you compare like accounts over certain periods of time, such as A/R in
2017 and 2018. To prepare a vertical analysis, you select an account of interest
(comparable to total revenue) and express other balance sheet accounts as a percentage. You might show merchandise inventory or A/R as a percentage of total
assets, for example.
Using horizontal analysis
Horizontal analysis compares account balances and ratios over different time periods, such as a company’s sales in 2017 and its sales in 2018.
Figure 3-3 is an example of how to prepare a horizontal analysis for two years. For
useful trend analysis, you need to use more years (most investors use five), but
this example gives you all the info you need to prepare a horizontal analysis for an
unlimited number of years.
FIGURE 3-3:
Incomestatement
horizontal
analysis for 2017
and 2018.
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The analysis computes the percentage change in each income statement account
at the far right. The first number you might consider is the change in profit. Net
income declined by 42.29 percent. Consider these two numbers and how they contributed to the decline:
»» Repairs expense increased by 39.76 percent.
»» Sales declined by 5 percent.
To isolate the reason for the net income decline, look at the change in total dollars
as well as the percentage change. The repair expense is the largest percentage
change — an increase in costs. But note that the dollar amount of change is only
$1,650 ($4,150 to $5,800). On the other hand, the sales decline was $25,000
($500,000 to $475,000). The decrease in sales has a bigger impact on the net
income decline when dollars are considered.
Implementing vertical analysis
Vertical analysis restates each amount in the income statement as a percentage
of sales. This analysis gives the company a heads-up if cost of goods sold or any
other expense appears to be too high compared with sales. Reviewing these comparisons allows management and accounting staff at the company to isolate the
reasons and take action to fix the problem(s).
Figure 3-4 is an example of how to prepare a vertical analysis for two years. As
with the horizontal analysis, you need to use more years for any meaningful
trend analysis. This figure compares the difference in accounts from 2017 to 2018,
showing each account as a percentage of sales for each year listed.
Analyzing Financial
Statements
FIGURE 3-4:
Incomestatement vertical
analysis for 2017
and 2018.
© John Wiley & Sons, Inc.
CHAPTER 3 Analyzing Financial Statements
319
At the bottom of the analysis, note that net income, as a percentage of sales,
declined by 2.62 percentage points (6.67 percent to 4.05 percent). As a dollar amount, net income declined by $14,096 ($33,333 to $19,237). Management
should consider both the percentage change and the dollar amount change.
Using Common Size Financial Statements
One way to visually zero in on potential problems and missteps taking place
within a business is to prepare and study common size financial statements.
Common size financial statements get rid of the dollars and cents, reflecting account
balances as percentages. With the vertical analysis of income statement items, for
example, all income statement items are shown as a dollar amount and percentage of total sales. With a common size income statement, you omit any references
to the dollar figures.
The big deal about common size financial statements is that the distraction of the
dollar amounts is taken away. Cleaning up the statements this way allows the user
to compare different companies in the same industry in a more equitable manner.
Just because one company has higher total revenue than another doesn’t necessarily make it a better company to invest in or loan money to. Showing accounts
as a percentage of another account of interest rather than a dollar amount allows
you to see the big picture of how the business is doing rather than obsessing about
the difference in dollar amounts.
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IN THIS CHAPTER
»» Touching on corporate governance
»» Studying the characteristics of a
corporation
»» Reading company notes and
disclosures
»» Figuring out who is responsible for
full disclosure
Chapter
4
Explaining Disclosures
A
nnual reports educate the shareholders about corporate operations for
the past year. For all the information that’s included in financial reports,
sometimes the numbers just won’t add-up unless you’re aware that there
was a change in policy or some adjustments that isn’t normally included in the
standard presentations.
In this chapter, we shed light on the explanatory notes and disclosures that commonly pop up in corporate annual reports, as well as other information found in
most corporate annual reports. You’ll find out how a business becomes a corporation, and you review the four characteristics of a corporation: continuity, easy
transferability of shares, centralized management, and (the biggie) limited liability. Annual reports educate the shareholders about corporate operations for the
past year.
Questioning Self-Governance
Simply put, corporate governance is the framework under which a corporation
operates. At its core, this framework involves establishing financial controls
(policies and procedures that govern how the company’s finances are handled),
showing accountability to the shareholders, and making sure that corporate
CHAPTER 4 Explaining Disclosures
321
management acts in the best interest of the shareholders and the community in
which it operates. Financial controls and accountability are covered in depth in the
upcoming section “Reviewing Common Explanatory Notes.”
Part of a corporation’s self-regulation includes fully disclosing information on
its financial statements — hence, the focus on corporate governance in a chapter
about financial statement notes and disclosures.
The subject of corporate governance could fill an entire book. But here are just a
couple of examples of ways that corporations need to self-regulate:
»» Acting in the best interests of the shareholders: The corporation should
operate so that the shareholders can expect a reasonable rate of return. The
corporation doesn’t pay excessive bonuses to corporate officers, for example,
because those bonuses might reduce cash flow to such a point that the
business can’t operate effectively.
»» Being sensitive to environmental concerns: The corporation shouldn’t
pollute or cause health issues through its business waste or other byproducts
for those living in the communities in which the business operates.
Identifying Corporate Characteristics
Many people have only a murky understanding of how a business becomes a corporation and what being a corporation means. This section walks you through the
process and explains the characteristics of a corporation to provide a broader context for understanding corporate governance and financial statement disclosures.
Incorporation — the process of turning a regular business into a corporation — is
governed by state statute. If a company wants to set up shop as a corporation, it
must play by the rules of the state in which it operates. For more about incorporating, see Book 6, Chapter 1.
In most states, the incorporation process kicks off when the company files a
corporate charter or articles of incorporation with the secretary of state. This document contains all pertinent facts about the new corporation, including its
name, address, and information about the type and number of stock shares it’s
authorized to issue. The corporation must name a registered agent: the person the
secretary of state can contact to ask questions. After the secretary of state accepts
the charter, parties who are interested in purchasing shares of stock in the business hold a meeting. Then these shareholders elect a board of directors, and the
corporation is off and running!
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Every corporation has four characteristics:
»» Limited liability: This term means that investors in a corporation normally
can’t be pursued for corporate debt. If a vendor, a lender, or some other
entity to which it owes money sues the corporation, individual investors are
generally off the hook.
But you may encounter exceptions to this general rule, hinging on the
corporation’s managing itself according to state statute. Also, the federal
government and state departments of revenue can go after shareholders or
corporate officers for certain types of unpaid taxes. One example is the trust
fund portion of the payroll taxes, which includes the employee portion of
federal withholding tax, Federal Insurance Contributions Act (FICA) tax, and
Medicare.
»» Easy transferability of shares: This characteristic means that if a person has
the money, they can purchase shares of stock in a corporation — with the
expectation of selling the shares in the future if they need the money. This
characteristic doesn’t quite ring true, however, for closely held corporations
(those with few shareholders). If you’re the majority shareholder in a private
corporation, you don’t have to sell shares to just anyone.
Easy transferability of shares applies more to the purchase and sale of shares
of publicly traded stock. Publicly traded stocks trade on exchanges, which are
set up to connect buyers and sellers.
»» Centralized management: The management of a corporation shouldn’t be
divided among many groups. For the corporation to function at full
efficiency, shareholders give up the right to chime in on every decision it
makes. The shareholders elect the board of directors, who oversee the
corporate operations and choose officers to handle day-to-day business
operations.
»» Continuity: Until the corporation is formally dissolved, it’s assumed to have
unlimited life, continuing into perpetuity. The members of the board of
directors can change, corporate officers can change, and shareholders may
change, but the corporation rolls on and on.
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Explaining Disclosures
This is a very simplified version of the incorporation process, which can vary by
state. An initial public offering (IPO), which occurs when a company offers shares
of common stock to the public for the first time, is much more complicated than
the previous paragraph may lead you to believe.
Reviewing Common Explanatory Notes
One aspect of corporate self-governance is giving financial-statement users all
information they need to gauge the company’s performance and financial health
accurately. Some of that information comes in the form of explanatory notes.
Leveling the playing field among
financial statements
Explanatory notes are discussions of items accompanying the financial statements; they contain important disclosures that aren’t presented in the financial
statements themselves. The financial statements are the income statement (see
Book 4, Chapter 1), balance sheet (see Book 4, chapters 2, 3, and 4, and Book 5,
Chapter 1), and statement of cash flows (see Book 5, Chapter 2).
Notes are essential to fulfill the needs of the external users of the financial statements: people like you who may be interested in investing in the business, banks
that might loan the company money, or government agencies that need to make
sure the company complied with reporting or taxation issues. External users don’t
work for the company, so they aren’t privy to the day-to-day accounting transactions taking place within the business.
Information that can’t easily be gleaned from reviewing the financial statements
has to be spelled out in notes and disclosures, which explain how or why a company handles a transaction a certain way. Full disclosure allows external users to
understand what’s going on at the company and creates a level playing field so an
external user can compare the financial statements of one company with those of
another company.
Such notes are part of the corporate annual report, which provides shareholders
both financial and nonfinancial information about the company’s operations in
past years. (See Book 5, Chapter 5 for more on annual reports.)
The notes come after the financial statements in the corporate annual report and
are ordered to mirror the presentation of the financial statements. In other words,
notes for income statement accounts come first, followed by balance sheet notes
and then items reflecting on the statement of cash flows.
The U.S. Securities and Exchange Commission (SEC) requires certain explanatory
notes specifically for publicly traded companies. As a best practice, however, many
preparers of financial statements for private companies follow SEC guidelines.
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This section explains the explanatory notes commonly addressed in financial
accounting textbooks. Most of these subjects are presented elsewhere in this book
in more detail, so you get a brief overview here and references to let you know
where you can find more info.
Each explanatory note is a light-bite (truncated) version. Depending on the company and the complexity of the underlying accounting transaction, explanatory
notes can be long and boring to wade through for all but the most diligent and
experienced investors. Each type of note is accompanied by a simple version of
what you see in real life.
The first order of business when a company prepares its explanatory notes is to
describe in general the business and its significant accounting policies. Some
businesses break the two broad topics into different notes; the first could be called
Basis for Presentation and the second Accounting Policies. Alternatively, the company could have one note called Summary of Business and Accounting Policies.
Taking this first step creates a fairer presentation of the financial statements.
Information about accounting policies helps financial readers interpret the statements. A footnote is required for each significant accounting choice the company
makes.
Each accounting policy must be applied consistently, because using the same policies each year makes the financial statements easy to compare. The principle of
consistency is explained in Book 1, Chapter 4.
If a company decides to change an accounting policy, the financial impact of the
change must be explained to readers of its financial statements. You can find out
more in “Looking for important event disclosures” later in this chapter.
At the very least, the explanatory notes should include what depreciation methods
the company uses, how the company values its ending inventory, what it uses as
its basis of consolidation, how it accounts for income taxes, information about
employee benefits, and how it accounts for intangible assets. The following sections touch on these subjects.
Note: Explanatory notes may explain the time period and payments due on a capital lease. Leases aren’t covered in detail in this book, but that you may see leases
in the notes section.
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Explaining Disclosures
Explaining significant accounting policies
Reviewing depreciation and inventory
valuation methods
Depreciation (see Book 3, Chapter 1) consists of spreading the cost of a long-term
asset over its useful life, which may be years after the purchase. Inventory valuation
methods detail how a business may value its ending inventory (see Book 8,
Chapter 2).
The methods a company opts to use for both depreciation expense and inventory
valuation can cause wild fluctuations in the amount of assets shown on the balance sheet and the amount of net income (or loss) shown on the income statement. Because of this fluctuation, the financial-statement user needs to know
which methods the company uses to compare one company’s financial-statement
figures fairly with another company’s. Differences in net income could merely be
a function of depreciation or valuation methodology — a fact the user would be
unaware of without the footnote.
Assuming that depreciation and inventory are addressed in note 1, here’s a truncated example of such a note:
NOTE: SUMMARY OF BUSINESS AND ACCOUNTING POLICIES
We compute inventory on a first-in, first-out basis. The valuation of inventory
requires we estimate the value of obsolete or damaged inventory.
We compute depreciation for financial reporting purposes using the straight-line
method, generally using a useful life of 2 to 5 years for all machinery and
equipment.
Consolidating financial statements
Consolidation is what happens when companies merge or when a larger company
(called a parent company) acquires one or more smaller ones (subsidiaries). In the
context of generally accepted accounting principles (GAAP), consolidation refers
to the aggregation of financial statements of two or more companies so those
statements can be presented as a whole.
The parent company and the subsidiaries continue to operate separately and produce separate sets of financial statements. A consolidation is simply a “what-if”
set of financials statements, assuming that the companies operated as one entity.
In this section of the footnotes, the company confirms the fact that the consolidated financial statements do indeed contain the financial information for all its
subsidiaries. Any deviations from including all subsidiaries must be explained.
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NOTE: SUMMARY OF BUSINESS AND ACCOUNTING POLICIES
Our consolidated financial statements include our parent account and all wholly
owned subsidiaries. Intercompany transactions have been eliminated, and we use
the equity method, which means we report the value based on our proportionate
ownership, to account for investments in which we own common stock.
Accounting for income taxes
Financial statements prepared by using GAAP and those prepared for tax purposes
differ. The former are created by using what’s called book accounting, and the
latter are created by using tax accounting. Temporary and permanent differences
can exist between the book and tax figures. Keep reading for a brief explanation
of each difference.
Here’s an example of a permanent difference: Using book accounting, assume that
a business can expense 100 percent of the meal and entertainment costs that it
incurs in the normal course of business. For tax purposes, however, it can expense
at most 50 percent of the same costs. This difference is permanent because under
the Internal Revenue tax code, the business is never able to expense 100 percent.
The difference between book and tax expenses is permanent.
The most common temporary difference relates to depreciation. Suppose that
a company uses straight-line depreciation for book purposes and a moreaccelerated method for tax purposes. In the short run, there will be a difference in
depreciation expense. Eventually, over time, the amount of depreciation the company expenses for an asset will balance out, so the total amount of depreciation is
the same in either method. The difference in depreciation expense is temporary.
The company must address the differences between book and tax, called deferred
tax assets and liabilities, in the footnotes to the financial statements. Here’s a truncated example of such a note:
NOTE: TAXES
Income before taxes was $7.68M, and the provision for federal taxes was $2.78M,
an effective tax rate of 36.2 percent. Deferred income taxes reflect the net tax
effects of temporary differences between the carrying amounts of assets and
liabilities for financial reporting versus for tax reporting purposes.
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Explaining Disclosures
Here’s a truncated example of a note that addresses consolidation:
SPELLING OUT EMPLOYEE BENEFITS
Details about the company’s expense and unpaid liability for employees’ retirement and pension plans are also spelled out in the footnotes. The obligation of the
business to pay for postretirement health and medical costs of retired employees
must also be addressed.
Accounting for employee benefits is a somewhat advanced accounting topic. Just
remember that employee benefits require an explanatory note, and you’ll be fine.
Here’s a truncated example of such a note:
NOTE: RETIREMENT BENEFIT PLANS
We provide tax-qualified profit sharing retirement plans for the benefit of our
eligible employees, former employees, and retired employees. As of December 31,
2022, approximately 80 percent of our profit sharing fund was invested in equities
with the rest in fixed-income funds. We have independent external investment
managers.
Walking through intangibles
Intangible assets aren’t physical in nature, as desks and computers are. Two common examples of intangibles are patents, which license inventions or other unique
processes and designs, and trademarks, which are unique signs, symbols, or names
that the company uses. (See Book 4, Chapter 3 for more information about intangibles.) Besides explaining the different intangible assets the company owns via
an explanatory note, the business needs to explain how it determined the intangible asset’s value posted to the balance sheet.
Here’s a truncated example of such a note:
NOTE: INTANGIBLE ASSETS
We classify intangible assets with other long-term assets. As of December 31, 2022,
our intangible assets consisted of the following: patents, copyrights, and goodwill.
They are generally amortized on a straight-line basis. We perform a yearly review
to determine whether useful life is properly estimated, and to determine whether
the value of the intangible asset has been impaired.
Looking for important-event disclosures
A company must also provide information in its annual report explaining the following topics: accounting changes, business combinations, contingencies, events
that occurred after the balance sheet date, and segment reporting.
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Accounting changes
A company may have up to three types of accounting changes to report: a change
in accounting principle, a change in an accounting estimate, or a change in a
reporting entity. Narrative descriptions of accounting changes go in the explanatory notes to the financial statements early in the game — usually, in the first or
second note.
Following is an explanation of each type of accounting change:
»» Accounting principles guide the way the company records its accounting
transactions. Under GAAP, a company is usually allowed different ways to
account for transactions. GAAP allows companies to use different depreciation methods to expense the cost of long-lived assets, for example.
For financial statements, changes in accounting principles have to be shown
by retrospective application to all affected previous periods (unless doing so
isn’t practical). This process involves three steps:
•
Adjust the carrying amounts of affected assets and liability accounts for the
cumulative effect of the change.
•
Take any offset (difference in amounts) to beginning retained earnings. In
other words, the difference in carrying amounts increases or decreases
beginning retained earnings.
•
If the financial report shows multiple years for comparison, show the effect
of the new accounting principle in each of the reported years.
»» Accounting estimates are numbers that a company enters into the financial
records to reflect its best guesses as to how certain transactions will shake
out. Going back to the depreciation example, consider the estimate for salvage
value, which is how much a company assumes that it will be able to get for a
long-lived asset when the time comes to dispose of it. If something happens
to make you believe that your original estimate of salvage value was wrong,
and you change it, you’ve changed your accounting estimate.
A change in accounting estimate has to be recognized currently and prospectively. If salvage value is recalculated, for example, current and future financial
statements show the salvage value as corrected. No change is made in earlier
financial statements.
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Explaining Disclosures
The topic of event disclosure is usually discussed separately from the topic of
explanatory notes that accompany financial statements. But keep in mind that
event disclosure information goes in the footnotes to the financial statements
right along with the accounting method information described in the preceding
section.
»» Reporting entities reflect which business combinations are shown on the
financial statements, also known as consolidated financial statements. When a
business owns more than 50 percent of another business, the investor
business is called a parent, and the investee is the subsidiary. If something
changes in the way the subsidiaries show up on the financial statements,
that’s a change in reporting entity.
Changes in reporting entities are shown retrospectively to the financial
statements of all previous periods, so you have to show the dollar amount
effect of the change of reporting entities in the balances of all related assets
and liabilities. Any offsetting amount goes to the beginning balance of
retained earnings.
Business combinations
Accounting textbooks typically cover basic business combinations, which include
these three:
»» Mergers: Two or more companies combine into a single entity. Mergers are
usually regarded as friendly combinations — not hostile takeovers.
»» Acquisitions: One company acquires another business. The business doing
the acquiring takes over, and in essence, the target (acquired) company ceases
to exist. Acquisitions usually aren’t quite as friendly as mergers.
»» Dispositions: A company transfers, sells, or otherwise gets rid of a portion of
its business. A shoe manufacturer that makes dress shoes, slippers, and
tennis shoes, for example, might decide to sell its slipper division to another
company.
If a company involves itself in any of these three activities during the financial
reporting period, it has to explain the transaction and spell out the effect of the
business combination on the financial statements. Business combination information goes in the explanatory notes to the financial statements very early; it
first crops up in the first or second note and is addressed as needed in subsequent
notes.
If a company is involved in a disposition, GAAP dictates that it disclose not only
the facts and circumstances surrounding the disposition, but also any anticipated
operational losses from getting rid of a portion of its business. The losses are calculated net of tax, which means you factor in any increase or decrease in tax due
because of the disposition. The company must also show any loss or gain on the
sale of that portion of the business (also net of tax) on the income statement.
These results are pulled out and reported separately because they won’t continue into the future. This activity is typically posted to an account called income
(or loss) from discontinued operations.
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A contingent liability exists when an existing circumstance may cause a loss in the
future depending on other events that have yet to happen (and indeed may never
happen). The company might be involved in an income tax dispute, for example.
Disclosing this contingent liability is a requirement if the company will owe a
substantial amount of additional tax penalties and interest should the unresolved
examination end up in the government’s favor. See Book 4, Chapter 4 for a general
discussion of contingencies.
Here’s a truncated example of a contingency note:
NOTE: COMMITMENTS AND CONTINGENCIES
As of December 31, 2022, we were contingently liable for guarantees of indebtedness owed by third parties in the amount of $3 million. These guarantees relate to
third-party vendors and customers and have arisen through the normal course of
business. The amount represents the maximum future payments that we could be
responsible to make under the guarantees; however, we do not consider it
probable that we will be required to satisfy these guarantees.
A contingent liability needs to be reported not only as a disclosure via a footnote
to the financial statements, but also in the financial statements if it’s probable
and the amount of loss can be reasonably estimated. This disclosure specifically
states that the company doesn’t consider the loss contingency probable, so footnote disclosure without inclusion in the financial statements is all that’s required
for this example.
Events that happen after the balance sheet date
The company also must address any events that happen after the close of the
accounting period but before the financial statements are released. Like contingent liabilities, depending on their nature, subsequent events may require only a
disclosure in the footnotes to the financial statements, or they may require both a
disclosure and an adjustment of the figures in the financial statements to reflect
the dollar-amount effect of the subsequent event.
How the company handles an event that happens after the balance sheet date
depends on whether the event is classified as Type I or Type II:
»» Type I events: These events affect the company’s accounting estimates
reflected on the books but not confirmed as of the balance sheet date.
(See the earlier section “Accounting changes” for an explanation of accounting
estimates.) A good example is the estimate for uncollectible accounts. This
estimate exists on the books at the balance sheet date, but the company can’t
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Explaining Disclosures
Contingencies
be sure of the resolution of the estimate until a subsequent event occurs,
such as a customer’s bankruptcy filing. At that point, the company confirms
that the amount is uncollectible.
If the confirming event (such as the bankruptcy) occurs after the balance
sheet date but before the financial statements are finalized, the company has
to adjust its financial statements. Footnote disclosure can be used to explain
the event as well.
»» Type II events: These events aren’t on the books before the balance sheet
date and have no direct effect on the financial statements under audit. The
purchase or sale of a division of the company is a classic example of a Type II
event.
These events are also called nonrecognized events. This means that if they’re
material, they have to be disclosed in footnotes to the financial statements,
but the financial statements don’t have to be adjusted.
Here’s a truncated example of a note on an event that took place after the balance
sheet date:
NOTE: SUBSEQUENT EVENT
On February 1, 2022, we entered into an agreement to sell our ownership interests
in our ABC division to XYZ Manufacturing for approximately $5 million in cash. The
transaction is subject to certain regulatory approvals. We expect the transaction to
close in the 4th quarter of 2022.
Segment reports
Business segments are components that operate within a company. A clothing
manufacturer might make dresses, blouses, pants, and sweaters, all of which
are business segments. If a business has various segments, it must disclose info
about each segment — such as its type, geographic location, and major customer
base — so that the users of the financial statements have sufficient information.
Here’s a truncated example of such a note:
NOTE: SEGMENT REPORTING
As of December 31, 2022, our organizational structure consisted of the following
operating segments: North America and Europe. Our North American segments
derive the majority of their revenue from the sale of finished clothing. Our
European segment derives the majority of its revenue from the sale of fabric and
notions to other European companies.
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The explanatory notes and disclosures, like the financial statements themselves,
are the responsibility of the company’s management and its accounting staff.
Management and the internal accounting staff prepare the explanatory notes
and disclosures by using the applicable American Institute of Certified Public
Accountants (AICPA) disclosure checklist. All GAAP guides contain a comprehensive appendix listing the full AICPA disclosure checklist.
After management prepares the financial statements and explanatory notes and
disclosure information, the company often hires an independent certified public
accountant (CPA) to evaluate management’s work. The CPA is independent, which
means that they have no special relationship with or financial interest in the company. The CPA may or may not be required to be independent, depending on the
work they perform for the client.
CPAs perform three major types of financial-statement work:
»» Audits: Auditing is the process of investigating information that’s prepared by
someone else, usually company management and the accountants the
company employs, to determine whether the financial statements are fairly
stated. CPAs performing audits must investigate the assertions that a
company makes on its financial statements, including any notes and
disclosures.
Financial-statement assertions often relate to how the company conducts
business, such as how it makes and spends money and how it records
financial information about its property, plant, and equipment; its long-term
liabilities and equity; and its cash and investments.
An audit provides a reasonable level of positive assurance, which means the
financial statements are free of material errors and are stated in accordance
with GAAP. But an audit doesn’t provide an absolute guarantee that the
financial statements contain no errors. Also, an audit isn’t designed or
performed to detect all fraud.
Although accountants employed by the business prepare the financial
statements (including the notes and disclosures), only an independent CPA
can audit them.
»» Reviews: When a CPA conducts a review, they look at the company’s docu-
ments and provides negative assurance, which means that the CPA finds no
reason to believe that the information prepared by company management is
incorrect. The CPA looks over the company’s financial statements, noting
whether they’re of proper appearance, for example — that is, whether they
contain appropriate explanatory notes and disclosures per the AICPA
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Explaining Disclosures
Putting the Onus on the Preparer
disclosure checklist and conform to GAAP. Reviews are usually performed for
privately owned companies when the users of the financial statements
require some sort of assurance about the financial statements’ assertions but
don’t require a full-blown audit.
»» Compilations: If a CPA is hired to do a compilation, they can compile financial
statements (using information provided by company management) that omit
footnote disclosures required by GAAP or that use another comprehensive
basis of accounting, such as cash-basis accounting (see Book 3, Chapter 6).
Preparing the statements this way is okay as long as omitting the explanatory
notes and disclosures is clearly indicated in the report without intent to
mislead users.
When footnote disclosures have been omitted, CPAs add a paragraph to the
compilation report stating that management has elected to omit disclosures.
This paragraph lets the user know that if the financial statements did contain
the explanatory notes or disclosures, that information may affect their
conclusions.
Here’s an example of the language used when a company is omitting compilation disclosures:
»» “Management has elected to omit substantially all the disclosures required by
generally accepted accounting principles. If the omitted disclosures were
included in the financial statements, they might influence the users’ conclusions about the company’s financial position, results of operations, and its
cash flows. Accordingly, these financial statements are not designed for those
who are not informed about such matters.”
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IN THIS CHAPTER
»» Staying private or going public: Why
annual reports differ among
companies
»» Identifying the three purposes of a
corporate annual report
»» Recognizing common sections in an
annual report
»» Analyzing Form 10-K
Chapter
5
Sharing Public Reports
M
ost of the chapters in books 4 and 5 are devoted to explaining how to
prepare financial statements (the income statement, balance sheet, and
statement of cash flows). But what happens to these statements after
they’re done? Do they just get filed away in case anyone asks to see them?
Absolutely not! The financial statements become the heart of a company’s annual
report to its shareholders. An annual report is a document that the company can
share with its current owners, potential investors, creditors, the media, and so
on; it can be an important public relations tool that shows the outside world
how the company is doing. For many companies, the report is also a regulatory
requirement.
This chapter explains the ins and outs of a corporate annual report, including the
three key purposes it serves. Here, you also find out about Form 10-K, an annual
filing that the U.S. Securities and Exchange Commission requires from most publicly traded companies.
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Differentiating between Private
and Public Companies
A corporate annual report (which may also be called the annual report or the annual
report to shareholders) may look different depending on whether the company in
question is private or public.
The corporate annual report for a private company — one whose stock isn’t traded
on the open market — is usually a bare-bones document that gives users just the
mandatory information about how the company performed in the past year. You
don’t find many bells and whistles in a private company’s report; most private
companies are closely held (have a small number of owners), so they aren’t too
concerned about how a larger audience will react to the report. On the other hand,
a public company’s report is often loaded with bells and whistles, such as marketing material designed to tout the company to potential investors and creditors.
Another key difference between the annual reports of private and public companies is that private companies don’t always have their financial statements
audited, whereas public companies do. A private company usually has its financial
statements audited only if doing so is required to fulfill a business purpose.
(Perhaps a creditor or an insurer that provides bonding — compensation to customers in case the company doesn’t fulfill its obligations — requires an audit.)
Public companies’ financial statements must always be audited in order to fulfill
regulatory requirements. What does it mean for the statements to be audited?
After the company creates the statements, it employs an independent certified
public accountant (CPA) to gather sufficient information to express an opinion on
whether the statements are materially correct. (In other words, they don’t contain any misstatements that could significantly affect the decisions made by users
of the financial statement.) See Book 9 for a detailed explanation of auditing.
Only after a public company’s financial statements are audited can they be
included in the company’s annual report to the shareholders.
This chapter focuses on the annual reports that large public companies prepare
to show you what the most elaborate reports look like. You can access the corporate annual report for just about any publicly traded corporation online. Go to
the home page of any company in which you have an interest; look for an Investor link on the home page and click it. Voilà! Chances are that you’re looking at
the annual report. If you can’t find the Investor link, don’t spin your wheels.
Just search the web by using the key phrase “[Company name] corporate annual
report.” You’ll likely locate it easily.
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Finding Purpose in Reports
This section spells out the three distinct goals of the annual report for a public
corporation: to promote the company, to display its financial performance and
goals, and to meet regulatory requirements.
Meeting regulatory requirements
Companies that issue publicly traded securities — as well as companies that meet
certain other criteria — have to file annual reports with the U.S. Securities and
Exchange Commission (SEC). The specific report required by the SEC is called
Form 10-K. The final section of this chapter (“Walking Through Form 10-K”)
explains which companies have to file this form and what it entails.
To avoid having to create two separate types of annual reports, some companies
include in their reports to shareholders all the information that the SEC requires
in Form 10-K. SEC and other regulatory bodies are addressed in Book 4, Chapter 1.
Stating financial performance and goals
Less flashy but of decidedly more interest to serious investors are the sections that
address the corporation’s financial performance in the past year. The information
in these sections indicates how closely the company came to hitting its projected
revenue figures. Additionally, the company addresses how it intends to improve
financial performance going forward.
Here are some examples of financial goals:
»» Increasing revenue by expanding into global markets.
»» Becoming regarded as a premier employer.
»» Managing operations for greatest effectiveness.
»» Increasing brand awareness.
(Brand awareness is a fancy way of saying that the company wants to make
sure consumers recognize the company and its signature products. The
purpose of brand awareness is also tied to making the company’s products
preferred over similar ones marketed by the competition.)
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Sharing Public Reports
Most large companies would produce an annual report even if the U.S. government
didn’t require them to do so, because an annual report is such a crucial marketing
and public relations tool. But because publicly traded companies must adhere to
stringent regulatory requirements, not issuing an annual report isn’t an option.
Marketing and PR messages
A substantial portion of a corporate annual report is devoted to the company’s
boasts about what it accomplished during the preceding year and where it expects
to go in the coming year. The language can be full of hyperbole and puffery.
The purpose of this marketing and PR material is to keep existing shareholders
pumped up about the wisdom of their investment and to attract new shareholders
to the fold. This kind of content comes mostly in narrative form in the reports, as
a “message from” some executive or another, but there can be subtle bias even in
the footnotes or in the manner in which some reports are treated.
Reading the Annual Report
to Shareholders
This section takes you through the sections that you most often find in a corporate
annual report. With the exception of the audited financial statements, the sections
are put together in an effort to draw readers into the inner workings of the business in an attempt to raise their comfort with, and confidence in, the company.
Audited financial statements, on the other hand, require a specific presentation.
Writing the narrative for a corporate annual report is an art. Many times, the
report is contracted out to professionals rather than produced in-house, although
the company’s chief executive or managing director always has a say in the format
of the report. This section contains a brief overview of what you might expect to
see in a corporate annual report. Especially if a company is large, the report may
include a plethora of additional information.
If you have the time, check out Reading Financial Reports For Dummies, 4th Edition,
by Lita Epstein (John Wiley & Sons, Inc.). Although the following sections touch
on the fundamentals, this book walks you through reviewing financial reports
from A to Z.
Meeting the chair of the board of directors
Most casual investors in a corporation have absolutely no idea who the chairperson of the board of directors is or what that person does. Although the duties of
the chairperson are similar from company to company, the person who holds the
position is unique to the particular company.
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The chairman of the board of directors is the head honcho who oversees the board
of directors (and is usually elected by the other members of the board). The board
of directors consists of people elected by the shareholders to guide the company
based on the firm’s mission or vision.
The board of directors doesn’t handle the day-to-day activities of any business;
that’s management’s job. But approving the hiring of upper-management personnel, such as the chief executive officer (CEO), is a function of the board of
directors.
Highlighting key financial data
In the beginning of the annual review, the company gives the shareholders a condensed version of how well the company performed during the preceding year.
This condensed info gives casual readers what the company perceives as being the
main points of interest. At very least, this section contains a summary of operations, earnings per share data, and balance sheet data:
»» Summary of operations: This summary shows the company’s bottom-line
net income for at least three years (and preferably five to ten years). Net
income is the excess of revenue and gains over expenses and losses during a
financial period.
»» Earnings per share (EPS): This calculation shows the net income per out-
standing share of common stock. Read on for an explanation of this formula.
Many investors focus on this figure, comparing it with their other investments
and with other companies’ EPS in the same industry. An investor might
compare the EPS of, say, The Coca-Cola Company with the EPS of PepsiCo to
gauge the value of one company’s stock over the other, given that these
companies are in the same industry.
Three calculations you may see in an annual review are basic EPS, diluted EPS,
and cash dividends (see Book 4, Chapter 4 for additional details on all three).
Here are examples of each:
•
Basic EPS: To figure basic EPS, divide net income for the financial period by
the weighted average number of shares of common stock outstanding.
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Sharing Public Reports
In the corporate annual report, you meet the chairman via a letter whose salutation is something like “Dear Fellow Shareholder.” The letter gives the company’s
top management team a chance to review all the accomplishments of the company during the preceding year. The letter also summarizes goals for the future. It
ends by thanking the shareholders for their support and offering a firm promise
to work tirelessly to continue earning the trust of the shareholders and growing
their value in the company stock.
The weighted average factors in the fluctuations of stock outstanding
during the entire year, instead of taking stock outstanding at January 1 and
stock outstanding at December 31 and dividing it by 2.
If ABC Corp. has net income of $100,000, and the weighted average
number of shares of common stock outstanding is 21,833, basic EPS is
$100,000 ÷ 21,833 = $4.58.
•
Diluted EPS: If the company has issued stock options or convertible debt, or
convertible preferred stock that the investor has the option to convert to
common stock, the company has to show diluted EPS, which is a complicated calculation. (Stock options are benefits that allow employees to
purchase a certain number of shares of company stock at a predetermined
date and price.)
Diluted EPS calculates earnings per share by estimating how many shares
could theoretically exist after all stock options and convertible securities
have been exercised into common stock shares. So if ABC Corp.’s weighted
average of common stock outstanding after these extras are added is
24,989, its diluted EPS is $100,000 ÷ 24,989 = $4.00.
•
Cash dividends: This calculation is the amount per share paid to shareholders of record. The company must have earnings to pay a dividend, because
dividends are a payment of earnings. The board of directors determines
the dividend paid, if any, to shareholders of record.
»» Balance sheet data: This section shows selected figures from the balance sheet
in which the company believes the shareholders have an interest. The
company might show total assets, which are all assets (current and long-term)
that the company owns as of the balance sheet date. The company may also
show long-term debt, which is any debt that the company won’t have paid off
within 12 months of the balance sheet date.
Even though these figures are compressed, they’re based on — and must reconcile with — the audited financial statements.
Figure 5-1 shows an example of this condensed financial data.
Touting company achievements
Regarding distinct PR purpose, the company expands on any facts the chairman
of the board discusses in their letter to the shareholders. This section may breakdown how the company has increased growth per capita, which is the average
income growth per person. Per capita growth could mean that the company sold
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more products to existing consumers or expanded its sales base into new markets
or countries. Companies want to emphasize that they’re attracting new customers while maintaining a bond with existing customers.
Sharing Public Reports
FIGURE 5-1:
Select financial
information.
© John Wiley & Sons, Inc.
Looking into the future
In its annual report, a company addresses where it sees itself in the future —
both short-term and long-term. Although the business may not provide specific
financial targets (such as total sales or new customers), it gives readers its strategy for moving forward. Doing so addresses any concerns an investor may have
about whether the business is a going concern — that is, whether it will be able
to stay in business for at least 12 months beyond the balance sheet date, generating or raising enough cash to pay its operating expenses and make appropriate
payments on debt. Investors aren’t going to get all fired up about their ownership of company stock if they believe that the company will be around for only a
couple more years. Therefore, annual reviews normally give a three- to five-year
expectation for financial information. Often, companies associate their growth
predictions with social and economic transitions, such as changes in population
demographics (aging and income, for example).
Meeting management
This section of the annual report introduces other members of the board of directors, the management team for each division of the company, and committee
members (such as members of the audit committee). Most likely, the report
includes pictures of all of them posed at company headquarters.
CHAPTER 5 Sharing Public Reports
341
Walking through Form 10-K
The SEC requires that all companies registered with it file Form 10-K each year,
shortly after the end of the company’s fiscal year. The SEC also requires these
companies to file Form 10-Q each fiscal quarter. Public corporations must register
with the SEC.
Registration Requirement Thresholds:
»» Class of securities: Any company that issues securities traded publicly on a
stock exchange or in the over-the-counter market (in which dealers buy from
and sell to interested investors for their own accounts via the phone or
computer) must register with the SEC.
»» Assets or holders: Any company with more than $10 million in assets and
2,000 or more shareholders of any class of equity, such as common or
preferred stock, must register with the SEC.
»» Publicly traded: Any company whose equity (stock) or debt (bonds) is publicly
sold pursuant to a registration statement must register with the SEC.
A registration statement is filed with the SEC when a company wants to issue
securities to the public. This statement includes a full and fair disclosure of the
securities being issued, info about the company and what it does, the
company’s financial position, and what the company plans to do with the
proceeds from the issuance. The company submitting the filing is referred to
as the registrant.
Registration with the SEC doesn’t mean that the SEC is giving the company a
stamp of approval. It merely means that the company has provided all documents
required for registration.
Form 10-K consists of a facing page and four additional parts: business, market/
financial, management/corporate governance, and exhibits/financial statement
schedules. The following sections explain each part in turn.
Facing page: Identifying the affected
company
The facing page of Form 10-K gives basic info about the company (the SEC registrant), including its name, address, telephone number, and the fiscal year in
question. It also lists the title and class of securities (equity and debt) that are registered with the SEC and the number of shares outstanding. Some more-advanced
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information appears on the facing page, such as whether the company is required
to file certain reports or has done so voluntarily.
Part I: Finding out more about
the registrant
This section requires the following additional info:
»» The year in which the company organized.
»» Its form of organization.
»» Any bankruptcy proceedings, business combinations, or changes in the
method of conducting business. The registrant might state “We were incorporated in February 1945 under the laws of the State of Delaware and succeeded to the business of a New York corporation.”
The Part I information can be incorporated by reference from the annual report to
the stockholders if that report contains the required disclosures. If the company
opts to do so, it must cross-reference Form 10-K with the annual report, showing
what was incorporated and from which pages in the annual report. The company
could write “See page 10 of the 2022 annual report for this information.”
Part II: Revealing the company’s
financial performance
Part II is the meat of Form 10-K because it reveals a company’s financial performance in the past year. This part features information about where the company’s
stock is traded, analysis and discussion by company management, and the audited
financial statements.
Market information and financial highlights
In Part II, the company tells the SEC which markets list and trade the company’s
common stock. Two U.S. examples are the New York Stock Exchange and Nasdaq.
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Sharing Public Reports
Part I contains information about the company, including an overview of what
the company does and any risk factors surrounding it. A risk factor might be
heightened competition that hurts the core business or a significant depletion of
the raw materials the company needs to make its products.
The company also lists the high and low common-stock market prices and dividends declared for the year in question. More than likely, the company will also
include its key financial data from the annual report to stockholders. (Refer to
“Highlighting key financial data” earlier in this chapter.)
Management discussion and analysis
Part II also includes a management discussion and analysis section. Normally,
management recaps business operations and discusses significant financial
trends within the company during the past couple of years. The management of a
fast-food restaurant chain, for example, probably would discuss how government
regulations to combat obesity are expected to affect the business.
Audited financial statements
The audited financial statements, critical accounting policies, estimates, and
explanatory notes and disclosures also appear in Part II. Accounting policies include
how a company recognizes revenue and expenses and where these figures show
up on the financial statements. An example of an estimate is the allowance for
uncollectible accounts, which is what the company anticipates it won’t be able to
collect from customers who purchased on credit; see Book 4, Chapter 2. For additional guidance on explanatory notes and disclosures, see Book 5, Chapter 4.
Auditing is the process of systemically gathering enough evidence to support the
facts that a company is showing in the financial statements. The results of an
audit are communicated to all interested users in a format that they can understand and use for their intended purposes.
The goal of a financial statement audit is for the auditor to form an opinion regarding whether the financial statements are free of material misstatement. Auditors
aren’t responsible for preparing the financial statements they’re auditing. In fact,
they can’t prepare them; doing so would violate the concept of independence.
Therefore, the items under audit are company management’s responsibility. In other words, the financial statements contain management assertions —
management’s assurance that the information provided is materially correct.
A company accountant uses these assertions to produce the financial statements.
After conducting the audit of the financial statements, the auditor can express one
of four basic options:
»» Unqualified: An unqualified opinion is the best the client can get! It means
that the audit has been conducted in accordance with generally accepted
auditing standards (GAAS) and that the financial statements conform with
generally accepted accounting principles (GAAP) in all material aspects.
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»» Qualified: An auditor may have to issue a qualified opinion when the
company doesn’t use GAAP consistently, or circumstances may have prevented the auditor from getting enough evidence to be able to issue an
unqualified opinion. When the end user (a potential investor, for example)
sees this opinion, they know that they can’t rely on the information in the
financial report as much as they could if the auditor had offered an unqualified opinion. Qualified opinions are referred to as “except for” opinions,
because the language in the audit report often uses the phrase except for to
explain why the report is qualified.
auditor issues an adverse opinion if the financial statements don’t present the
client’s financial position, results of operations, and cash flows in conformity
with GAAP. This type of opinion is issued only when the financial statements
contain material departures from GAAP.
»» Disclaimer of opinion: This happens when the auditor can’t form an opinion
on a client’s financial statements. A disclaimer might be issued when the
auditor isn’t independent, for example.
Book 9, Chapter 1 displays a standard unqualified audit opinion. That report gives
you some idea of the language used.
Part III: Identifying management
and corporate governance
Yippee! You’ve successfully navigated the detailed parts of Form 10-K. Next up is
a discussion of management and governance. In this short section, the company
lists its directors and executive officers — most likely with a reference to Part I of
Form 10-K (if that section already provided sufficient information). Part III might
read as follows: “See Item X in Part I of this report for information regarding
executive officers of the corporation.” Otherwise, the company lists each officer’s
name, title/office, and any other relevant information (such as whether they are
associated with another, unrelated organization). Some of the issues corporate
governance addresses are ethical business behavior, responsibility for the community in which the company operates, and equitable treatment of the shareholders. Corporate governance demands full, fair disclosure associated with the
financial statements so that investors can make informed decisions. For a manufacturing company, this section might note that the company takes care not to
pollute the drinking water of adjacent cities by illegally dumping factory runoff.
Most companies state that they have a code of business conduct for both employee
and nonemployee directors. If the code isn’t included in Form 10-K, the form will
CHAPTER 5 Sharing Public Reports
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Sharing Public Reports
»» Adverse: As you can probably guess, an adverse opinion isn’t good! The
at least state where on the company website this information resides. See Book 5,
Chapter 4 for more about corporate governance.
Part IV: Exhibiting evidence
This section lists the documents that are part of Form 10-K and gives the exhibit
number under which each document can be found. This section can go on interminably, listing such items as Exhibit No. 6.8.5: 2005 Stock Option Plan of the
Company: Amended and Restated Through December 31, 2018. Pretty exciting stuff! The last page contains the signature of the chairman of the board of
directors, the CEO, the chief financial officer, the principal accounting officer,
all directors, and the attorney-in-fact (the person who holds power of attorney)
attesting to the fact that the report doesn’t contain any untrue statement of a
material fact or omit any necessary material facts.
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6
Planning and
Budgeting for
Your Business
Contents at a Glance
CHAPTER 1:
Looking at the Legals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
Surveying Structures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
Going It Alone: Sole Proprietorships. . . . . . . . . . . . . . . . . . . . . . . . . 353
Choosing the Right Legal Structure for Income Tax. . . . . . . . . . . . . 354
CHAPTER 2:
Incorporating Your Business. . . . . . . . . . . . . . . . . . . . . . . 361
Securing Capital: Starting with Owners . . . . . . . . . . . . . . . . . . . . . . . 362
Recognizing Legal Roots. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
Incorporating a Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
CHAPTER 3:
Drawing Up a Business Plan . . . . . . . . . . . . . . . . . . . . . . . 375
Outlining the Basic Business Plan. . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
Developing a Business Plan. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379
Incorporating Third-Party Information into Your Plan. . . . . . . . . . . 386
CHAPTER 4:
Budgeting for a Better Bottom Line . . . . . . . . . . . . . . 389
Brushing Up on Budgeting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
Recognizing Factors That Affect Your Budgeting Process. . . . . . . . 391
Understanding Budgeting Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395
Reviewing Revenue and Production Budgets. . . . . . . . . . . . . . . . . . 398
CHAPTER 5:
Mastering Budgeting Strategies. . . . . . . . . . . . . . . . . . . 403
Budgeting with Cash or Accrual Accounting . . . . . . . . . . . . . . . . . . . 404
Budgeting to Produce the Income Statement
and Balance Sheet. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
Flexing Your Budget: When Plans Change. . . . . . . . . . . . . . . . . . . . . 408
CHAPTER 6:
Planning for Long-Term Obligations. . . . . . . . . . . . . . 415
Managing Long-Term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
Accounting for Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
IN THIS CHAPTER
»» Weighing the benefits of partnerships
and limited liability companies
»» Looking out for number one in a sole
proprietorship
»» Considering the tax ramifications of
your choices
Chapter
1
Looking at the Legals
F
orming a business can be amazingly easy or extremely complicated, depending on the type of business entity being created. If you’re flying solo, you’re
a business unto yourself and really don’t need to do anything to establish
yourself as a sole proprietorship. Unless you say otherwise, the Internal Revenue
Service considers your business to be a sole proprietorship. With a little extra
effort, you can establish your business as a partnership, to share duties and profits
among owners, or create a limited liability company (LLC) to provide your business some extra legal protection. With a little more effort, and a lot more paperwork, you can establish your business as a full-fledged corporation.
This chapter presents the ABCs of the three types of business entities: partnerships, LLCs, and corporations. First, you get a brief overview of sole proprietorships and partnerships. Then you find out all you need to know about the different
types of corporations — C corporations and S corporations — and tax considerations for each.
Surveying Structures
Suppose that you’re starting a business with one or more other owners, but you
don’t want it to be a corporation. You can choose to create a partnership or a limited
liability company (LLC), which are the main alternatives to the corporate form of
business.
CHAPTER 1 Looking at the Legals
349
A partnership is also called a firm. You don’t see this term used to refer to a corporation or LLC nearly as often as you do to refer to a partnership. Firm connotes
an association of a group of people working together in a business or professional
practice.
Compared with the relatively rigid structure of corporations, the partnership and
LLC forms of legal entities allow the division of management authority, profit
sharing, and ownership rights among owners to be very flexible. A partnership
agreement, for example, allows the partners to choose how they’ll share profits, losses, and ownership and stipulate whether any partners receive guaranteed
payments for the work they perform as partners.
The following sections highlight the key features of these two legal structures.
Partnering up
Partnerships avoid the double-taxation feature that corporations are subject to
(see “Choosing the Right Legal Structure for Income Tax” later in this chapter for
details), because all profits and losses “pass through” the business to its partners.
Partnerships also differ from corporations with respect to owners’ liability:
»» General partners are subject to unlimited liability. If a business can’t pay its
debts, its creditors can reach into general partners’ personal assets. General
partners have the authority and responsibility to manage the business.
They’re roughly equivalent to the president and other high-level managers of
a business corporation. The general partners usually divide authority and
responsibility among themselves, and often they elect one member of their
group as the senior general partner or elect a small executive committee to
make major decisions.
»» Limited partners escape the unlimited liability that the general partners have
hanging around their necks. Limited partners aren’t responsible, as individuals, for the liabilities of the partnership entity. These junior partners have
ownership rights to the business’s profit, but they don’t generally participate
in the high-level management of the business. A partnership must have one
or more general partners; not all partners can be limited partners.
Many large partnerships copy some of the management features of the corporate
form — for example, a senior partner who serves as chair of the general partners’
executive committee acts in much the same way as the chair of a corporation’s
board of directors.
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In most partnerships, an individual partner can’t sell their interest to an outsider
without the consent of all the other partners. You can’t just buy your way into a
partnership; the other partners have to approve your joining the partnership. In
contrast, you can buy stock shares and thereby become part owner of a corporation without the approval of the other stockholders.
Looking at the LLC
The LLC is an alternative type of business entity. An LLC is like a corporation
regarding limited liability, and it’s like a partnership regarding the flexibility of
dividing profit among the owners. An LLC can elect to be treated as either a partnership or a corporation for federal income tax purposes. Consult a tax expert if
you’re facing this choice.
The key advantage of the LLC legal form is its flexibility, especially regarding how
profit and management authority are determined. An LLC permits the founders of
the business to put up, say, only 10 or 20 percent of the money to start a business
venture but to keep all management authority in their hands. The other investors
share in profit, but not necessarily in proportion to their invested capital.
Limiting liability: Professional corporations
and LLPs
Professional partnerships — physicians, certified public accountants (CPAs), lawyers, and so on — may choose to become professional corpo rations (PCs), which are
a special type of legal structure that state laws offer to professionals who otherwise would have to operate under the specter of unlimited partnership liability.
States also permit limited liability partnerships (LLPs) for qualified professionals
(such as doctors, lawyers, CPAs, and dentists), in which all the partners have limited liability.
CHAPTER 1 Looking at the Legals
351
Looking at the Legals
LLCs have a lot more flexibility than corporations, but this flexibility can have a
downside. The owners must enter into a very detailed agreement that spells out
the division of profit, the division of management authority and responsibility,
their rights to withdraw capital, and their responsibilities to contribute new capital as needed. These schemes can get very complicated and difficult to understand,
and they may end up requiring a lawyer to untangle them. If the legal structure of
an LLC is too complicated and too far off the beaten path, the business may have
difficulty explaining itself to a lender when applying for a loan, and it may have
difficulty persuading new shareholders to put capital into the business.
These types of legal entities were recently created in reaction to large damage
awards in malpractice lawsuits against partners. The professionals pleaded for
protection from the unlimited liability of the partnership form of organization,
which they had traditionally used. Until these types of legal entities came along,
the code of professional ethics of the various professions required that practitioners operate in a partnership (or as sole practitioners or proprietors). Today,
almost all professional associations are organized as PCs or LLPs. They function
very much as partnerships do but without the unlimited liability feature, which is
like having the best of both worlds.
Understanding how partnerships and LLCs
distribute profits
A partnership treats salaries paid to partners (at least to its general partners) as
distributions from profit. In other words, profit is determined before the deduction of partners’ salaries. LLCs are more likely to treat salaries paid to owner–
managers as an expense (as a corporation does). Accounting for compensation
and services provided by the owners in an LLC and the partners in a partnership
gets rather technical and is beyond the scope of this book.
The partnership or LLC agreement specifies how to divide profit among the owners. Whereas owners of a corporation receive a share of profit directly proportionate to the number of common stock shares they own, a partnership or LLC doesn’t
have to divide profit according to how much each owner invested. Invested capital
is only one of three factors that generally play into profit allocation in partnerships and LLCs:
»» Treasure: Owners may be rewarded according to how much of the treasure —
invested capital — they contributed. So if Jane invests twice as much as Joe,
her cut of the profit may be twice as much as his.
»» Time: Owners who invest more time in the business may receive more of the
profit. Some partners or owners, for example, may generate more billable
hours to clients than others, and the profit-sharing plan reflects this disparity.
Some partners or owners may work only part-time, so the profit-sharing plan
takes this factor into account.
»» Talent: Regardless of capital and time, some partners bring more to the
business than others. Maybe they have better business contacts, or they’re
better rainmakers (people who have a knack for making deals happen), or
they’re celebrities whose names alone are worth a special share of the profit.
However their talent affects the business, they contribute much more to the
business’s success than their capital or time suggests.
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BOOK 6 Planning and Budgeting for Your Business
A partnership needs to maintain a separate capital (ownership) account for each
partner. The total profit of the entity is allocated into these capital accounts, as
spelled out in the partnership agreement. The agreement also specifies how much
money each partner can withdraw from their capital account. Partners may be
limited to withdrawing no more than 80 percent of their anticipated share of
profit for the coming year, for example, or they may be allowed to withdraw only
a certain amount until they’ve built up their capital accounts. The capital that
remains in the partnership is used to operate the business.
Going It Alone: Sole Proprietorships
A sole proprietorship is the business arm of a person who decides not to do business
as a separate legal entity (as a corporation, partnership, or LLC). It’s the default
designation when you don’t establish a legal entity.
Describing a sole proprietorship
Understanding liability and financial
reporting
As the sole owner (proprietor), you have unlimited liability; if your business can’t
pay all its liabilities, the creditors to whom your business owes money can come
after your personal assets. Many part-time entrepreneurs may not know this fact
or may put it out of their minds, but it’s a big risk to take. Some part-time business consultants operate their consulting businesses as sole proprietorships. If
they’re sued for giving bad advice, all their personal assets are at risk (though
they may be able to buy malpractice insurance to cover these losses).
CHAPTER 1 Looking at the Legals
353
Looking at the Legals
A sole proprietorship isn’t a separate entity; it’s like the front porch of a house,
attached to the house but a separate, distinct area. You may be a sole proprietor of a business without knowing it! A person might do house repair work on a
part-time basis or be a full-time barber operating alone. Both businesses are sole
proprietorships. Any time you regularly provide services for a fee, sell things at a
flea market, or engage in any business activity whose primary purpose is to make
profit, you’re a sole proprietor. If you carry on business activity to make profit or
income, the IRS requires that you file a separate Schedule C, Profit or Loss From
Business, with your annual individual income tax return. Schedule C summarizes
your income and expenses from your sole-proprietorship business.
Obviously, a sole proprietorship has no other owners to prepare financial statements for, but sole proprietors should still prepare these statements to see how
their businesses are doing. Banks usually require financial statements from sole
proprietors who apply for loans.
One other piece of advice for sole proprietors: Although you don’t have to separate invested capital from retained earnings, as corporations do, you should still
keep these two separate accounts for owners’ equity, not only for the purpose of
tracking the business, but also for the benefit of any future buyers of the business.
Choosing the Right Legal Structure
for Income Tax
When deciding which type of legal structure is best for securing capital and managing their business, owners should also consider the income tax factor. They
should know the key differences between the two kinds of business entities from
an income-tax point of view:
»» Taxable entities (C corporations): These corporations are subject to income
tax on their annual taxable income. Also, their stockholders pay a second
income tax on cash dividends that the business distributes to them from
profit, making C corporations and their owners subject to double taxation.
The owners (stockholders) of a C corporation include in their individual
income tax returns the cash distributions from the after-tax profit paid to
them by the business.
»» Pass-through entities (partnerships, S corporations, and LLCs): These
entities don’t pay income tax on their annual taxable income; instead, they
pass through their taxable income to their owners, who pick up their shares of
the taxable income on their individual tax returns. Pass-through entities still
have to file tax returns with the IRS, even though they don’t pay tax on their
taxable income. In their tax returns, they inform the IRS how much taxable
income is allocated to each owner, and they send each owner a copy of this
information to include with their individual income tax return.
Most LLCs opt to be treated as pass-through entities for income tax purposes. But
an LLC can choose instead to be taxed as a C corporation and pay income tax on
its taxable income for the year, with its individual shareholders paying a second
tax on cash distributions of profit from the LLC. Why would an LLC choose double
taxation? Keep reading: The following sections explain the differences between
the two types of legal structures in terms of income taxes. These examples assume
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BOOK 6 Planning and Budgeting for Your Business
that the business uses the same accounting methods in preparing its income
statement that it uses for determining its taxable income — a realistic assumption, though there are many technical exceptions to this general rule. To keep this
discussion simple, the examples focus on differences in federal income tax, which
is much larger than any state income tax that may apply.
C corporations
A corporation that doesn’t qualify as an S corporation (explained in the next section) or that doesn’t elect this alternative if it does qualify, is referred to as a C
corporation in tax law. A C corporation is subject to federal income tax based on
its taxable income for the year, keeping in mind that a host of special tax credits
(offsets) could reduce or even eliminate the amount of income tax a corporation
has to pay. Suppose that a business is taxed as a C corporation. Its abbreviated
income statement for the year just ended is shown in Figure 1-1.
FIGURE 1-1:
© John Wiley & Sons, Inc.
Given the complexity and changing nature of income tax law, the following discussion avoids going into details about income tax form numbers and the rates
used to determine the income tax amounts in each example. By the time you read
this section, the tax rates probably will have changed, but the following discussion
does use realistic numbers.
Refer to the C corporation income statement example in Figure 1-1 again. Based
on its $2.2 million taxable income for the year, the business owes $748,000 in
income tax — assuming a 34 percent tax rate for this level of corporate taxable
income. (Most of the annual income tax should have been paid in installments to
the IRS before year-end.) The income tax is a big chunk of the business’s hardearned profit before income tax. Finally, don’t forget that net income means
bottom-line profit after income tax expense.
Being a C corporation, the business pays $748,000 income tax on its profit before
tax, which leaves $1,452,000 net income after income tax. Suppose that the business distributes $500,000 of its after-tax profit to its stockholders as their just
rewards for investing capital in the business. The stockholders include the cash
CHAPTER 1 Looking at the Legals
355
Looking at the Legals
Abbreviated
annual income
statement for a C
corporation.
dividends as income in their individual income tax returns. Assuming that all
the individual stockholders have to pay income tax on this additional layer of
income, as a group they would pay $75,000 in income tax to Uncle Sam (based on
a 15 percent rate on corporate dividends).
A business corporation isn’t legally required to distribute cash dividends, even
when it reports a profit and has good cash flow from its operating activities. But
paying zero cash dividends may not go over well with all the stockholders. If
you’ve persuaded your Aunt Hilda and Uncle Harry to invest some of their money
in your business, and if the business doesn’t pay any cash dividends, they may be
very upset.
S corporations
A business that meets the following criteria (and certain other conditions) can
elect to be treated as an S corporation:
»» It has issued only one class of stock.
»» It has 100 or fewer people holding its stock shares.
»» It has received approval for becoming an S corporation from all its
stockholders.
Suppose that the example business in the preceding section qualifies and elects
to be taxed as an S corporation. Its abbreviated income statement for the year is
shown in Figure 1-2. An S corporation pays no income tax itself, as you see in this
abbreviated income statement. But it must allocate its $2.2 million taxable income
among its owners (stockholders) in proportion to the number of stock shares each
owner holds. If you own one tenth of the total shares, you include $220,000 of
the business’s taxable income in your individual income tax return for the year,
regardless of whether you receive any cash distribution from the profit of the
S corporation, which is likely to push you into a high income tax rate bracket.
FIGURE 1-2:
Abbreviated
annual income
statement for an
S corporation.
© John Wiley & Sons, Inc.
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BOOK 6 Planning and Budgeting for Your Business
Considering the pros and cons
When its stockholders read the bottom line of this S corporation’s annual income
statement, it’s a good news/bad news thing. The good news is that the business
made $2.2 million net income and doesn’t have to pay any corporate income tax
on this profit. The bad news is that the stockholders must include their respective shares of the $2.2 million on their individual income tax returns for the year.
The total amount of individual income tax that would be paid by the stockholders as a group is tough to pin down. Each investor’s tax situation is different.
An S corporation could distribute cash dividends to its stockholders, which would
provide them the money to pay the income tax on their shares of the company’s
taxable income.
Figuring out taxes
Here’s another twist: In some cases, stockholders may prefer that their S corporation not distribute any cash dividends. They’re willing to finance the growth
of the business by paying income tax on the taxable profits of the business —
without taking a distribution from the S corporation. This strategy relieves the
business of making cash distributions to pay the income tax. Many factors come
into play in choosing between an S and C corporation. Choosing the better option
isn’t easy. Consult a CPA or other tax professional before making your final
decision.
Partnerships and LLCs
The LLC type of business entity borrows some features from the corporate form
and some features from the partnership form. The LLC is neither fish nor fowl;
it’s an unusual blending of features that have worked well for many business
ventures. A business organized as an LLC has the option to be a pass-through
tax entity instead of paying income tax on its taxable income. A partnership
doesn’t have an option; it’s a pass-through-tax entity by virtue of being a
partnership.
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The main tax question concerns how to minimize the overall income tax burden
on the business entity and its stockholders. Should the business be an S corporation (assuming that it qualifies) and pass through its taxable income to its
stockholders, which generates taxable income to them? Or should the business
operate as a C corporation (which always is an option) and have its stockholders
pay a second tax on dividends paid to them in addition to the income tax paid by
the business?
Following are the key income tax features of partnerships and LLCs:
»» Pass-through tax entity: A partnership is a pass-through tax entity, just like
an S corporation.
When two or more owners join together to invest money to start a business,
don’t incorporate, and don’t form an LLC, the tax law treats the business as a
de facto partnership. Most partnerships are based on written agreements
among the owners, but even without a formal written agreement, a partnership exists in the eyes of income tax law (and in the eyes of the law in general).
»» Making a choice: An LLC has the choice between being treated as a pass-
through tax entity and being treated as a taxable entity (like a C corporation).
All you need to do is check a box in the business’s tax return to make this
choice. Many businesses organize as LLCs because they want to be passthrough tax entities (although the flexible structure of the LLC is also a strong
motive for choosing this type of legal organization).
The partners in a partnership and the shareholders of an LLC pick up their shares
of the business’s taxable income in the same manner as the stockholders of an
S corporation, and they include their shares of the entity’s taxable income in their
individual income tax returns for the year. Suppose that your share of the annual
profit as a partner, or as one of the LLC’s shareholders, is $150,000. You include
this amount in your personal income tax return.
The legal structure issue
Choosing the best legal structure for a business is a complicated affair that goes
beyond just the income tax factor. You need to consider many other factors, such
as the number of equity investors who will be active managers in the business,
state laws regarding business legal entities, the ease of transferring ownership
shares, and so on. After you select a particular legal structure, changing it later
isn’t easy. Asking the advice of a qualified professional is well worth the money
and can prevent costly mistakes.
Sometimes, the search for an ideal legal structure that minimizes income tax
and maximizes other benefits is like the search for the Holy Grail. Business owners shouldn’t expect to find the perfect answer; they have to make compromises
and balance the advantages and disadvantages. In its external financial reports,
a business has to make clear which type of legal entity it is. The type of entity is
a very important factor to the lenders and other creditors of the business (and to
its owners, of course).
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One other thing bears mentioning: Today, many people form their own entities,
whether it be a corporation or an LLC, with the assistance of software and websites, under the assumption that they now have the limited liability asset protection afforded to that entity. But forming an entity and keeping it legal can be a
complex task, and every state has different rules. One little misstep can make it
easy for the corporate shield to be pierced in the event of a lawsuit. Hire a competent business attorney to make sure you’re protected. Consider the attorney’s fees
to be a form of insurance.
Looking at the Legals
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IN THIS CHAPTER
»» Structuring the business to attract
capital
»» Taking stock of the corporate legal
structure
»» Issuing and managing stock shares
Chapter
2
Incorporating Your
Business
F
rom the perspective of an investor, the obvious reason for investing in a
business rather than putting money in a safer type of investment is the
potential for greater rewards. As a partial owner of a business, you’re entitled
to a partial share of its profit. On the other hand, you’re subject to the risk that
the business could go down the tubes, taking your money with it. In an ideal scenario, sales would be amazing, but even then, some claims to the profits may rank
higher than yours. Owners of preferred stock will get their share before owners of
common stock, and holders of corporate debt, such as bond owners, will get their
piece before anyone else.
This chapter shows how legal structure changes the very nature of who owns the
company, how the company is funded and managed, and even whether your company has a legal rights through the concept of corporate personhood.
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Securing Capital: Starting with Owners
Every business needs capital. Capital provides money for the assets a business
needs to manufacture products, make sales, and carry on operations. Common
examples of assets are the working cash balance a business needs for day-today activities, products held in inventory for sale, and long-life operating assets
(buildings, machines, computers, office equipment, and so on).
Assume that a typical business in your industry needs capital equal to one half of
annual sales revenue. You’d plan your financing efforts to raise that amount of
capital. This ratio varies from industry to industry, of course. Many manufactures
need a high ratio of capital to sales, so they’re described as being capital-intensive.
One of the first questions that providers of business capital ask is how the business entity is organized legally — that is, which specific form or legal structure
the business is using. The different types of business legal entities present different risks and potential rewards to business-capital providers. Book 6, Chapter 1
has more information on legal business structures.
Whatever its legal structure, a business gets the capital it needs from two basic
sources: debt and equity. Debt refers to the money borrowed by a business, and
equity refers to money invested in the business by owners plus profit earned and
retained in the business (instead of being distributed to its owners). No matter
which type of legal entity form it uses, every business needs a foundation of ownership (equity) capital. Owners’ equity is the hard-core capital base of a business.
Contrasting two sources of equity
Every business — regardless of how big it is, whether it’s publicly or privately
owned, and whether it’s just getting started or is a mature enterprise — has owners. Virtually no business can get all the capital it needs by borrowing. Your firm
can obtain equity financing from two sources:
»» Investors: Outside investors can provide the business both start-up funds
and a continuing base of capital, or equity.
»» Owners: The firm’s founders may provide their own capital in exchange for
equity.
Without the foundation of equity capital, a business wouldn’t be able to get credit
from its suppliers and couldn’t borrow money. As they say in politics, the owners
must have some skin in the game.
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Considering investors
When you’re incorporating your own business, the average investor isn’t your
target audience. In the vast majority of cases, the first investor in the initial public
offering of a new corporation is the investment bank that assisted with the process of incorporation to begin with. Then the investment bank sells the shares it
bought on the secondary market to generate its own profits from the service being
offered as an intermediary.
The equity capital in a business always carries the risk of loss to its owners. So
what do the owners expect and want from taking on this risk? Their expectations
include the following:
»» Share in profits: Owners expect to earn profit on their equity capital in the
business and to share in that profit by receiving cash distributions from
company earnings and from increases in the value of their ownership shares,
with no guarantee of either.
»» Participate in management: They may expect to participate directly in
the management of the business, or they may plan to hire someone else
to manage the business. In smaller businesses, an owner may be one of the
managers and may sit on the board of directors. In very large businesses,
however, you’re just one of thousands of owners who elect a representative
board of directors to oversee the managers of the business and protect the
interests of the nonmanager owners.
»» Share in sales proceeds: Looking down the line to a possible sale of the
business or a merger with another business, they expect to receive a proportionate share of the proceeds if the business is sold or to receive a proportionate share of ownership when another company buys or merges with the
business. Or they may end up with nothing in the event the business goes
kaput and nothing’s left after the creditors are paid off.
Dividing owners’ equity
Certain legal requirements often come into play regarding the minimum amount
of owners’ capital that a business must maintain for the protection of its creditors.
Therefore, the owners’ equity of a business is divided into two separate types of
accounts:
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When owners invest money in a business, the accountant records the amount of
money as an increase in the company’s cash account. When double-entry accounting is used, the amount invested in the business is recorded as an increase in an
owners’ equity. (See Book 1, Chapter 2 to find out about double-entry accounting.)
»» Invested capital: This type of owners’ equity account records the amounts of
money that owners have invested in the business, which could have happened many years ago. Owners may invest additional capital from time to
time, but generally speaking, they can’t be forced to put additional money into
a business (unless the business issues assessable ownership shares, which
is unusual).
»» Retained earnings: The profit a business earns over the years that has been
retained and not distributed to its owners is accumulated in the retained
earnings account. If all profit is distributed every year, retained earnings has a
zero balance. If a business loses money, its accumulated loss causes retained
earnings to have a negative balance, which generally is called a deficit.
Whether to retain part or all of annual net income is one of the most important
decisions that a business makes; distributions from profit have to be decided at
the highest level of a business. A growing business needs additional capital for
increasing its assets, and increasing the debt load of the business usually can’t
supply all the additional capital. So the business plows some of its profit for the
year back into the business rather than distributing it to its owners.
Leveraging equity capital with debt
Leverage refers to using debt to add capital to your business. Leveraging is a good
strategy if the company can generate more in earnings than it pays in interest
expense and fees on the debt. If a business is interested in using leverage, the first
consideration is how much of the balance sheet should include debt.
Suppose that a business has $10 million in total assets. The balance sheet equation is Assets – liabilities = equity. $10 million in total assets doesn’t mean that
the company has $10 million of equity. You have to subtract liabilities from assets
to compute equity. Assuming the business has a good credit rating, it probably
has some amount of trade credit extended for purchases, which is recorded in the
accounts payable liability account.
Other kinds of operating liabilities may also come into play. Suppose that the
company’s accounts payable and other operating liabilities total $2 million. At
this point, you’ve identified $10 million in total assets less $2 million in liabilities, which leaves $8 million to account for. The $8 million could represent other
liabilities. Some of the $8 million may be equity. In a sense, you’re filling in the
numbers in the balance sheet equation:
$10 million total assets – $2 million liabilities = $8 million to be identified (either
more liabilities or equity)
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Some businesses depend on debt for more than half of their total capital. By contrast, others have virtually no debt. You’ll find many examples of both public and
private companies that have no borrowed money. But as a general rule, most businesses carry some debt (and, therefore, have interest expense).
The debt decision isn’t really an accounting responsibility, although when the
decision is made to borrow money, the accountant is very involved in recording debt and interest transactions. Deciding on debt is the responsibility of the
chief financial officer (CFO) and chief executive officer (CEO) of the business. In
medium-size and smaller businesses, the chief accounting officer (controller)
may also serve as the CFO. In larger businesses, two people hold the top financial
and accounting positions.
The loan contract between a business and its lender may prohibit the business
from distributing profit to owners during the period of the loan. Or the loan agreement may require the business to maintain a minimum cash balance. Generally
speaking, the higher the ratio of debt to equity is, the more likely a lender is to
charge higher interest rates and insist on tougher conditions.
When borrowing money, the president (or another officer in their capacity as an
official agent of the business) signs a note payable for the lender. In addition,
the lender may ask the major investors in a smaller, privately owned business to
guarantee the note payable of the business as individuals in their personal capacities, and it may ask their spouses to guarantee the note payable as well. The individuals may endorse the note payable, or a separate legal instrument of guarantee
may be used.
The individuals promise to pay the note if the business can’t make payments. You
should definitely understand your personal obligations if you’re inclined to guarantee a note payable of a business. You may have to pay part or perhaps the entire
amount of the loan from your personal assets if the business is unable to honor
its obligation.
The legal system in most nations enables entities to be created for conducting
business activities. These entities are separate and distinct from the individual
owners of the business. Business entities have many of the rights of individuals,
including the right to own property and enter into contracts. In starting a business
venture, one of the first tasks the founders must attend to is selecting the type of
legal structure to use, which usually requires the services of a lawyer who knows
the laws of the state in which the business is organized.
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Recognizing Legal Roots
A business may have one or more owners. A one-owner business may choose to
operate as a sole proprietorship, a limited liability company (LLC), or a corporation; a multi-owner business must choose to be a partnership, an LLC, or a corporation. (See Book 6, Chapter 1 for more details on the legal matters surrounding
this topic.) The most common type of business is a corporation (although the
number of sole proprietorships would be larger if part-time, self-employed
people were included in this category). No legal structure is inherently better
than another; which one is right for a particular business is something that the
business’s managers and founders need to decide when they start the business.
The following section focuses on the basic types of legal entities that owners can
use for their business.
Incorporating a Business
The law views a corporation as a real, live person. Like an adult, a corporation
is treated as a distinct, independent person who has rights and responsibilities.
(A corporation can’t be sent to jail, but its officers can be put in the slammer if
they’re convicted of using the corporate entity for carrying out fraud.) A corporation’s “birth certificate” is the legal form that it files with the secretary of state
of the state in which the corporation is created (incorporated). A corporation must
also have a legal name. You’re not allowed to use certain names, such as the State
Department of Motor Vehicles. Consult a lawyer when choosing a name for your
corporation.
The corporate legal form offers several important advantages:
»» A corporation has unlimited life; it stays alive until the shareowners vote to
terminate the entity.
»» The ownership interests in a corporation — specifically, the shares of stock
issued by the corporation — are generally transferable. You can sell your
shares to another person or bequeath them in your will to your grandchildren. You don’t need the approval of the other shareholders to transfer
ownership of your shares.
»» Each ownership share typically has one vote in the election of directors of a
corporation. In turn, the directors hire and fire the key officers of the corporation. This legal entity provides a practical way to structure the management of
a business.
Just as an adult child is an entity separate from their parents, a corporation is
separate from its owners. The corporation is responsible for its own debts, for
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example. Assuming that you didn’t cosign for one of your parents’ loans, the bank
can’t come after you if your parents default on their loan, and the bank can’t come
after you if the corporation you invested money in goes belly-up. If a corporation
doesn’t pay its debts, its creditors can seize only the corporation’s assets, not the
assets of the corporation’s owners.
This important legal distinction between the obligations of the business entity
and its individual owners is known as limited liability — that is, the limited liability
of the owners. Even if the owners have deep pockets, they have no legal exposure
for the unpaid debts of the corporation (unless they used the corporate entity
to defraud creditors). The legal fence between a corporation and its owners is
sometimes called the corporate shield because it protects the owners from being
held responsible for the debts of the corporation. So when you invest money in a
corporation as an owner, you know that the most you can lose is the amount you
put in. You may lose every dollar you put in, but the corporation’s creditors can’t
reach through the corporate entity to grab your assets to pay off the business’s
liabilities. (But to be prudent, you should check with your lawyer on this issue to
be sure.)
Issuing stock shares
When raising equity capital, a corporation issues ownership shares to people who
invest money in the business. These ownership shares are documented by stock
certificates, which state the name of the owner and the number of shares. (An
owner can be a person, another corporation, or any other legal entity.) The corporation has to keep a register of how many shares everyone owns. Many public corporations use an independent agency to maintain their ownership records. Stock
shares are commonly issued in book entry form, which means you get a formal letter (not a stock certificate) attesting to the fact that you own so many shares. Your
legal ownership is recorded in the official books, or stock registry, of the business.
The stockholders of a private business have the right to sell their shares, although
they may enter into a binding agreement restricting this right. Suppose that
you own 20,000 of the 100,000 stock shares issued by the business. You have
20 percent of the voting power in the business; one share, in this case, has one
vote. You may agree to offer your shares to the other shareowners before offering the shares to someone outside the current group of stockholders. Or you may
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The owners of a corporation are called stockholders because they own stock shares
issued by the corporation. The stock shares are negotiable, meaning that the owner
can sell them at any time to anyone who’s willing to buy them without having
to get the approval of the corporation or other stockholders. Publicly owned corporations are those whose stock shares are traded in public markets, such as the
New York Stock Exchange and Nasdaq.
agree to offer the business itself the right to buy back the shares. In these ways,
the continuing stockholders of the business control who owns the stock shares of
the business.
Offering different classes of stock shares
Before you invest in stock shares, you should ascertain whether the corporation
has issued just one class of stock shares. A class is one group, or type, of stock
shares with identical rights; every share is the same as every other share. A corporation can issue two or more classes of stock shares. A business might offer
Class A and Class B stock shares, for example, giving Class A stockholders a vote
in elections for the board of directors but not granting voting rights to Class B
stockholders.
State laws generally are liberal in allowing corporations to issue different classes
of stock shares. A whimsical example is that holders of one class of stock shares
could get the best seats at the annual meetings of the stockholders. But whimsy
aside, differences among classes of stock shares are significant and affect the
value of the shares of each class of stock.
Common stock and preferred stock are two classes of corporate stock shares that are
fundamentally different. Here are two basic differences:
»» Fixed dividend amount: Preferred stockholders are promised (though not
guaranteed) a certain amount of cash dividends each year, but the corporation makes no such promises to its common stockholders. (The company
must generate earnings to pay any type of dividend, including dividends on
preferred stock.) Each year, the board of directors must decide how much,
if any, cash dividends to distribute to its common stockholders.
»» Claims on assets: Common stockholders have the most risk. A business that
ends up in deep financial trouble is obligated to pay off its liabilities first and
then to pay its preferred stockholders. By the time the common stockholders
get their turn to collect, the business may have no money left to pay them.
In other words, the common shareholders are last in line to make a claim on
assets.
Neither of these points makes common stock seem very attractive. But consider
the following points:
»» Preferred stock shares are promised a fixed (limited) dividend per year and
typically don’t have a claim to any profit beyond the stated amount of
dividends. (Some corporations issue participating preferred stock, which gives
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the preferred stockholders a contingent right to more than just their basic
amount of dividends.)
»» Preferred stockholders may not have voting rights. They may not get to
participate in electing the corporation’s board of directors or vote on other
critical issues facing the corporation.
The advantages of common stock, therefore, are the ability to vote in corporation
elections and the unlimited upside potential: After a corporation’s obligations to
its preferred stock are satisfied, the rest of the profit it has earned accrues to the
benefit of its common stock. Although a corporation may keep some earnings as
retained earnings, a common-stock shareholder may receive a much larger dividend than a preferred shareholder receives.
Here are some important points to understand about common-stock shares:
»» Each stock share is equal to every other stock share in its class. This way,
ownership rights are standardized, and the main difference between two
stockholders is how many shares each owns.
»» The only time a business must return stockholders’ capital to them is when
the majority of stockholders vote to liquidate the business in part or in total.
Otherwise, the business’s managers don’t have to worry about stockholders
withdrawing capital. If one investor sells common stock to another shareholder, the company’s capital balance is unchanged.
»» A stockholder can sell their shares at any time without the approval of the
other stockholders. The stockholders of a privately owned business, however,
may agree to certain restrictions on this right when they become stockholders
in the business.
»» Stockholders can put themselves in key management positions, or they may
Now, don’t get the impression that if you buy 100 shares of IBM, you can get
yourself elected to its board of directors. On the other hand, if you have the
funds to buy 100 million shares of IBM, you could very well get yourself on the
board. The relative size of your ownership interest is key. If you put up more
than half the money in a business, you can put yourself on the board and
elect yourself president of the business. That decision may not be the most
savvy business decision, but it’s possible. The stockholders who own 50
percent plus one share constitute the controlling group that decides who’s on
the board of directors.
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delegate the task of selecting top managers and officers to the board of
directors, which is a small group of people selected by the stockholders to set
policies and represent stockholders’ interests.
The all-stocks-are-created-equal aspect of corporations is a simple, practical
way to divide ownership, but its inflexibility can be a hindrance. Suppose that
the stockholders want to delegate extraordinary power to one person or to give
one person a share of profit out of proportion to their stock ownership. The business can make special compensation arrangements for key executives and ask
a lawyer for advice on the best way to implement the stockholders’ intentions.
Nevertheless, state corporation laws require that certain voting matters be settled by a majority vote of stockholders. If enough stockholders oppose a certain
arrangement, the other stockholders may have to buy them out to gain a controlling interest in the business. (The LLC legal structure permits more flexibility in
these matters.)
Determining the market value
of stock shares
When you consider selling your shares of stock in a company, you probably want
to know the market value of each of your shares. There’s a world of difference
between owning shares of a public corporation and owning shares of a private
corporation.
Public means that an active market exists for the stock shares of the business;
the shares are liquid. You can convert your shares to cash in a flash by calling
your stockbroker or going online to sell them. You can check a daily financial
newspaper, such as The Wall Street Journal, for the current market prices of many
large publicly owned corporations. Or you can go to one of many websites (such
as finance.yahoo.com) that provide current market prices. But stock shares in
privately owned businesses aren’t publicly traded, so you need to take a different
approach to determine the value of your shares.
Stockholders of a private business rarely worry about putting a precise market
value on their shares — until they’re serious about selling their shares or something else happens that demands putting a value on the shares. When you die,
the executor of your estate has to put a value on the shares you own for estate tax
purposes. If you divorce your spouse, a value is needed for the stock shares you
own, as part of the divorce settlement. When the business itself is put up for sale,
a value is put on the business; dividing this value by the number of stock shares
issued by the business gives the value per share.
Other than during events like these, which require that a value be put on the stock
shares, the shareowners of a private business get along quite well without knowing a definite value of their shares. This doesn’t mean they have no idea of the
value of their business and what their shares are worth. They read the financial
statements of their business, so they know its profit performance and financial
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condition. In the back of their minds, they should have a reasonably good estimate
regarding how much a willing buyer may pay for the business and the price they
would sell their shares for. So even though they don’t know the exact market value
of their stock shares, they’re not completely in the dark about that value.
Generally speaking, the value of ownership shares in a private business depends
on the recent profit performance and the current financial condition of the business, as reported in its latest financial statements. The financial statements may
have to be trued up, as they say, to bring some of the historical cost values in the
balance sheet up to current replacement values. For more about performing business valuations, see Book 5, Chapter 1.
Business valuation is highly dependent on the specific circumstances of each
business. The present owners may be very eager to sell, and they may be willing to
accept a low price instead of taking the time to drive a better bargain. The potential buyers of the business may see opportunities that the current owners don’t
see or aren’t willing to pursue. Even Warren Buffett, who has a well-deserved
reputation for knowing how to value a business, admits that he’s made some real
blunders along the way.
Keeping alert for dilution of share value
Watch out for developments that cause a dilution effect on the value of your stock
shares — that is, that cause each stock share to drop in value. Specifically, dilution
means that your earnings per common stock share have declined. If this earnings
per share figure declines, investor interest in the common stock also is likely to
decline. The most basic level of measuring earnings per share involves common
stock, as explained in this section.
»» Issuing additional shares: A business issues additional stock shares at the
going market value but doesn’t really need the additional capital; the business
is in no better profit-making position than it was before issuing the new stock
shares. A business might issue new stock shares to let a newly hired CEO buy
them, for example. The immediate effect may be a dilution in the value per
share. Total earnings are the same, but those earnings are spread over more
common-stock shares. Over the long term, however, the new CEO may turn
the business around and lead it to higher levels of profit that increase the
stock’s value.
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Sometimes, the dilution effect is the result of a good business decision, so even
though your earnings per share decrease in the short term, the long-term profit
performance of the business (and, therefore, your value of the common stock
shares) may benefit. But you need to watch these developments closely. The following situations cause a dilution effect:
»» Offering additional shares at a discount: A business issues new stock
shares at a discount below its stock shares’ current value. The business might
issue a new batch of stock shares at a price lower than the current market
value to employees who take advantage of an employee stock-purchase plan,
for example. Issuing stock shares — at any price — has a dilutive effect on the
market value of the shares. But in the grand scheme of things, the stockpurchase plan may motivate employees to achieve higher productivity levels,
which can lead to superior profit performance for the business. Finally, keep
in mind that issuing shares at a discount means that you don’t raise as much
capital for the business. The main purpose of issuing additional stock shares is
to deliberately dilute the market value per share. Suppose that a publicly
owned corporation doubles its number of shares by issuing a two-for-one
stock split. Each shareholder gets one new share for each share they already
own without investing any additional money in the business. As you would
expect, the market value of the stock drops by half — which is exactly the
purpose of the stock split. The lower stock price may attract more investors.
After all, 100 shares of a $20 stock cost less than 100 shares of a $40 stock.
A stock split doesn’t change the total market value of the company. When the
number of shares is doubled in a two-for-one stock split, the value of each share
is cut in half. As a result, the total market value stays the same.
Recognizing conflicts between
stockholders and managers
Stockholders are primarily concerned with the profit performance of the business; the dividends they receive and the value of their stock shares depend on it.
Managers’ jobs depend on living up to the business’s profit goals. But whereas
stockholders and managers have the common goal of optimizing profit, they have
certain inherent conflicts of interest:
»» Manager compensation: The more money managers make in wages and
benefits, the less stockholders see in bottom-line net income. Stockholders
obviously want the best managers for the job, but they don’t want to pay
more than they have to.
Most public business corporations establish a compensation committee
consisting of outside directors that sets the salaries, incentive bonuses, and
other forms of compensation of the top-level executives of the organization.
An outside director is one who has no management position in the business
and, therefore, should be more objective because they’re not beholden to
the CEO.
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»» Control over the business: The question of who should control the
business — managers who are hired for their competence and are intimately
familiar with the business, or stockholders who may have no experience
relevant to running this business but whose money makes it tick — can be
tough to answer. Ideally, the two sides respect each other’s contributions to
the business and use this tension constructively.
As an investor, be aware of these issues and how they affect the return on your
investment in a business. If you don’t like the way your business is run, you can
sell your shares and invest your money elsewhere. (If the business is privately
owned, however, there may not be a ready market for its stock shares, which puts
you between a rock and a hard place.)
Incorporating Your
Business
CHAPTER 2 Incorporating Your Business
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IN THIS CHAPTER
»» Examining the four basic parts of a
business plan
»» Creating a business plan, from idea
through development
»» Including reliable third-party info in
your business plan
Chapter
3
Drawing Up a
Business Plan
W
hether a business is a start-up or a mature operation, a clear and concise business plan is an essential tool to assist businesses with securing
cash, managing their operations, and protecting their interests.
This chapter provides the basic understanding and tools needed to develop a
viable business plan, which is translated into economic value via the production of financial forecasts and projections. The planning process described in
this chapter includes numerous elements. This chapter discusses obtaining current market information (on the potential demand for a new product and what
price the market will support) and evaluating personnel resources (to ensure that
proper professionals are available to support a business). Another issue addressed
is determining how great operational constraints (such as manufacturing space
availability or environmental regulations) may be in terms of expanding into a
new location.
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Outlining the Basic Business Plan
All too often companies proceed with strategies anchored in the past instead of
evaluating and investigating the markets in which they operate and looking to the
future. Management’s reason for doing something a certain way often sounds like
this: “We’ve always done it like that” or “This is how the industry has operated
for the past umpteen years.” Developing a business plan compels management to
be more future focused.
A solid business plan should represent management’s foundation and justification for birthing, growing, operating, and/or selling a business based on present
economic and market conditions and future projections. Without a solid plan, a
business is destined to operate by trial and error — an approach that often leads
to failure.
Business plans come in a variety of shapes, sizes, forms, and structures and often
take on the characteristics of the business founder(s). It may resemble its creators by emphasizing certain traits or areas of expertise the founders have. For
instance, a type-A personality may use a number of bold adjectives to describe the
massive, huge, unlimited, exceptional potential of a future market opportunity.
As for unique areas of expertise, different sections of the business plan may be
developed in depth, whereas other sections may be presented in quasi-summary
format because the needed information isn’t readily available (for presentation).
Herein lies the first lesson of developing a business plan: The business plan should
be built from the outside looking in so that any reasonable party can clearly and
quickly understand the business concept.
The business plan can come in a multitude of formats and include all types of
information, data, graphs, charts, analyses, and more. The basis of every business
plan, however, is in four main sections, as explained in the following sections.
You can find business plan software to speed up the process. The software provides templates for each segment of your business plan, including a set of projected financial statements. This software is straightforward and easy to use.
The executive summary
The executive summary is a brief overview of the business concept in terms of the
market opportunity, the operational logistics required to bring a product and/
or service to market, the management team that’s going to make it happen,
the amount of capital needed to execute the plan, and the potential economic
return. This section of the business plan is really nothing more than a condensed
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Although the meat of the business plan resides in the remainder of the document,
this section is the most critical in terms of attracting interest from capital sources
and/or management. The reader of the business plan must be able to conceptualize, understand, and justify the business concept from the information presented
in the executive summary. This section must gain the reader’s interest, generate
some type of excitement, and move him with a sense of urgency to pursue the
business opportunity at hand.
Although the executive summary is the first section of the business plan, consider
writing it last, so you can draw information from the other sections of the plan.
If you write it first, you’re probably going to need to rewrite it later to make it
consistent with information in the remaining sections.
The market assessment
The market assessment substantiates the present or future need for a product or
service that’s not being met in the current marketplace. Although this section of
the business plan isn’t necessarily more important than the others, it takes precedence because without a market for the product or service, a business has no
reason to provide it.
You support the business concept by quantifying the size of the market in coordination with qualifying the market need, but that step is only half the battle (and
often the easier of the two halves). Beyond providing information and supporting data on the market size, characteristics, and trends, the market assessment
must also present a clear understanding of the business’s competitive niche, target market, and specific marketing strategies. Identifying the specific niche and
target market and developing an effective marketing strategy to capitalize on the
opportunity present is often more challenging and critical to the future success of
the business venture. And to top it all off, locating reliable and meaningful data
essential to supporting your conclusions on the market opportunity can often be
difficult.
All marketing sections should include a summary of the competition that savvy
entrepreneurs or business managers can use to their advantage in several ways:
»» By including an overview of the competition, the business establishes
credibility with the readers (because it indicates that you’ve done your
homework).
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summary of the entire business concept, presented in a neat and tidy overview
of five pages or (ideally) fewer. The general idea is that the executive summary
should capture the critical content of each of the three primary areas of the business plan in an efficient and easy to digest manner.
»» By reading in-depth competitor assessments, managers may identify weaknesses in competitors’ plans that can be exploited.
»» By evaluating competitors’ strengths and weaknesses, managers can better
understand business risks.
For more about competitive analysis, check out Competitive Intelligence For Dummies,
by Jim Underwood (John Wiley & Sons, Inc.).
The operational overview
Following the market segment of the business plan is a well-developed company
operating overview. This segment of the business plan addresses a number of
operational issues, including personnel requirements, technological needs, locations (for offices, production/manufacturing, warehouses/distribution centers,
and so on), company infrastructure requirements, international considerations,
professional/expert counsel resources, and the like. This segment drives various
business-operating elements in terms of the resources needed to implement and
execute the business plan. For example, if a company is planning on expanding
into new foreign markets where the local government still “influences” the distribution channels, then the operating segment needs to address how the product will
be distributed and which international partners will be essential to the process.
Business plans often dedicate a large portion of the operational overview to
providing an overview of the management team. The overview covers the members’ past credentials as well as their responsibilities with the new business
concept. The market may be ripe and capital plentiful, but without a qualified management team, the business concept will sink more times than not.
In today’s challenging economic environment, management qualifications and
credibility have taken on an entirely new level of importance, given the heightened sensitivity to management accountability and transparency.
The management team responsible for executing the business plan is a key component of the business plan. Initially, financing and capital sources are lured in
by business plans and may turn over any concept in the plan to a slew of professionals for further due diligence, reviews, evaluations, and critique. For example,
if a capital source has concerns over the technological basis within a biomedical
company, then medical- or technology-based professionals can be brought in
to complete additional research and analysis and either approve or dismiss the
idea. However, the management team standing behind the business plan and its
execution is really what the capital and financing sources invest in. The integrity, experience, determination, passion, commitment, and competence of the
management team are of utmost importance. Any weakness in this area is likely
to drive away investors and their capital.
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In a sense, the financial summary brings all the elements of the business plan
together from an accounting and financing perspective. In the financial summary,
financial forecasts project the anticipated economic performance of the business
concept based on the information and data presented earlier in the business plan:
»» The market segment drives the revenue portion of the forecasts, because the
information accumulated and presented there substantiates items such as
potential unit sales growth (in relation to market size), pricing, and revenue
sources by product and service.
»» The operational overview drives the expense element of the forecast, because
it addresses the business cost structure in terms of personnel, assets,
company infrastructure, and so on.
You can look at the financial summary as a projected financial report that
includes a forecasted income (profit and loss) statement, balance sheet, and cash
flow statement. All this information quantifies the capital required to execute the
business plan.
Developing a Business Plan
Accounting is more art than science, especially when it comes to developing a
business plan. Nobody can tell you precisely what to put into your business plan,
but the following sections provide valuable guidance and tools to explain the process and get you started.
Business plans shouldn’t be reserved for new companies just starting out or an
existing business looking at launching new products. All companies should implement formal business-planning processes to ensure that their business interests
are properly managed and protected.
Recognizing the evolution of business
plans: BOTE, WAG, and SWAG
The real start of developing any business plan is coming up with the initial concept, idea, or thought. Over time, the plan evolves usually in line with the following progression:
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The financial summary: Performance
and required capital
»» BOTE: Back of the envelope
»» WAG: Wild-ass guess
»» SWAG: Scientific wild-ass guess
These acronyms on developing business plans and projections are presented
somewhat in jest, but at the same time, they do help you understand the evolution of a business plan and projection model from how an idea is born to how it’s
communicated in financial language to various parties.
Whether you apply these acronyms and follow this logic or rely on another creation and development cycle, the same key concept holds. Business plans and
projection models should continue to evolve, improve, and strengthen over time
as more and more effort is invested to bring the idea to life.
BOTE
BOTE usually represents the very first financial projection developed for a business plan: back of the envelope (or back of a napkin at a restaurant). Yes, even the
majority of the most astute and experienced business professionals and entrepreneurs can attest to jotting down the basic concepts, needs, potential sales, costs,
and profits of a business idea or concept on a random piece of paper (or with a
simple mobile communication device application). Sometimes you need to get it
out of your head and down in writing just to see whether it makes any sense to
begin with. You’d be amazed at how often BOTE estimates are used.
WAG
If the idea passes the BOTE test, the next step in the evolution of the planning
process is the ever-present WAG (or wild-ass guess). The WAG is somewhat more
sophisticated than the BOTE in that it tends to incorporate more thought and
some basic research. WAGs are usually produced by using software tools such
as Microsoft Excel and incorporate the basic economic structure of the business,
starting with sales and then moving through the remainder of the income statement by capturing costs of sales, operating expenses, and overhead or general and
administrative costs. You can then draw two simple conclusions:
»» How profitable the idea will be
»» More importantly, how much capital or cash the idea needs in order to
achieve success
These conclusions aren’t overly sophisticated, but they’re an early attempt to
assign numbers to the idea.
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If your idea has passed both the BOTE and WAG stages, congratulations are in
order because you now can use the much more powerful tool, SWAG (scientific
wild-ass guess) to further the development of your business plan. In other words,
the business plan and supporting projection model are actually getting some
serious attention and logical consideration. You can begin to use external sources
(or third-party data/information) to actually start to substantiate and corroborate the idea’s potential. The first real form to the business plan and projection
models are taking shape. You may be incorporating the use of technology tools
to draft the business plan (for example, Microsoft Word), to build version 1.0 of
the projection model (perhaps with Microsoft Excel), and to begin to prepare a
presentation to summarize the plan (for example, with Microsoft PowerPoint).
Taking a problem-solving approach
If you’re thinking of starting a business, any business, a simple way to develop
a business plan is to consider the customer’s problem, your proposed solution,
your solution’s cost, the price a customer may be willing to pay for the solution,
and the size of the potential market for the product or service. Here’s an example:
»» The problem: You’re a serious road bike rider, and you ride loads of miles
with other riders each weekend. As a group, you all agree that changing a flat
tire can be a hassle, because of the extra equipment you have to bring and
the fact that tire tubes can be difficult to inflate. You see a need for a more
reliable bike pump that a rider can carry.
»» The solution: After doing some research and working with a designer, you
come up with a lightweight bike pump that seals more tightly to the bike tire
tube stem, so that pumping up the bike tube is much easier. You have a
manufacturer produce 50 of the pumps and hand them out to your biking
friends. Everyone agrees that your bike pump is more effective and solves a
problem for the rider.
»» Your solution’s cost: Take a look at how much it costs to produce 50 pumps
and what the cost would be if you manufactured thousands of units. Could
you negotiate a much lower cost from suppliers? Assume that, after mulling
over the manufacturing process, you can come up with a realistic cost of
$55 per unit.
»» What customers may be willing to pay: Now that you have some evidence
that your product solves an urgent problem, you mull over how much a bike
rider would be willing to pay for your solution. You research the product
features and prices of other bike pumps and determine that serious bike
riders would be willing to pay $60 for a higher-quality bike pump. Given your
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SWAG
$55 cost per unit, is a $5 profit (about an 8 percent profit on the sale price)
enough to justify selling the product?
»» The size of your market: Finally, you perform research to determine the size
of your potential market. Based on current trends and preferences, you
discover that 20 million people in U.S. ride bikes at least once a month and
that 2.5 million consider themselves serious bike riders who ride three to four
times a month. If you can sell your bike pump to 10 percent of the serious
riders in the first two years of operations, you would generate 250,000 sales
and $15 million in total revenue.
This approach to creating a business plan provides a great outline that touches
on all of the essentials.
Getting the process going
After the business’s executive management teams or new company founders have
decided that the concept for the new business endeavor has merit (which is by no
means a small task), you can begin drafting the business plan. You can prepare a
draft by following four simple steps:
1.
Delve into historical business information.
In order to start the budgeting process, you should have a good understanding
of your company’s prior financial and operating results. Review as much
history as is available and relevant to the current idea, whether it stretches
back three months, one year, five years, or longer. Of course if you’re planning
an entirely new business, the availability of internal historical information is
limited, but plenty of external information is usually available from similar
businesses.
Although the history of a company may provide a basic foundation on which to
develop a budget, by no means is it an accurate predictor of the future.
2.
Involve key management.
You must ensure that all key management team members are involved in the
planning process, covering all critical business functions, to produce a reliable
projection. The accounting and financial departments actively participate in the
planning (and rightfully so, as these are the people who understand the
numbers the best) and they produce the final forecast. Critical business data
comes from numerous parties and sources, and all of that data must be
included in the planning process to produce the most reliable projections
possible.
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Gather reliable data.
The availability of quality market, operational, and accounting data represents
the basis of the budget. A good deal of this data often comes from internal
sources. For example, salespeople may pick up on customer needs that aren’t
being met in the marketplace or a company executive may hear about pending
legislation that’s likely to lead to new opportunities. With this information and
some research, you can begin to determine sales volumes, personnel levels,
wages rates, commission plans, and so on.
The internal information is certainly of value, but it represents only half of what
you need, because external information and data are just as critical. Having
access to quality and reliable external third-party-produced information is
absolutely essential to the overall business planning process and the production of reliable forecasts. Market forces and trends that aren’t apparent in
internal data may be occurring and set to impact your new business, product,
or service over the next 24 months. (For more about gathering information
from external sources, see “Incorporating Third-Party Information into Your
Plan” later in this chapter.)
4.
Coordinate the start of the planning process.
Most companies tend to start the planning process for the next year in the
fourth quarter of their current calendar year. This way, they have access to
recent financial results on which to support the budgeting process moving
forward.
The closer the date of the financial data is to when the projection is made, the
more detailed the information and results being produced. If you prepare a
budget for the coming fiscal year, then you can reasonably include monthly
financial statement forecasts (with more detailed support available). Looking
two or three years out, you can produce quarterly financial statement projections (with more summarized assumptions), and so on.
When preparing your company’s budgets, try to use information that’s as complete, accurate, reliable, and timely as possible. Though you can’t be 100 percent
sure about the data and information gathered for your plan (because by definition,
you’re attempting to predict the future with a projection), with proper resources
(including appropriate internal management, external subject-matter experts
or consultants, and allocating financial resources to secure critical information
that’s not readily available or free), you can avoid large information “black holes.”
What worked two years ago may not provide management with the necessary
information today on which to make appropriate business decisions. Just ask any
retailer that formerly relied on brick-and-mortar stores and print-based advertising campaigns how the Internet and e-commerce have reshaped their business models. Although management has put forth the effort to restructure the
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3.
company’s operations in a changing market environment, a plan based on an
old projection model with outdated assumptions doesn’t capture the essence of
the new market realities. Remember, the planning process represents a living,
evolving thing that must constantly be updated and adapted to changing market
conditions.
Analyzing and streamlining information
with SWOT and KISS
If you’re not careful, the data-accumulation process can engulf the entire planning effort. And if you get too much data, you can’t digest it or draw any type of
meaningful conclusion. Fortunately, two simple but powerful planning tools are
available to make sense of the data and present it in an easily accessible format:
SWOT and KISS.
The SWOT analysis
Strengths, weaknesses, opportunities, and threats: A SWOT analysis is an effective planning and budgeting tool used to keep businesses focused on critical issues
that may lead to wonderful successes or horrible failures. The SWOT analysis
should be as comprehensive as possible and capture both relevant information for
the specific idea as well as incorporating more broad-based data about the company, the industry, and the competition. The simple SWOT analysis (or matrix) in
Figure 3-1 provides a better understanding of how it works.
A SWOT analysis is usually broken down into a matrix containing four segments. Two of the segments are geared toward positive attributes (for instance,
a company’s strengths and its opportunities) and two are geared toward negative
attributes (weaknesses and threats). In addition to illustrating these categories,
Figure 3-1 makes reference to the terms internal versus external. This distinction
highlights the fact that certain attributes tend to come from internal company
sources (namely, strengths and weaknesses) and other attributes from external
sources (typically opportunities and threats).
Used correctly, a SWOT analysis not only provides invaluable information to support the planning process but also (and more importantly) helps identify the type
of management a business has in place. The success of any business plan hinges
on having the right leaders driving the bus to take the opportunity from a concept
to reality. A frontline manager in need of direction can assist with this process but
generally isn’t qualified to lead. You need a bona fide businessperson to lead the
charge.
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Drawing Up a
Business Plan
FIGURE 3-1:
A simple SWOT
analysis.
©John Wiley & Sons, Inc.
A variety of different parties may conduct SWOT analysis. In a larger or wellestablished business, the management team assigned to complete a project or
pursue an opportunity may take the lead. The SWOT analysis is then evaluated
and interpreted by the company’s executives, who consider whether it’s viable
and whether the right people are in place. On the other hand, two founders just
starting a business may complete a SWOT analysis. When the SWOT is complete,
company executives may ask a third-party consultant to review the document.
An outside expert can provide management with an unbiased view on whether
the analysis is realistic.
Remember to KISS
You know what KISS stands for: Keep it simple, stupid. Used in the marketing
world for years, the concept of KISS also applies to business plans. When developing a business plan, be as clear and direct as possible. Summarize the data,
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use images and graphs wherever necessary to illustrate points, and present clear
directives for moving forward. And follow the credo “When in doubt, leave it out.”
That is, if information isn’t essential to making a point, omit it. Don’t make the
end user of the business plan sift through it to extract meaning.
If you’re an executive or owner of a business, you must be able to understand the
big picture and the key economic drivers of your company’s success in order to
prepare proper business plans, strategies, and, ultimately, forecasts. The ability
to understand and positively affect the key economic drivers of your business and
empower the management team to execute the business plan represents the end
game. Getting lost in excessive amounts of detail (“Why did you spend an extra
$500 on the trip to Florida?”) generally isn’t the best use of senior management’s
time, because every level of detail adds more and more complexity to the plan,
which can get overwhelmed with TMI (too much information).
Incorporating Third-Party Information
into Your Plan
When building reliable and credible business plans, don’t underestimate the
importance of accumulating data and information from reliable independent third
parties (including various trade and industry sources). The following sections
explain how and where to gather the information you need and the importance of
starting with solid data.
Gathering the info
Not so long ago, valuable third-party market, industry, and technological information was gathered via archaic methods such as researching in a library, subscribing to trade journals and magazines, and attending seminars or educational
trade shows. Today, most of the information you need is available online, which
has improved the efficiency of accumulating information significantly. Most
industries’ trade organizations now regularly produce and provide content via the
web, but you have to be prepared to pay for it, because reliable information costs
money.
Incorporate trade shows, seminars, and educational events into your efforts to
accumulate third-party data. These events can not only offer a great source of
information, but also (and potentially more importantly) be places to make contacts with potential future employees, vendors, customers, and funding sources
that can assist with the execution of the business plan.
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»» The World Gold Council provides an excellent overview of consumer gold-
buying trends and patterns by price points, types of jewelry, and different
sales channels. This information can support the marketing segment of the
business plan.
»» If the production of jewelry is required, then information on available
manufacturing sources is needed. Because a large majority of jewelry is
produced globally (from Southeast Asia to Europe to Central America), the
company needs to make sure that it has a good handle on the political, social,
and economic stability of any foreign suppliers.
»» In addition, if the jewelry company is going to sell products through retail
storefronts, then an overview of commercial real estate rental rates, trends,
and so on can be incorporated (for a specific geographical area) to support a
critical expense driver in the business.
Riding the CART concept: Complete,
accurate, reliable, and timely
During the planning process, evaluate your data to make sure it’s complete, accurate, reliable, and timely (CART). Actually, you should apply the concept of CART
to all business segments; whether you’re developing a business plan, analyzing
periodic operating results, or evaluating an employee benefit plan. Business owners and managers must have complete, accurate, reliable, and timely information
to make savvy business decisions. Whether the information and data is coming
from internal or external sources, from the marketing or manufacturing departments, the basis of the budget is having access to complete, accurate, reliable, and
timely information.
»» Complete: Financial statements include a balance sheet, income statement,
and a statement of cash flows. All three are needed in order to understand
the entire financial picture of a company. If a projection model is incorporating an expansion of a company’s manufacturing facility in a new state (to keep
up with rising demand), all information related to the new facility needs to be
accumulated to prepare the budget. This info includes the cost of the land and
facility, utility costs in the area, potential environmental issues, whether a
trained workforce is available, and so on. Overkill isn’t the objective; having
access to all “material” information and data is.
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The third-party information you gather should cover multiple aspects of your
business. Following are three examples of data sources for a jewelry company:
»» Accurate: Incorporating accurate data is absolutely essential for preparing
the business plan. Every business plan needs to state the price your company
charges for the goods or services it sells, how much employees are paid, what
the monthly office rent is, what evolving patterns exist in sales channels, and
every other relevant detail. Accumulating accurate information, whether from
internal sources or external third parties, represents a critical and ongoing
management endeavor.
»» Reliable: The concepts of reliability and accuracy are closely linked, but they
differ as well. A piece of information may be accurate without being reliable.
For example, you may conduct some research and find that the average wage
for a paralegal in San Diego, California, is $24 per hour. This data sounds
accurate, but if the business model you’re developing requires paralegals with
special training who demand $37 per hour, the information isn’t reliable.
»» Timely: Finally, the information and data must be accumulated in a timely
fashion. Data provided six months after it was needed doesn’t do management much good. Companies live and die by having access to real-time
information on which to make business decisions and change course (and
forecasts) if needed.
An old phrase that’s often quoted, “Don’t put the cart before the horse,” means
you shouldn’t buy a cart before you have a horse to pull it; in other words, you
should do things in the proper order. However, the CART principle is a case in
which the “cart” always needs to come first. You must put the CART information
and data before the horse (the business plan). If you attempt to offer a business
plan that hasn’t been created through CART data, the end result will be nothing
short of disastrous.
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IN THIS CHAPTER
»» Getting up to speed on budgeting
fundamentals
»» Gathering accurate information and
projections
»» Drawing up a budget — the essential
budget documents
Chapter
4
Budgeting for a Better
Bottom Line
Y
ou need accurate information to make smart decisions about your business.
A well-planned budget may be the most important piece of information
you use. Budgeting is a proactive process, the thinking person’s accounting. You anticipate future outcomes and can maximize them. You anticipate problems and may be able to minimize or eliminate them. Taking that approach is a lot
better than operating in ignorance and reacting to events as they arise.
In this chapter, you look at budgets, consider how to anticipate costs, and work
through some essential budget documents.
Brushing Up on Budgeting
A budget is a financial plan that includes both financial and nonfinancial information. Its most obvious features are revenue and expense projections — how much
you anticipate earning and spending. The budget can also contain nonfinancial
information, such as how many employees you think you need.
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A budget is a forecasting document, but businesses also use it as a financialcontrol tool to monitor activities in their business. One control is to review spending and ensure that you don’t exceed your budgeted spending. Often, a company
(or a division or a department within it) isn’t allowed to spend more than has been
budgeted. Budgets cover a specific period, most commonly a year, and they look
into the future. Although you use historical information to develop a budget, the
activities you plan happen in the future.
Every business should complete the budgeting process before the start of the new
fiscal year. Although that advice may seem to be obvious, many companies start
the new year without a completed budget. By starting the year with a budget in
place, you can get the most out of your budgeting efforts, and company management can focus on executing their plans for the year. Without a budget, you have
no clear idea of what you can afford to invest in to improve your organization.
Meeting the master budget
The master budget is a comprehensive picture of your plans for the future and how
the plans will be accomplished. It’s a summary of your financial and operating
plans:
»» The financial plan (financial statements, really) is what you share with outside
parties that need your budgeted information, including lenders, stockholders,
and perhaps even regulatory agencies.
»» The operating plan (also known as the operating budget) is used internally,
mostly by managers, to set sales goals and develop internal budgets. You
hand the operating plan to your managers, and the managers implement
the plan.
Operating plans can contain nonfinancial information. Decisions about production, hiring, and selling efforts are components of operating plans.
Understanding key budgeting concepts
Budgeting forces you to plan how to use your assets wisely to generate revenue.
(Assets are resources, including cash, buildings, machinery, office equipment,
and anything else your businesses uses to conduct business.) As you develop your
budget, keep the following key concepts in mind:
»» Depreciation: Long-term assets, such as trucks and machinery, depreciate;
that is, they wear out and are worth a little less every day as you use them up.
You need to budget for operating costs and depreciation so that you have
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sufficient cash to replace these assets when they’re used up or no
longer useful.
»» Opportunity cost: When you use an asset to manufacture product A, you
give up the opportunity to use that asset to produce product B, which would
have generated revenue too. When developing a budget, consider opportunity cost, and make choices on how to use assets that minimize these costs.
»» Cash flow: When you conduct business, cash flows through your business,
Planning strategically
Whether you’re starting a new business, launching a new division or a new product line, or simply preparing for the future, you need to develop a strategic plan —
your business’s road map to the future. The plan reminds you, your employees,
and third parties of what you do, how you do it, the customers you do it for, and
maybe even how you’ll do it in a superior way. Your strategic plan summarizes
where your business is, where it wants to go, and how it’s going to get there.
Your budget, of course, is an important part of strategic planning. The budgeting
process forces you to think, make decisions, and come up with reasonable forecasts. You can’t sidestep potential negatives, either; doing that would be like being
a farmer who overlooks the possibility of drought.
If you’re trying to attract financing to fuel your business venture, you’d better
have a strategic plan (business plan) in place that lays out exactly how the business is going to generate sufficient revenue to cover its bills and make payments
on its loans or produce a return on any investments in the business. Nobody will
lend money to or invest in a business without seeing how that business plans to
make money.
Recognizing Factors That Affect Your
Budgeting Process
Whether you’re developing a budget for a business or a household, one of your
biggest challenges is coming up with good ballpark estimates. Consulting a
fortune-teller or staring into a crystal ball probably won’t help. Useful information
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coming in as revenue and going out as expenses. One of your primary goals in
developing a budget is making sure that you have at least as much cash
flowing in as you do flowing out.
comes from your experience, what you know about timing, the facts and figures
your staff supplies, and your own sales projections.
Experience counts
Business owners who have little experience in an industry often plan poorly, in
part because they don’t have much personal history to go on. Also, some people
have trouble accepting the reality of their business prospects. They may really
want the business to grow 30 percent, for example, and can’t accept the fact that
10 percent is more realistic.
Consider three brothers who were opening a pizza-parlor franchise. The franchise
was successful in other parts of the county. The brothers were opening a store in
a new area of town. All good. None of the brothers had any restaurant-industry
experience. Two of the brothers sold business envelopes, and the third was a professional golfer. Not so good.
The brothers performed an analysis and determined that the profit margin was
only 5 percent — barely enough to pay each of them a meager salary. They went
forward with the business anyway. Perhaps they thought that the 5 percent
figure was wrong or that they could somehow increase it. Within a few years, the
brothers closed the business. If they’d had experience in the pizza business, they
probably wouldn’t have bought the parlor, or they would have at least had more
realistic expectations.
An experienced management team is the secret ingredient that can generate
impressive results for your business. Your veteran employees make the smart
decisions to cut expenses, increase sales, and generate profits.
Timing is everything
Different business decisions have different timelines that depend, in part, on the
dollar amount of the decision you’re making. Understanding your timeline helps
you make intelligent decisions about spending. If you decide to use a different
supplier for your materials, for example, you could start buying materials from
that company immediately. No problem. On the other hand, completing a move
into a newly constructed building may take a year or more. You need to consider
timelines for your more-expensive business decisions. If you’re building a new
office, for example, determine how long construction will take.
Explain your timeline in your business plan. If you’re providing financial statements for one year, you may need to explain payments for a building (asset) that
isn’t completed. It’s perfectly reasonable to expect a business to pay for major
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assets over a long period; just be sure to explain it to your investors or lenders.
You may have a one-year operating budget, along with a capital expenditure budget
for three to five years. The capital expenditure budget is the big-things-I’ll-buyand-pay-for-long-term budget. This budget helps you and others visualize your
long-term plans and spending.
People get you headed in the right direction
Talk to your staff. If you’re concerned about wasting material in the manufacturing process, talk to people on the factory floor. Maybe you’ll find out that poor
quality is the reason why some material is wasted during production. Maybe some
denim you use to make jeans tears too easily, and you need to find a new supplier.
You may never find out about that problem if you don’t spend some time on the
factory floor.
Talk with the sales staff to plan sales for the year. Good salespeople know their
clients. They may know about a client’s purchasing plans for next year. They may
even know a client’s budget to buy your product! Also, a good salesperson knows
the customer’s financial condition. If the customer’s business is growing, that
customer may buy more from you. If the business is in financial trouble, sales
may decline.
Have a conversation with the accountant during planning. They know how cash
flow turned out last year. You can look at the data on how quickly you collected
cash for sales.
Also, your attorney may remind you of any legal issues that could generate
expenses during the year, such as costs for legal services or costs to settle litigation. Those costs require cash, and you need to include them in your plan.
When your budget is in good shape, present it to your staff, and explain where the
company is headed. They’ll feel more confident knowing the company’s direction
and prospects, especially if they played a role in developing the budget.
Sales projections pay off
Sales projections help answer the question of how you earn a reasonable level of
profit. The answer is complicated if competitors are selling the same product or
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The budgeting process isn’t only about numbers; it also involves people. A budget
is something that a group of people typically reviews and eventually comes to an
agreement on. Involve people, consider their opinions, and get their buy-in on the
budget. If the company’s managers don’t generally agree on where you’re headed
in your budget, you may need to revise it.
service, of course, because it suggests that you may have to lower prices to stay
competitive. If you want to cut prices to attract business, you need to plan your
costs so that your profit level remains reasonable. Another possibility is to improve
the design of your products but not change prices. If you take that approach, you
add the cost of design to product costs. But increased sales without cutting prices
may offset the cost of design.
Good planning is useful; poor planning leads to projections (of profit, sales, and
company growth) that aren’t useful. If you base decisions on inaccurate projections, you’re likely to use assets in ways that won’t maximize your profits. Simply
put, you end up spending time and money on the wrong activities.
Coming up with accurate sales projections often begins with market research.
Suppose that you’re selling running shoes, and you discover that 10 million people
buy running shoes each year in the United States, spending an average $80 for
a pair. Fortunately, you’ve priced your shoes at $78, so you’re right around the
average.
Next, you estimate that your firm can capture 10 percent of the U.S. running-shoe
market, which means total sales volume of 10 percent of a 10 million-unit market,
or 1 million units sold in a year. Because you’re selling shoes for $78 a pair, you
project your sales to be $78 million.
Finally, you consider whether the market is growing or shrinking. If the runningshoe market is growing at 10 percent per year, you could reasonably increase your
sales projection by 10 percent each year. Market growth, of course, is affected by
the overall economy and the specific industry (sporting goods, in this case). Competitors may also affect your growth. You’d need to project all these contingencies
before coming up with a reasonable sales forecast.
The sales growth rate drives decisions about spending, employee hiring, and
cash planning. If you’re selling 30 percent more, you can plan to increase your
spending and hire employees to manufacture 30 percent more of your product.
Also, you can probably expect a 30 percent increase in cash inflow as a result of
growth.
But wait! If a more careful review indicates 10 percent growth, your 30 percent
projection creates some problems for you. You increased your spending and hiring, assuming the 30 percent level, but the sales and cash inflows will come
in at only 10 percent. Put simply, you’re planning on spending 20 percent too
much. Whether you’re building homes or selling running shoes, the numbers
still apply.
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Understanding Budgeting Basics
Begin the budgeting process by deciding which company entities require a budget
and how detailed that budget needs to be. You may decide to develop a budget for
the entire company or for each division or department within it.
When you create your budget (based on reasonable assumptions) and start the
year’s business, you have actual costs and levels of activity to review. A difference
between an actual cost and standard cost is a variance — a scorecard that tells you
how close your budget assumptions were to actual results. Fortunately, you can
modify your budget to deal with variances. (See Book 7, Chapter 4 for more about
variance analysis.)
Your budget becomes a set of pro forma financial statements. Pro formas are whatif statements filled with budgeted, planned, and forecasted items. Unless you have
a crystal ball, your budget is always a collection of educated best guesses about
the future.
To keep things simple, a budget uses three basic financial statements: the balance
sheet, the income statement, and the statement of cash flow. (Head over to Books
4 and 5 for more on financial statements.) Another aspect is an explanation of
your source of funds.
Sourcing funds
Your budget determines whether you have enough funds to run your business.
Ideally, you get all the money you need from selling products or services, but
that’s not always the case.
The financial plan (also loosely called the business plan) explains the source of funds
to run the business. You can raise money by borrowing cash (debt) or by offering
investors ownership in the business (equity) in exchange for cash. (See Book 6,
Chapter 1 for guidance on raising funds.) For now, consider how you budget for
the process.
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In budgeting, you begin with some assumptions. The assumptions are called
standard costs and are the specific planned levels of cost and activity. You might
assume a standard labor rate (cost) of $20 per hour for a sewing-machine operator or a standard material rate of $75 per square foot for marble for kitchen
countertops.
If you borrow, you repay a creditor the original amount borrowed (principal) and
interest on the loan, usually on a written schedule. The interest cost and principal
repayment must be included in the budget.
You can also raise funds by selling ownership in your business, offering investors
equity. Equity investors are rewarded in two ways: stock appreciation and dividends.
The most common way to sell ownership is to sell common stock. Investors expect
you to explain (through your budget) how you plan to generate a profit for the
year. If the company is profitable, the value of their ownership in your business
increases. They could eventually sell their ownership interest to someone else for
a profit.
You also need to consider whether to pay dividends. Dividends are a share of the
profits earned by the company paid to equity investors. Without any company
earnings, of course, you can’t pay dividends.
Using the balance sheet
The balance sheet lists the company’s assets, liabilities, and equity (essentially the
difference between assets and liabilities) as of a certain date. Think of the actual
balance sheet as being a snapshot in time; think of the budgeted balance sheet as
being a pretty good estimate of the actual financial statement.
Liabilities are claims on your assets. Having a liability means that you owe someone money. Liabilities include items such as unpaid utility bills and payroll costs
you haven’t yet paid. Future interest and principal payments on a loan are also
liabilities. When you pay a liability, you use an asset (cash, in most cases) to make
payments.
Assets – Liabilities = Equity
Consider a scenario. You own a little shop. You sell all your assets: your inventory,
furniture, and your building. You use the cash you receive to pay all your liabilities: utility bills, payroll, and bank loan. Whatever cash remains after you pay your
liabilities is your equity. Equity is the true value of your business. Now you see
the logic behind the balance sheet formula: Assets minus liabilities equals equity.
Working with the income statement
The income statement shows revenue, expenses, and net income (profit) or loss.
For most business owners, the income statement is the most important report. It
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shows whether a business was profitable over a given period (such as a month,
quarter, or year), whereas the balance sheet shows assets, liabilities, and equity
as of a specific date. The nice thing about modern accounting software is that it
can generate an income statement almost instantly. Think of the budgeted income
statement as being a pretty good projection of your company’s sales, expenses,
and profit.
The income statement formula is incredibly simple:
Revenue – Expenses = Net income or loss
The statement of cash flows analyzes sources of cash (cash inflows) and uses of
cash (cash outflows) over a given period. (Stroll over to Book 5, Chapter 2 for
more on cash flows.) When an accountant puts together a cash-flow statement,
they review every transaction that affected cash. A very simple model is what’s in
your checkbook. If inflows are good, you probably have enough cash to operate. If
the checkbook shows that you’re overdrawn, outflows have exceeded inflows, and
you’ve got trouble.
The goal is to assign every cash transaction to one of three categories, although
most of your cash activity is in the operating section. To simplify the process, find
the financing and investing activities first, because they represent fewer transactions. The remaining transactions are operating activities.
The three cash-flow categories are
»» Operating activities: These activities occur when you run your business each
day. You buy material, pay for labor, ship goods, pay interest on loans, and
collect cash from customers.
»» Financing activities: These activities occur when you raise money for your
business and when you pay lenders or investors. You receive cash when you
sell equity, and you receive cash when you borrow. You pay cash when you
pay dividends, and you pay cash when you pay down a loan (pay back some
of the principal).
»» Investing activities: These activities occur when you buy or sell assets.
Writing a check for a new vehicle and receiving cash when you sell equipment
are investing activities.
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Analyzing the statement of cash flows
The statement of cash flows lists the beginning cash balance; all the cash activity
for the period, grouped in three categories; and the ending cash balance:
Ending cash balance = Beginning cash balance +/– Net cash flow of operating
activities +/– Net cash flow of financing activities +/– Net cash flow of investing
activities
A simpler formula is
Ending cash balance = Beginning cash balance + Cash inflows for the period – Cash
outflows for the period
The ending cash balance in the statement of cash flows equals the cash balance in
the balance sheet (or is supposed to, anyway). If the statement of cash flows is for
March, for example, the ending cash balance should equal the balance sheet cash
balance for the last day of March.
When you create your budget, it should include all three financial statements: balance sheet, income statement, and statement of cash flows.
Reviewing Revenue and Production
Budgets
Revenue and production budgets, put simply, forecast how many units you plan
to produce and how many units you plan to sell. Suppose that you’re budgeting
to manufacture doors. You need to forecast how many sales you expect. Then you
have to consider how many garage doors you already have in inventory and plan
how many you need to manufacture to meet the sales forecast. Ta-da! When you
know the number of doors you need to make, you can budget for material and
labor costs. Material and labor costs are considered to be direct costs because they
can be traced directly to your product.
Indirect costs are those that can’t be traced directly to the product. Repair and
maintenance costs for a machine, for example, are indirect costs. You might
assign these costs by dividing the total cost incurred by the number of hours the
machine ran during the month, which would give you a rate per machine hour.
If you incur two hours of machine time to make one unit of product, you would
multiply two hours by the machine rate per hour. That indirect cost total would be
added to the unit of product.
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Revenue, production, inventory, direct materials, direct labor, indirect costs
(overhead), and cost of goods sold are all budgeted items.
Applying the revenue formula
Suppose that you forecast selling 200 doors in March. Consider how many doors
you need to manufacture. Assuming a selling price of $300 per door, here’s your
revenue budget:
Budgeting for a Better
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Revenue budget = 200 units × $300
Revenue budget = $60,000
Using the inventory formula
The basic inventory formula is as follows:
Ending inventory = Beginning inventory + Production – Sales
Your production will change based on how many doors you already have in inventory. So if you have 75 completed doors in beginning inventory, you won’t need to
manufacture all 200 units you plan to sell.
But wait! Do you want any doors in ending inventory? If you think you’ll have
orders during the first few days of the next month, you’ll probably want to have at
least a few doors left at the end of this month. So you might decide on an ending
inventory of 50 doors.
Take the inventory formula and calculate the door production you need. Assume
that x is production in units, and solve for x:
Ending inventory = Beginning inventory + Production – Sales
50 = 75 + x – 200
50 – 75 + 200 = x
x = 175
This simple algebra problem shows that production should be 175 units. Table 4-1
shows a production budget.
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TABLE 4-1
Door Production Budget
Cost
Quantity
Price
Total
Direct material (wood)
80 square feet
$1 per square foot
$80
Direct labor (labor)
2 hours
$25 per hour
$50
Indirect costs allocated
1 hour
$15 per hour
$15
Cost per unit
Production cost
$145
Units
Unit cost
Total cost
175
$145 (above)
$25,375
The production budget includes direct materials, direct labor, and indirect costs
(overhead). In this example, the indirect cost is allocated based on machine hours.
Add the costs to get a unit cost. Then multiply units to be produced by the cost per
unit. That amount is the total cost of production: $25,375.
Assessing cost of goods sold
One of two things usually happen with the finished goods produced: You either
sell them (cost of goods sold), or they’re still on the shelf (finished goods inventory). Beginning inventory and production don’t matter.
What costs should be attached to the goods you sell, and how much did they cost
to produce? (If you’re a retailer, how much did they cost to get?) To continue with
the door-manufacturing example, assume that the first goods you sell are from
beginning inventory. Because all 75 units of beginning inventory are sold, use a
formula to determine how many units of the March production are sold:
March production sold = Total sales – Beginning inventory
March production sold = 200 – 75
March production sold = 125
Assume also that the cost per unit of beginning inventory is $143. That cost is different from the March production cost of $145. (The change occurred because the
costs of materials and labor required to make a door rose.) Table 4-2 displays the
cost of goods sold budget.
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TABLE 4-2
Door Cost of Goods Sold Budget
Units
Cost Per Unit
Total Cost
Beginning inventory
75
$143
$10,725
March production sold
125
$145
$18,125
Total
200
$28,850
There’s one more calculation. (There’s always one more calculation.) Now calculate your ending inventory budget:
Ending inventory budget = Units × Cost per unit
Ending inventory budget = 50 × $145
Ending inventory budget = $7,250
You’ve planned revenue, production, and inventory. Great! Now you need to figure
out how to pay for it all. If you don’t have a budget for an adequate cash amount
to operate, you can’t do business.
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The total cost of goods sold is higher ($28,850) than the total production cost in
Table 4-1 ($25,375), which makes sense, because Table 4-1 deals only with producing 175 units. You sold 200 units, but 75 units came from inventory. Because of
adjustments for beginning and desired ending inventory, you don’t always need
to produce in a month the number of units you sell in a month.
IN THIS CHAPTER
»» Applying accrual accounting to the
budget process
»» Producing a budgeted income
statement and balance sheet
»» Creating a flexible budget
Chapter
5
Mastering Budgeting
Strategies
I
f you are ready to tackle more detailed aspects of budgeting, weigh the pros and
cons of budgeting with cash-basis or accrual accounting, and develop a flexible
budget, then this chapter is for you. For an overview of budgeting basics, check
out Book 6, Chapter 4.
This chapter explains how to use the information from your budget for sales
and production to create a budgeted income statement and balance sheet. It also
reveals how to put together a flexible budget that accommodates different levels
of production. But the first order of business is to understand why accountants use
accrual rather than cash-basis accounting to create budgets.
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Budgeting with Cash or Accrual
Accounting
Nearly every large corporation uses accrual accounting both to record transactions and to budget. Small businesses have a choice of cash-basis accounting or
accrual-basis accounting:
»» Cash-basis accounting posts revenue and expenses to the financial state-
ments based solely on cash transactions. Nothing happens until you take cash
in or pay it out. This type of accounting is a simple way of doing things, with no
accounts receivable and no accounts payable.
»» Accrual-basis accounting states that expenses are matched with revenue,
regardless of when cash moves in or out of the checkbook. The accrual basis
is a better method to account for profits because revenue and expenses are
matched more precisely.
A useful budget uses accrual accounting, which matches revenue with expenses.
Using the cash method — budgeting based on cash inflows and outflows —
doesn’t provide an accurate picture of your budgeted profit level.
Accounting for cash
On a very basic level, your cash budget is a reflection of your checkbook. It’s the
sum of the deposits you make (revenue) and the checks you write (costs). The
budgeting result of cash basis accounting is a cash budget.
Such a budget assumes that all your customers pay for sales in cash during the
month of sale and that you pay all costs during the month that the goods are sold.
This scenario is highly unlikely for most businesses.
It’s more likely that you write a check in February for materials for a product you
sell in April. Similarly, you may pay an employee in December for work done to
make a product that’s sold in January. Suppose that you own a shop that sells
greeting cards, flowers, and gifts. Your beginning cash balance for the month is
$100,000. Table 5-1 displays a cash budget for the shop.
This cash budget has a $16,000 increase in cash during the month ($116,000 –
$100,000). You had $50,000 in sales. If you hadn’t collected any cash from customers during March, your cash balance would decrease by $34,000, the total of all
the cash outflows. If that happened, you’d start the next month with $34,000 less
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cash. You need to consider whether your April cash budget (next month) would
work with a lower beginning balance in cash. You don’t want to start in the red.
TABLE 5-1
Gift-Shop Cash Budget, Month of March
Amount
Beginning cash balance
$100,000
Add customer payments for sales
$50,000
Less:
Inventory purchases
$20,000
Payroll costs
$10,000
Utilities costs
$1,000
Lease cost
$3,000
Ending cash balance
$116,000
The cash budget is similar to the statement of cash flows. Table 5-2 shows an
example statement of cash flows for the gift shop.
TABLE 5-2
Gift-Shop Budgeted Statement of Cash Flows
Amount
Beginning cash balance
$100,000
Cash flow from operations
$16,000
Cash flow from financing
$0
Cash flow from investing
$0
Ending cash balance
$116,000
Note that the beginning and ending cash balances in Table 5-2 agree with the cash
budget ($100,000 at the beginning and $116,000 at the end). The cash flow calculation from operations is
Net cash inflow from operations = Customer payments – Cash outflows
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If you don’t think you’ll have enough cash for a period, you can consider how to
get it.
Net cash inflow from operations = $50,000 – $34,000
Net cash inflow from operations = $16,000
All the cash flows for the gift shop are related to day-to-day operations. None of
the cash activity is related to financing or investing.
Accruing experience
An effective budget applies the matching principle, which states that you should
match the timing of the expenses of creating and delivering your product or service with the timing of getting revenue from the sale. This approach demonstrates
accrual basis accounting (as opposed to cash basis accounting). Accrual accounting
ensures that revenue is more precisely matched with the expenses incurred to
generate revenue.
In accrual accounting, when you create an invoice, the accounts receivable (A/R)
system generates a receivable, even though the customer may not pay for, say,
30 days. When the payment arrives, the receivable is adjusted to zero, meaning
that it’s been satisfied by the payment. Accrual accounting is considered to provide a more accurate reflection of business activity than cash accounting. By the
way, the system still allows for straight cash sales — those in which you sell now
and the customer pays now.
The same is true of purchases you make. When you buy now and pay later, you
create a payable. When the bill comes and you pay it, the payable is adjusted to
zero. The system, of course, allows you to make straight cash purchases — those
in which you buy and pay your vendor now.
Suppose that you manage a catering business. The food, preparation cost, and
delivery expenses related to the Jones family reunion should be matched with the
revenue from the Jones family. Ideally, you want the expense and the revenue to
be posted in the same time period. You wouldn’t want the Jones expenses posted
in March and the Jones revenue posted when the family paid (say, in April). That’s
not the best reflection of your business activity.
The downside of accrual accounting is that your income statement revenue and
expenses rarely match your cash inflows and outflows. You can be rich in receivables and darned poor in cash. But most companies still prepare a cash flow statement even if they’re using accrual accounting.
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Budgeting to Produce the Income
Statement and Balance Sheet
A final step in the budgeting process is creating a budgeted balance sheet and
budgeted income statement. Your balance sheet and income statement, whether
budgeted or actual, are the two great financials: They reflect the bottom line,
showing how the business is doing.
Well-balanced sheets
Your balance sheet is a fine indicator of business health. Table 5-3 shows a healthy
balance sheet.
TABLE 5-3
Budgeted Balance Sheet
Amount
$100,000
Less liabilities
$50,000
Equals equity
$50,000
As you review your balance sheet budget, keep in mind that the goal is to maintain enough assets to run your business, which includes production (if you make
things), buying inventory (if you’re a retailer), or employing people (for manufacturing, retailing, or service businesses).
The balance sheet should include assets needed for selling and distributing your
products. Managing your business generates liabilities, too (accounts payable,
long-term debt, and so forth). That’s okay, as long as you have a plan to pay them.
If revenue doesn’t supply you enough of the best asset — cash — you need a plan
to raise capital. Capital represents an investment in your business. If you invest
$20,000 in your business, the $20,000 is considered to be capital for the business,
which means you’re probably either issuing debt (taking out a loan) or selling
equity (shares of the company) to stockholders.
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Assets
The incredible income statement
Most business owners are most interested in the income statement. The owner
typically plans this budget document first. Table 5-4 shows a budgeted income
statement that projects a healthy net income.
TABLE 5-4
Budgeted Income Statement
Amount
Revenue
$50,000
Less expenses
$25,000
Equals net income
$25,000
You figure out how much revenue the company can generate. Then you subtract
likely expenses from revenue, and the result is your net income. After that, think
about how cash will move (the cash-flow statement) and where your company
will get sufficient assets to operate (the balance sheet).
As you move forward in managing your business, don’t be surprised if cash flow
becomes the most important budget item for you. Without enough cash flow, not
much happens.
Flexing Your Budget: When Plans Change
Regardless of how carefully you budget, plans may change. Suppose that you plan
a cross-country family camping trip. You diligently create a budget spreadsheet
based on your research and assumptions. Unfortunately, nearly everything costs
more than you estimated.
A 30 percent increase in the price of gas, for example, adds more than $1,000 to
the cost of the trip. And although you timed the trip to drive 600 miles per day,
you didn’t take into account stops for coffee, restrooms, or motion sickness.
As the road trip attests, budgets don’t have to be set in stone. This section explains
how to use flexible budgets to manage your business’s operations.
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Controlling your business
Budgeting helps you plan your business’s operations. But you also need to control
your business — to monitor what’s actually happening. Controlling involves constantly comparing actual activity with your budget and carefully analyzing and
understanding any differences. To accomplish this task, you need budget reports
that compare your budgets (what should have happened) with what actually happened. Suppose that your company budgeted $100,000 for sales in the first quarter. Actual sales for the quarter fall short, at only $70,000. First, call the sales
manager to find out what happened. (Maybe a computer snafu accidentally canceled customer orders.) Then take corrective action. (Fix your computer and call
your customers to apologize.) Finally, adjust your future plans. (Cut next quarter’s
production estimates.)
Book 6, Chapter 4 provides the basic template for budgeting, offering projections
for sales, expenses, production levels, and cash flows to help you plan for future
periods. The major flaw of this template is that it’s static, projecting only one scenario based on a single set of sales estimates. It can’t change.
Enter the flexible budget. As activity levels change, you can easily adjust a flexible
budget and continue to use it to plan and control your business.
Dealing with budget variances
One benefit of flexible budgeting is that it helps you understand the reasons
for your company’s variances — the differences between actual and budgeted
amounts. Book 6, Chapter 4 introduces the concept of a variance. The next section
gives you the lowdown on the flexible budgeting process, but first, you should
delve a little deeper into the issue of variances.
Always indicate whether a variance is favorable or unfavorable. A variance is
usually considered to be favorable if it improves net income and unfavorable if it
decreases income. Therefore, when actual revenue exceeds budgeted amounts,
the resulting variance is favorable. When actual revenue falls short of budgeted
amounts, the variance is unfavorable. On the other hand, when actual expenses
exceed budgeted expenses, the resulting variance is unfavorable; when actual
expenses fall short of budgeted expenses, the variance is favorable.
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Therefore, a $30,000 difference throws off more than just your sales budget. It
also necessitates changing your production, purchases, direct labor, overhead
costs, and selling and administrative expenses, ruining the entire planning process and making it impossible for you to make future comparisons between your
budgets and actual results.
Management should investigate the cause of significant budget variances. Here
are some possibilities:
»» Changes in conditions: A supplier might have raised prices, for example,
causing the company’s costs to increase.
»» The quality of management: Special care taken to reduce costs can result in
favorable variances. On the other hand, management carelessness can drive
up unfavorable variances.
»» Lousy budgeting: An unrealistically ambitious budget is likely to cause
unfavorable variances.
Many managers use a system called management by exception. They investigate
the largest variances, whether favorable or unfavorable, and ignore the rest. This
strategy helps managers prioritize potential problem areas in operations.
Implementing a flexible budget
To compute variances that can help you understand why actual results differed
from your expectations, creating a flexible budget is helpful. A flexible budget
adjusts the budget for your actual sales or production volume. Your budget might
have assumed that you’d produce 5,000 units, but you actually produce 5,100 units.
The flexible budget accommodates this new number, making all the appropriate
adjustments to sales and expenses based on the unexpected change in volume.
To prepare a flexible budget, you need to have a budget, to understand cost behavior, and to know the actual volume of goods produced and sold.
Consider Kira, president of the fictional Skate Company, which manufactures roller
skates. Kira’s accountant, Steve, prepares the overhead budget shown in Figure 5-1.
Skate had a great year; actual sales came to 125,000 units (see Figure 5-2). But
much to the disappointment of Steve and Kira, the overhead budget report, shown
in Figure 5-2, reports major overruns. For each category of overhead, Steve computes a variance, identifying unfavorable variances in indirect materials, indirect
labor, supervisory salaries, and utilities.
Skate’s total overhead exceeds budget by $25,000. Steve makes the elementary
mistake of treating variable costs as fixed. After all, portions of overhead, such as
indirect materials, appear to be variable costs. If Skate increases production from
100,000 units to 125,000 units, these variable costs should also increase. In other
words, comparing the $60,000 actual indirect cost of making 125,000 units with
the $50,000 budgeted indirect cost of making just 100,000 units makes no sense.
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You’re comparing apples and oranges. Different levels of activity (units) generate
a different level of variable costs (indirect costs).
FIGURE 5-1:
Mastering Budgeting
Strategies
Skate’s static
overhead budget.
© John Wiley & Sons, Inc.
FIGURE 5-2:
Skate’s overhead
budget report.
© John Wiley & Sons, Inc.
CHAPTER 5 Mastering Budgeting Strategies
411
Instead, Steve should flex the budget to determine how much overhead he should
have, assuming that the company makes more or less than the budgeted number
of units. The following sections show you how.
Separating fixed and variable costs
Some costs are variable, changing in response to activity levels, whereas other
costs are fixed and remain the same, regardless of activity level. Direct materials
are variable costs, for example, because the more goods you make, the more materials you need. On the other hand, some overhead costs, such as rent, are fixed;
no matter how many units you make, these costs stay the same. To determine
whether a cost is variable or fixed, think about whether the total cost changes
when the level of activity changes.
For Skate, an analysis indicates that indirect materials, indirect labor, and utilities
are variable costs. On the other hand, supervisory salaries, rent, and depreciation
are fixed. Steve recomputes variable costs with the assumption that the company
makes 125,000 units, as shown in Figure 5-3.
FIGURE 5-3:
Flexing variable
overhead costs.
© John Wiley & Sons, Inc.
In the original budget, making 100,000 units results in total variable costs of
$130,000. Dividing total cost of each category by the budgeted production level
results in variable cost per unit of 50 cents for indirect materials, 40 cents for
indirect labor, and 40 cents for utilities.
To compute the value of the flexible budget, multiply the variable cost per unit
by the actual production volume. Figure 5-3 indicates that the variable costs of
producing 125,000 should total $162,500 (125,000 units × $1.30).
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Comparing the flexible budget with actual results
The final step is combining the variable and fixed costs to prepare a new overhead
budget report, inserting the new flexible budget results into the overhead budget
report as shown in Figure 5-4.
Mastering Budgeting
Strategies
FIGURE 5-4:
Skate’s flexible
overhead budget.
©John Wiley & Sons, Inc.
Look at that! After you adjust for the change in production level, Skate’s variance is suddenly favorable. Actual overhead of $355,000 was $7,500 less than the
$362,500 flexible budget.
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IN THIS CHAPTER
»» Identifying long-term liabilities
»» Reporting gain or loss on debt
extinguishment
Chapter
6
Planning for Long-Term
Obligations
I
f you own a car or house you financed, you’re probably all too familiar with
long-term debt: loans that won’t be paid off by the end of the next 12-month
period. Well, companies have long-term debt too. A company usually uses
current debt as a vehicle to meet short-term obligations like payroll and incurs
long-term debt to finance company assets.
In this chapter, you get the lowdown on two types of long-term debt: notes
and bonds payable. Notes payable are debt a company takes on typically through
lending institutions, such as banks, to finance asset purchases. Asset purchases
include cars, equipment, and buildings. Hospital and municipalities issue bonds
payable (although corporations can issue them too). Here, you find out all you
need to know about this complicated topic.
Managing Long-Term Debt
An immutable fact of running a business is that at some point the company will
have to take on long-term debt to grow its operations. After all, unless the business owners are running the business just for fun, they want to expand operations in the hopes of making more money.
CHAPTER 6 Planning for Long-Term Obligations
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The way you structure long-term debt affects the expense of borrowing the
money. When you finance a vehicle or home purchase, you probably shop around
for interest rates and evaluate the options of financing the loan for a shorter or
longer term. Businesses do the same, but they may carry millions of dollars of
debt on their balance sheet, and they have to service this debt. Debt service is the
process of making principal and interest payments on debt. Managing the debt
service is crucially important because minute differences in terms can have a
large effect on interest and the bottom line.
A company may raise cash to purchase assets, expand existing operations, or
maybe even buy another company. If the firm decides to do so by accumulating
long-term debt, management evaluates the relative merits of available forms of
long-term debt. The most common types of long-term debt are mortgages, notes
payable, and bonds payable. The next few sections discuss mortgages and notes
payable. See “Accounting for Bonds” later in this chapter for coverage of bonds.
If you need to make expensive purchases down the road, try to forecast when
you’ll need to pay for the new asset. Companies that use expensive machinery,
equipment, or tech products forecast when they must make a purchase, which
helps the owners decide on the need to borrow funds. Check out Book 8, Chapter 3
to find out more about planning for capital expenditures.
The many faces of notes payable
Notes payable are formal written documents that spell out how money is being borrowed. This type of agreement between a lender and a borrower specifies principal
(amount borrowed), rate (interest percentage the company pays to borrow the
money), frequency of payments, and term (the amount of time the company has
to pay off the loan).
Notes payable are issued in three different ways: face; no-face, no-interest; and
no-face, interest. These terms may make lending and borrowing seem like a silly
game of peekaboo, so take a look at their definitions in the following sections.
Keep in mind that face refers to face amount — a specific dollar amount stated on
the face of the note payable. It represents the principal amount that the borrower
must repay. The note payable document should list everything that the borrower
and lender need to know about the liability, including the principal amount owed.
Face
Face is the easiest type of note to account for. With this type of note, the present value of the note payable is the same as its face, which is the amount stated
on the note. (For more about present value, check out Book 5, Chapter 1.) This
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BOOK 6 Planning and Budgeting for Your Business
sameness results because the effective interest rate, which is the market interest
rate, and the stated interest rate (what’s printed on the face of the note payable)
are the same.
Market is the interest rate for a note of similar risk. The level of risk refers to the
creditworthiness of the borrower — the ability to repay principal (face amount)
and interest on time. For example, if one company loans another company $5,000
at an effective and stated rate of 10 percent due in three years, the journal entry
for the borrower to record issuance of the note is to debit cash and credit notes
payable for $5,000.
Each year, the borrower records interest expense at $500 ($5,000 × 0.10). The
journal entry is to debit interest expense and credit cash for $500. When the company pays off the debt at the end of the three years, the borrower records a credit
to cash and a debit (reduction) to notes payable for $5,000.
No-face, no-interest
A no-face, no-interest note payable is issued for the present value of the amount
the borrower receives from the lender, which is less than the face value (future
value) of the note. The difference between the face value and present value of the
note is called a discount, which represents the total interest to be paid over the life
of the loan.
To determine the present value of the amount borrowed and figure the discount,
use a present value of $1 table. This table assumes a single payment and that you
need to compute the present value of that payment. Search the web to find present
value tables for a single payment and for multiple payments (annuities). Take the
following steps, which assume a single payment:
1.
Using a present value of $1 table, find the factor at the intersection of the
loan percentage and period, as shown in Table 6-1.
2.
Multiply the present value factor you found in step 1 by the future value
of the loan amount to find the present value.
In this example, the face amount (future value) of the loan amount is $20,000,
so to find the present value of $20,000, take $20,000 × 0.68058 = $13,611.60
(rounded to $13,612). This is the present value of $20,000, discounted at
8 percent for five years.
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For example, for a five-year loan at 8 percent annual interest, skim down the
Periods column (on the left) until you find 5, and follow that row to the right
until you hit the 8.0% column. In this case, the factor inside the intersection of
row 5 and column 8.0% is 0.6805. If the decimal is extended one more place, the
more precise factor is 0.68058. Use that more precise factor for this analysis.
3.
Subtract the present value from the future value to determine the
discount.
The discount is $20,000 face amount (future value) – $13,612 (present value) =
$6,388.
TABLE 6-1
Present Value of $1 Lookup Table
Periods
7.0%
7.5%
8.0%
8.5%
1
0.9345
0.9302
0.9259
0.9216
2
0.8734
0.8653
0.8573
0.8494
3
0.8162
0.8049
0.7938
0.7829
4
0.7628
0.7488
0.7350
0.7215
5
0.7129
0.6965
0.6805
0.6650
Figure 6-1 shows how to journalize this transaction.
FIGURE 6-1:
Journalizing a
zero-rateinterest-bearing
note payable.
©John Wiley & Sons, Inc.
The discount on a notes payable account is a contra liability account. It follows
the note payable, amortized over the five-year life. The process of amortization
moves the discount balance (in the balance sheet) to the income statement via
interest expense by using the effective interest method. Figure 6-2 gives you a
bird’s-eye view of how this works, assuming that the effective interest rate is
8 percent.
Journalize the first year by debiting interest expense for $1,089 and crediting
discounts on notes payable for the same amount. For the second year, debit
interest expense for $1,176 and credit discounts on notes payable for the same
amount — and so on for the remaining three years. Note these points regarding
amortization:
»» The carrying amount of the note increases to face amount ($20,000) over the
life of the note payable (five years).
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»» The entire discount balance ($6,388) is moved to interest expense over the
same five-year life of the note payable.
FIGURE 6-2:
Discount
amortization
schedule: zerorate-interestbearing note.
©John Wiley & Sons, Inc.
No-face, interest bearing
Note that the stated interest rate on the note payable is 6 percent. However, both
the cash interest payments ($1,200 per year) and the principal amount are discounted based on an 8-percent rate.
You know that the present value of the principal is $13,612. However, you also
need to figure out the present value of the interest portion of the note. Use
Table 6-2 to find the present value of an annuity of $1 table. Because the interest
paid is a series of payments for the same amount, the payments are referred to as
an annuity. When you calculate the present value of the note payable (Table 6-1),
it’s the present value of a single amount.
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Now that you’ve tackled zero-interest-bearing notes payables, you can dig into
interest-bearing notes. Going back to the $20,000 example from the “No-face,
no-interest” section, assume the note payable has a stated (face) interest rate of
6 percent. At that stated rate, interest is $1,200 per year ($20,000 × 0.06). The
borrower pays interest to the lender at the end of each year.
TABLE 6-2
Present Value of an Annuity $1 Lookup Table
Periods
6%
8%
10%
1
0.9434
0.9259
0.9091
2
1.8334
1.7833
1.7355
3
2.6730
2.5771
2.4869
4
3.4651
3.3121
3.1699
5
4.2124
3.9927
3.7908
The factor at the intersection of 8 percent and five years in the present value
of an annuity of $1 table is 3.9927. The present value of the interest is $4,791
(rounded) ($1,200 × 3.9927). Add the two present value figures to get the carrying
value of the note, which is $18,403 ($13,612 + $4,791). Subtract $18,403 from the
face value of the note payable to get the discount of $1,597 ($20,000 – $18,403).
Figure 6-3 shows how to journalize this transaction, and Figure 6-4 gives you the
lowdown on the amortization table used to prepare the journal entry.
FIGURE 6-3:
Recording
discounted note
payable.
©John Wiley & Sons, Inc.
To record the borrower’s interest payment at the end of each year, journalize the
first year by crediting discounts on notes payable for $272 and debiting interest
expense for $1,472. The credit goes to cash for $1,200. For the second year, you
credit discounts on notes payable for $294, debit interest expenses for $1,494,
and credit cash for $1,200 — and so on for the remaining three years.
Mortgages payable
The most common type of note payable is a mortgage, which is used to finance
the purchase of real property assets such as land and buildings. The property
collateralizes the mortgage, which means the property is held as security on the
mortgage. If the company defaults on the mortgage, the lending institution seizes
the property and sells it in an attempt to recover as much of the loan balance as
possible.
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FIGURE 6-4:
Discount
amortization
schedule:
interest-bearing
note payable.
©John Wiley & Sons, Inc.
Mortgages require a formal closing procedure that’s typically done at the offices
of a title company, an independent middleman that coordinates the rights and
obligations during the sale for the buyer, seller, and mortgage company. As in the
purchase of a personal residence, reams of paperwork (such as the mortgage document and the transfer of the property’s title) are passed back and forth among
the buyer, seller, and closing agent for approval and signature.
Treasury bonds defined
Treasury bonds are debt the government of the United States issues to pay for
government projects. As with any bond, repayment of principal is accompanied
by a fixed (or variable in some new, inflation-proof U.S. bonds) interest rate.
Treasury bonds have nothing to do with treasury stock, which is corporate stock
the issuing corporation buys back from investors. To understand how to account
for corporate bond debt, see the “Accounting for Bonds” section in this chapter.
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Another type of long-term debt involves capitalized leases. A company doesn’t
always buy its fixed assets — sometimes it leases them. In this scenario, the
lessee, the person leasing the property, records the capital lease as both a leased
asset and a leased liability. Read more about accounting for leases in Book 8,
Chapter 4.
The dark side of debt-free
If a company pays off a debt (whether a note or a bond) early, the company must
determine whether a gain or loss was incurred on the transaction. (Paying off a
debt early is also referred to as debt extinguishment.) With an early payoff, any
unamortized discount or premium on the debt payable is removed from the books.
Because the debt is removed, any remaining discount or premium related to the
debt should also be removed. This transaction may generate a gain or loss.
When computing a gain or loss related to an early payoff, keep these points in
mind:
»» The liability is always debited (reduced) for the face amount of the debt.
»» Cash is credited (reduced) for the amount paid to remove the debt.
»» An unamortized discount is credited to adjust the remaining balance to zero.
»» After you post the first three entries, consider the remaining amount you
need in the journal entry to balance debits and credits. If you need a debit, it’s
a loss on bond extinguishment. A credit entry would be posted as a gain.
Imagine that a company repurchases a note payable for $104,000; the face value
is $100,000. It was issued at a discount, and $3,000 of the discount isn’t yet
amortized at the date of repurchase. Here’s the journal entry:
»» Debit bond payable $100,000 and loss on bond extinguishment $7,000
»» Credit cash (paid to lender) $104,000 and discount on bond payable $3,000
Remember that a business can remove the debt from its balance sheet only if one
of the following occurs:
»» The debtor pays the creditor and is totally relieved of the obligation.
For example, the debt was for $10,000 and the debtor paid the creditor the
full $10,000 plus all required interest.
»» The creditor legally releases the debtor from any further obligation.
For example, the creditor agrees to cancel a portion of the debt.
This chapter doesn’t discuss troubled debt restructuring, which is an advanced
financial accounting topic. This takes place when terms of the debt are modified
for market or legal reasons. A good example is when the financial institution
lowers the interest rate. Another example is a short sale of a home, in which the
lender allows the homeowners to sell the home for less than the balance due on
the loan, so the homeowners can get out from under a home they can’t afford and
the borrower can recoup a portion of the principal.
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Accounting for Bonds
Bonds are long-term lending agreements between a borrower and a lender. For
example, when a municipality (such as a city, county, town, or village) needs to
build new roads or a hospital, it issues bonds to finance the project. Corporations
generally issue bonds to raise money for capital expenditures, operations, and
acquisitions.
The selling price of bonds, like publicly traded stock, is normally set by what the
market will bear. The issuer of the bond sets the interest rate, which is known as
the stated, coupon, face, or nominal rate. All four terms mean the same thing —
the interest rate stated in the bond indenture.
A bond indenture is similar to any type of legal financing document that you may
have signed to finance a house or car. It describes the key terms of the bond issuance, including maturity date and interest rate.
The people who purchase a bond receive interest payments during the bond’s
term (or for as long as they hold the bond) at the bond’s stated interest rate. When
the bond matures (the term of the bond expires), the company pays back the bondholder the bond’s face value.
A bond is either a source of financing or an investment, depending on which
side of the transaction you’re looking at. Because this is a chapter on long-term
liabilities, most of the text looks at this transaction from the source of financing
viewpoint.
Valuing bonds payable
Understanding premiums, discounts, and yields
To understand the value placed on a bond, you need to know the relationship
between bonds prices and yield to maturity. Yield to maturity can be thought of as
an investor’s total return on a bond. The total return has two components:
»» Interest income earned on the bond.
»» If the bond is purchased at a discount, the investor is paid the face amount at
maturity. The difference between the discount and the face amount is a gain.
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A company can issue bonds either at face value (also known as par value), which
is the principal amount printed on the bond; at a discount, which is less than face
value; or at a premium, which means the bond sells for more than its face value.
Usually face value is set in denominations of $1,000.
The gain adds to the total return on the bond. A bond purchased at premium
results in a loss when the investor is paid the face amount. The loss reduces
the investor’s total return on the bond.
Going over the effective interest rate
Generally accepted accounting principles (GAAP) prefers the effective interest
method when accounting for bonds issued at a discount or a premium. When
using the effective interest method, you amortize by using the carrying value of the
bonds, which is face amount plus unamortized premium or minus unamortized
discount.
You see the effective interest method used to amortize the no-face, no-interest
note payable (see “No-face, no-interest” earlier in this chapter). In that instance,
the discount represents the interest earned by the lender over time. Check out
Figure 6-2. The carrying amount started as the cash received by the issuer when
the note payable was issued. That amount can also be stated as the face amount
less the unamortized discount, or $20,000 – $6,388 = $13,612.
Over time, the carrying amount is increased by the discount amortization each
year. At the note’s maturity, the carrying amount is equal to the face amount,
$20,000. If you’re the borrower, the amortization of the discount generates more
interest expense to you (see Figure 6-2). For the investor, amortization of the
discount generates more interest income. In either case, amortization increases
the carrying amount until it equals the face amount.
GAAP allows the straight-line method if the result is materially the same:
straight-line method versus effective interest rate method. Keep in mind that
International Financial Accounting Standards (IFRS) requires use of the effective
interest method.
Figuring out the present value of a bond
In many ways, this present value process is the same as the concepts used for
notes payable. Assume a company issues a $100,000 bond due in four years paying
7 percent interest annually at year-end. Here are the steps to compute the present
value of the bond:
1.
Compute annual interest expense.
The interest expense is $100,000 × 0.07 = $7,000 interest expense per year.
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BOOK 6 Planning and Budgeting for Your Business
2.
Find the market interest rate for similar bonds.
You can check a financial publication, such as The Wall Street Journal, for current
market rates on bonds. The market interest rate may differ from the rate
actually being paid. You want the market rate, because in the next step you use
the market rate to look up the present value factor for the interest payments.
Assume that the market rate for similar bonds is 11 percent. Specifically,
similar bonds (with similar credit rating, stated interest rate, and maturity date)
are priced to yield 11 percent. Because the stated rate is 7 percent, the bond
must be priced at a discount. The discount is amortized into income, which
increases the yield to maturity (see “Understanding premiums, discounts, and
yields” earlier in this chapter for details).
3.
Find the present value factors for the face value of the bond and interest
payments.
Use the present value of $1 table to find the present value factor for the bond’s
face amount. Use the present value of an annuity table to find the present
value factor for the interest payments. In each case, find the factor for four
periods (years) at 11 percent interest. In this example, the present value factor
for the bond’s face amount is 0.65873, and the present value factor of the
interest payments is 3.1025.
Search the web to find a present value of $1 table and a present value of an
annuity table. Look for tables that list the factors out to the fifth decimal place.
4.
Use the present value factors to calculate the present value of each
amount in dollars.
The present value of the bond is $100,000 × 0.65873 = $65,873. The present
value of the interest payments is $7,000 × 3.10245 = $21,717, with rounding.
5.
Add the present value of the two cash flows to determine the total
present value of the bond.
Issuing at face value
This one is the easiest type of bond transaction to account for. The journal entry to
record bonds that a company issues at face value is to debit cash and credit bonds
payable. So if the corporation issues bonds for $100,000 with a five-year term, at
10 percent, the journal entry to record the bonds is to debit cash for $100,000 and
to credit bonds payable for $100,000.
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In this example, $65,873 + $21,717 = $87,590.
Face value (or face amount) refers to the amount of debt stated on the face of the
bond certificate. It represents the amount that must be repaid at maturity. For
bonds, par value has the same meaning as face value. This section uses the term
face value because that term refers to the amount stated on the bond certificate.
Mulling over bond pricing
Bond prices are expressed as a percentage of par value (face amount). A bond
with a face amount of $1,000 may have a bond price of 100, or 100 percent of par
value ($1,000). Bonds issued at a premium have a bond price of more than 100.
For example, a price of 102 means 102 percent of par value. In this case, a $1,000
bond’s price would be $1,020. A bond priced at 98 (a discount), would have a price
of $980 per $1,000 bond.
Calculating interest payments
Interest payments don’t change, regardless of whether the bond is priced at par,
a premium, or a discount. To calculate interest payments on a bond, multiply the
principal amount by the interest rate stated on the face of the certificate (stated
rate). For example, suppose the stated rate of a bond is 10 percent, interest is to be
paid semiannually (every six months), the bonds are issued on July 1, and the first
interest payment isn’t due until December 31. The interest payment is principal
multiplied by interest rate multiplied by time; in this case, $100,000 × 0.10 × ½ =
$5,000. So your journal entry on December 31 is to debit bond interest expense for
$5,000 and credit cash for $5,000. The interest expense may change, depending on
whether the bond is priced at a premium or a discount. However, the cash payment
for interest is fixed.
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7
Making Savvy
Business
Decisions
Contents at a Glance
CHAPTER 1:
Costing Jobs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 429
Understanding How Job Costing Works. . . . . . . . . . . . . . . . . . . . . . . 429
Taking a Closer Look at Indirect Costs by Using
Normal Costing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436
Following the Flow of Costs through a Manufacturing System . . . . 439
CHAPTER 2:
Costing by the ABCs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445
Avoiding the Slippery Slope of Peanut Butter Costing. . . . . . . . . . . 445
Designing an Activity-Based Costing System. . . . . . . . . . . . . . . . . . . 450
Using Activity-Based Costing to Compute Total Cost,
Profit, and Sale Price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455
CHAPTER 3:
Contributing to the Margin . . . . . . . . . . . . . . . . . . . . . . . . 461
Computing Contribution Margin. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462
Preparing a Cost-Volume-Profit Analysis. . . . . . . . . . . . . . . . . . . . . . 465
Generating a Break-Even Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . 469
Shooting for Target Profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 471
Setting a Margin of Safety . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472
Measuring Operating Leverage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474
CHAPTER 4:
Accounting for Change with Variance
Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477
Setting Up Standard Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478
Understanding Variances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482
Teasing Out Variances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490
CHAPTER 5:
Pricing Wisely . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495
Differentiating Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495
Taking All Costs into Account with Absorption Costing. . . . . . . . . . 496
Pricing at Cost Plus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 497
Accounting Extremes: Trying Variable-Cost Pricing . . . . . . . . . . . . . 499
Hitting the Bull’s-Eye (Your Target Cost). . . . . . . . . . . . . . . . . . . . . . . 501
CHAPTER 6:
Formulating Equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
Analyzing Profitability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505
Using Assets Effectively . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507
Evaluating Firm Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509
Checking on Company Solvency. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 511
Managing Projects and Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512
IN THIS CHAPTER
»» Going over how job costing works
»» Using job costs to price a product or
service
»» Reviewing the flow of costs through a
manufacturing system
Chapter
1
Costing Jobs
J
ob costing is a methodology you use when the costs to manufacture a product or provide a service vary according to each customer’s unique needs. Job
costing allows you to provide detailed price estimates based on the product
or service provided. A roofing business, for example, uses job costing because the
cost varies according to the customer’s needs. The amount of material depends on
the type of roof and the square footage; labor time varies depending on the roof’s
size, pitch, and unique angles.
A cost object is the product, activity, or process that causes your company to incur
costs. In this chapter, you see how to assign costs to the cost object. You also find
out how to follow the flow of manufacturing costs as a product moves through the
production process.
Understanding How Job Costing Works
For some businesses, nearly every customer job has different costs, which is
where job costing asserts its value. You need a job-costing estimate to get the
customer’s business, and you need to track costs accurately so you can generate
a reasonable profit.
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The different costs for different jobs are often self-evident. Material costs,
labor hours, mileage cost, and type of equipment used are likely to vary. A treetrimming company, for example, incurs more costs to remove a 30-foot tree than
to remove a small stump. The big tree takes more labor and different equipment.
Some factors could lower costs and make a business more competitive in price (or
improve its bottom line). A tree-trimming company working on a job in a certain
neighborhood might distribute a flyer offering free estimates to other homes in
the neighborhood — a smart business move. If the service already stands to incur
the cost to locate its employees and equipment in a certain area, why not perform
as much work as possible while it’s there? The business can spread some costs
(such as mileage) over several jobs. As a result, its cost per job in that neighborhood is lower, boosting its profit. The business lesson is that a little bit of flyer
can go a long way.
Objecting to costs
A cost object is anything that causes you to incur costs. Think about a cost object
as a sponge that absorbs your money. The object can be a customer, job, product line, or company division. Carefully identifying cost objects helps you cost
your product or service accurately. Suppose that you manage a group of plumbers. You’re reviewing the month’s mileage expense (the equivalent of gasoline)
for your staff and notice a 20 percent increase from the previous month. Why?
You start asking questions. As it turns out, customer demand for plumbing work
required your staff to drive more miles, because the average customer lived farther away. In this example, the cost object was the group of customers for the
month. Without any customers, you wouldn’t have paid for all the gas. (Well, you
wouldn’t have had any income either, but never mind.) No cost object means no
costs incurred.
Direct costs are traced to the cost object, and indirect costs are allocated to the cost
object.
Indirect costs can be fixed or variable. Insurance costs on vehicles are a fixed
indirect cost. The premiums are fixed, and the cost is indirect to the job because
you can’t trace the vehicle insurance cost directly to a specific job. Utility costs for
the office (such as heating and cooling) are variable indirect costs. Costs vary with
the weather, but as with the insurance premiums, you can’t trace them directly
to any one job.
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Here’s how fixed and variable costs are assigned to cost objects:
»» Direct costs
• Variable direct costs, such as denim material; denim jeans are the cost
object
•
Fixed direct costs, such as a supervisor salary at an auto plant; an automobile produced is the cost object
»» Indirect costs
• Variable indirect costs, such as utility costs for a television-set manufacturing plant; a television set produced is the cost object
•
Fixed indirect costs, such as insurance for a plumbing vehicle; a plumbing
job is the cost object
Charging customers for direct
and indirect costs
To bill a customer and calculate a profit, you add up all the costs for that customer,
whether they’re direct or indirect costs.
If, for example, you manufacture kitchen countertops, you include all direct and
indirect costs of a custom countertop installation to bill the customer. A direct cost
may be marble (for material). To find the total cost of material for the job, you
compute direct material cost as Marble × Square footage used × Cost per square
foot.
Indirect costs are different. If your kitchen countertop business makes lease payments on an office building, the cost is indirect. You can’t know the exact amount
of indirect costs for the client. You also can’t trace the cost directly to a specific
customer, but you can allocate it by using a cost allocation base.
For job costs to be accurate, you need to collect information before you bill the
client. You also need to consider the difference between your cost estimate and
the final bill. Your client needs to understand how costs higher than the estimate
will be handled. Should the customer expect to pay it, or will you absorb the cost
(and lower your profit)? If this situation isn’t handled correctly, the customer may
be upset. Unforeseen things happen, of course, and you should explain when you
hand the customer the estimate that the final bill may be different. A customer is
likely to accept additional labor costs because the exact cost of labor is probably
hard for you to predict.
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Allocating indirect costs
Think about allocating indirect costs this way: You need to allocate a dollar
amount of cost (say, $100). You spread that cost over a group of customers, a
level of production, or some other activity level. In this section, you see how that
process may work.
A carpenter owns trucks that require repair and maintenance expense. That cost
can’t be traced to specific customers; instead, these indirect costs are allocated to
a cost object. You find a “best” method to assign repair and maintenance expense
to clients — perhaps labor hours worked for the customer.
The logic is that if you work more hours for a specific customer, you probably use
your truck more. If you use the truck more, that customer should absorb more of
your truck’s repair and maintenance cost.
Tracing the repair and maintenance cost of the truck back to a specific customer
is virtually impossible. So make your best educated guess to distribute the cost.
Defining cost allocation
Cost allocation is the process of connecting an indirect cost to a cost object. A cost
pool is a group of similar costs. You can think of a cost pool as a bunch of similar
cost objects thrown together. In this case, the cost object is a specific job.
A cost driver is an item that changes the total costs. If you drive the trucks more,
they require more repair and maintenance. An activity (driving to see customers)
drives up your costs (repair and maintenance).
Just to clarify: The cost object is the “sponge” that absorbs the cost. The cost
driver adds to the size of the sponge. A bigger sponge absorbs more cost. Suppose
that the total repair and maintenance expense for three carpentry trucks is $3,000.
During the month, your workers provide service to 300 clients. Each customer is
allocated $10 of repair and maintenance expense ($3,000 ÷ 300 clients). If the cost
driver increases to 400 clients per month, the carpenters drive more miles. As a
result, the trucks require more maintenance and possibly repairs. Your monthly
repair and maintenance expense is higher.
At 400 customers for the month, assume that total repair and maintenance
expense for three carpentry trucks is $3,600. Now each customer is allocated
repair expense of $9 ($3,600 ÷ 400 clients). The cost driver increase (number of
customers) changes your total cost to $3,600. Because you also have an increase
in total customers (400), the $3,600 is spread over a larger group. The total cost
increases, but the cost allocated per customer declines.
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Grouping similar costs into the same cost pool is often beneficial when the cost
driver is the same. Consider a cost pool for the indirect costs for the carpentry trucks.
In addition to repair and maintenance expense, the company pays for insurance and
depreciation on the three trucks. None of these costs can be traced to a specific customer; instead, you need to allocate these costs. A good cost pool includes depreciation, insurance, and repair costs on the trucks. This cost pool can be allocated in the
same way as the repair and maintenance costs in the preceding example.
Implementing job costing in manufacturing
To implement job costing in a manufacturing company, first think about dividing your costs into two piles: direct costs and indirect costs. In a manufacturing
setting, you have direct materials and direct labor that you can trace directly to
any given job. So far, so good. Next, think about what’s driving indirect costs. You
spread those indirect costs to the work you perform. Here’s an example. Reliable
Fencing manufactures and installs wooden fences for the residential market. The
company has a manufacturing component and a service component.
Reliable provides each customer a cost estimate, based on the type of fence, fence
height and length, and labor hours needed for installation. Because nearly every
job has a different set of costs, Reliable uses job costing. This system allows
Reliable to compute costs accurately, and from that information, the company can
calculate a selling price that generates a reasonable profit.
Imagine that you’re the manager of Reliable Fencing. The Johnsons have requested
an estimate for a fence in their backyard. To provide the estimate, you discuss the
fence models and types with them. You measure the length needed for the fence
and the height requested. Finally, you consider any extra labor costs you may
incur. The Johnsons want the fence to wrap around several trees so that it doesn’t
damage the tree trunks, for example.
The Johnsons’ fence is the cost object. Reliable will incur costs if the client orders
a fence and work starts on the project. But before getting an order, you have to
provide a cost estimate.
Figuring out direct costs
Reliable combines the cost of wood, paint, and a waterproofing treatment for the
wood. That combined cost represents direct materials. As the manager, you compute direct material costs:
Direct materials = Quantity of materials × Unit price paid for material
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You can see that the cost allocation process can get complicated.
You buy material measured in square feet. The unit cost is the price per square
foot. Here’s the amount of material needed and the cost:
Direct materials = 600 square feet of material needed × $5 per square foot
Direct materials = $3,000
Your other direct cost is direct labor. Your staff must cut the wood, paint it, waterproof it, and build the fence. They must measure and dig postholes. Then they
must fill the area around the posts and nail the fence boards to the posts, all while
keeping everything level. This work isn’t easy; it takes real skill and planning. As
a result, the owners of Reliable Fencing know that it’s best to hire skilled people
and pay them a reasonable hourly rate.
Your experience as Reliable’s manager allows you to estimate the labor time
needed based on several factors: the square footage of material needed; the length
and height of the fence; and any extra work, such as going around those tree
trunks. Here’s your formula for direct labor costs:
Direct labor = Hours of labor × Rate paid for labor
Note a difference in terms: Price is used for materials, and rate is the term used for
labor. That distinction comes up in the world of cost variances.
You estimate that 2 people working 20 hours can complete the job. Using these
numbers, you determine the labor cost:
Direct labor = Number of workers × Hours of labor per worker × Hourly rate paid
for labor
Direct labor = 2 workers × 20 hours × $20 per hour
Direct labor = $800
Consider one more direct cost. That formula is also used here:
Cost per mile = Cost per gallon of gas ÷ Miles per gallon for the vehicle
Mileage costs = Miles needed for client × Cost per mile
You calculate 15 miles (round-trip) from your office to the job site. The work will
be completed over several days, so you estimate 45 total miles.
Your trucks get 20 miles to the gallon, and your fuel cost is $4 per gallon. The cost
isn’t much, but here’s the direct cost for mileage:
Cost per mile = $4 gallon of gas ÷ 20 miles per gallon
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Cost per mile = $0.20 per mile
Mileage costs = 45 miles needed for client × $0.20 per mile
Mileage costs = $9.00
So you have three direct costs: materials, labor, and mileage. These costs are direct
because they can be traced to the cost object: the Johnsons’ fence.
Calculating indirect costs
To allocate indirect costs, you decide on two cost pools. One pool is your vehicle
and equipment costs, including depreciation, maintenance, repair, and insurance
costs. The other pool is office cost, which includes salary, benefits, accounting
costs, and legal costs for your company. The cost object for allocating these indirect costs is the customer base:
Vehicle and equipment costs
$4,000
Office cost
$7,000
Customers serviced
200
After you resolve how to allocate costs, try to keep things simple. Combine the
indirect costs into one amount: $4,000 + $7,000 = $11,000. Then divide the indirect cost total by the number of clients for the month:
Indirect cost allocation rate = $11,000 ÷ 200 customers = $55 per customer
Indirect cost allocation rate = $55 per customer
You may want to make your indirect cost allocation more specific. If you could
show the client how the specific job generates indirect costs, they’d be more
inclined to agree with your billing.
You need to weigh the cost and time needed to allocate costs against the benefit
of knowing more specific information. If customers generally accept the $55 allocation rate as reasonable, great. You probably have no reason to dig further into
your indirect costs.
If the majority of your customers have a problem with the rate, however, you
should consider more detailed analysis and present a more detailed indirect cost
billing. If not, you may lose the opportunity to do more work for the same group
of clients.
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435
Presenting total job costs
Table 1-1 shows the total costs for the Johnsons’ fence job.
TABLE 1-1
Job Cost Sheet — Johnson Fence Job
Cost Type
Amount or Quantity
Price or Rate
Total Cost
Direct material
600 square feet
$5 per square foot
$3,000
Direct labor
40 hours
$20 per hour
$800
Mileage
45 miles
$0.20 per mile
$9
Indirect costs
1 customer
$55 allocation
$55
Total job costs
$3,864
Taking a Closer Look at Indirect Costs
by Using Normal Costing
In this section, you apply indirect costs to your product or service. You also plan
direct and indirect costs by using a normal costing system. Actual costs represent
what comes out of your checkbook. You determine actual costs after the work is
completed. Normal costing instead uses budgeted data, which is generated before
the work is completed. Normal costing uses a budgeted price or rate multiplied by
the actual quantity used.
Planning your work without some budgeted rates of cost is difficult. Normal costing creates budgeted rates that you can use to plan your work. Although normal
costs may not equal your actual costs, they do give you a basis for planning your
spending each period.
Suppose that you operate a landscaping company. Changes in costs can make
planning difficult. Maybe the costs you pay for materials, labor, and other costs
change as the year progresses. The cost of grass seed may go up, increasing your
material costs. Or your labor costs decline because the economy slows. More people with the needed skills are looking for landscaping work, so you can offer a
lower pay rate.
If you use actual costs, which change over time, pricing your product to generate
a reasonable profit is difficult. If you had a 15 percent profit above costs, a cost
increase would eat away at your profit. Maybe higher costs lower your profit to
10 percent.
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Budgeting and cash management are similar to planning a vacation. First, you
determine the costs (airline, car rental, hotel, gas, and so on). Next, you plan your
cash flow to pay for the vacation cost. If the prices are fluctuating, planning is difficult. Many people try to book a vacation trip well in advance, so at least airfare
and lodging costs are fixed for the trip!
Budgeting for indirect costs
When you budget for indirect costs, you spread those costs to cost objects based
on a cost driver (refer to “Objecting to costs” earlier in this chapter). Before you
spread the indirect cost, you come up with a rate to allocate the costs to the product or service. The indirect cost rate allows you to price your product to produce a
reasonable profit.
As the manager of the landscaping company, you decide on a cost pool for indirect
costs. Your only indirect costs are vehicles and equipment (depreciation, insurance, and repair costs). Your company is new, with virtually no office costs to
consider yet.
Many companies hold a planning meeting around the end of their fiscal
(business) year. In the meeting, they make assumptions about many issues,
including next year’s costs. This meeting is when a company plans predetermined
or budgeted indirect cost rate. The predetermined overhead rate depends on total
indirect costs and the cost driver you select. Indirect costs are also referred to
as overhead costs.
During a planning session, you consider the prices and rates you paid last year.
You think about how prices and rates have changed and consider your estimates
of miles driven each month. Based on that analysis, here’s your budgeted indirect
cost rate:
Predetermined or budgeted indirect cost rate = $7,500 ÷ 1,400 miles =
$5.36 per mile
Not until the end of the year does the company know what the actual total indirect
costs and the actual miles driven will be. Here’s the actual indirect cost rate for
the vehicles and equipment (using miles driven for the month as the cost object).
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Planning your cash needs is also more challenging. If you need to buy $10,000
worth of grass seed in the next 30 days, what would happen if the price went up?
Maybe a shortage would increase your grass-seed cost to $12,000, so the check
you’d need to write would be for $12,000, not $10,000. Now you need to have
$2,000 more cash available.
The formula is explained in “Computing direct costs and indirect costs” later in
this chapter:
Indirect cost allocation rate = $8,000 ÷ 1,300 miles = $6.15 per mile
Predetermined or budgeted means planned. Your budgeted monthly rate has a lower
monthly cost level ($7,500 versus $8,000) but more monthly miles (1,400 versus
1,300). As a result, the budgeted overhead rate is lower. You use this rate to apply
indirect costs to every job during the year.
At the end of the year, you realize that you didn’t allocate enough costs to your
jobs. As a result, your actual profit will be lower than what you budgeted. Because
actual costs aren’t known until the end of the year, you almost always have a difference between budgeted and actual results.
Following a normal job costing system
Put together your budgeting process for indirect costs with a plan for direct costs.
Think of the combined process as normal costing. This chapter keeps hammering
away at this point, but it’s important: You trace direct costs and allocate indirect
costs.
Normal costing combines indirect cost rate with actual production. The process
gets you closer to actual total costs for your product.
Computing direct costs and indirect costs
To implement normal costing, you compute direct and indirect costs:
»» Direct costs: Traced to the cost object by multiplying actual prices and/or
rates by actual quantity for a specific job object
»» Indirect costs: Allocated to the cost object by multiplying predetermined or
budgeted indirect cost rate by actual quantity for a specific job object
Note that both direct and indirect costs use actual quantities in the formula. While
you come up with an indirect cost rate in planning, the rate is multiplied by actual
quantities. In this case, the quantity is jobs for the month.
Introducing the job cost sheet
A job cost sheet lists every cost incurred for a particular job, including direct material, direct labor, and all indirect costs. The job cost sheet is your basis for computing your sale price and your profit. You use this document to prepare a cost
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TABLE 1-2
Normal Job Cost Sheet — Landscaping Job
Cost Type
Amount or Quantity
Price or Rate
Total Cost
(Rounded)
Direct material
100 square feet of
grass seed
$12 per square foot
$1,200
Direct labor
15 hours of labor
$15 per hour
$225
Mileage
30 miles driven
$0.18 per mile
$5
Indirect costs
30 miles driven
$5.36 per mile
$161
Total job costs
$1,591
The indirect cost calculation (vehicle and equipment costs) uses the actual quantity (miles driven) and the estimated rate per mile. The other direct costs on the
job sheet use actual quantities and actual prices/rates.
Following the Flow of Costs through
a Manufacturing System
Costs flow through a manufacturing system, from buying materials for a product
all the way to the customer sale. When you envision the flow of costs, you find it
easier to collect all the product costs you need to price a product. When you know
all the steps, you remember all the costs related to those steps!
The manufacturing process described in the following sections assumes the company uses process costing, which assumes that each product manufactured is similar to the others or maybe even identical. As a result, you can track costs as they
move from one production department to another. You don’t need to track costs
by each customer or each customer job.
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estimate for a client. Table 1-2 shows a job cost sheet using normal costing for
a landscaping job. Because some job costs are based on budgets and estimates,
many businesses round the calculations. You see that total costs are rounded in
Table 1-2.
Managing costs with control accounts
Control accounts are temporary holding places for costs. Managing costs has to
start somewhere, and in accounting, that process most often starts with control
accounts.
Labor, materials, and indirect costs start in control accounts. Strange as it may
sound, these accounts and their balances don’t appear in the financial statements,
because the balances are eventually moved to other accounts. All the checks you
write for manufacturing costs are posted to control accounts first.
For many manufacturers and retailers, inventory is the biggest investment; more
cash is spent on inventory than on any other asset. For that reason, a big part of
operating a profitable business is controlling inventory costs.
Inventory is an asset you eventually sell to someone (a little different from buildings
and equipment, of course). For manufacturers, inventory has three components —
raw materials, work in process, and finished goods — whereas retailers have only
finished goods. Raw materials inventory is, broadly, products not yet started;
work-in-process inventory is partially completed products; and finished-goods
inventory is completed products.
The three kinds of inventory are assets, because you eventually sell the goods to a
customer. When you do, the inventory asset becomes an expense — cost of goods
sold. Managing inventory starts in a control account.
Following are the three major categories of control accounts. The amounts in each
of these accounts are eventually moved into production.
»» Materials: You buy materials (such as wood for making kitchen cabinets) in
advance of making your products. Materials control is the term for the control
account for material costs.
»» Labor: Consider labor costs. Employees report the hours they work on
time cards each week. Those cards list hours worked on various projects.
For custom cabinets, the time cards list customer jobs that employees
completed, and the hours worked. Wages payable control is the term for the
control account for labor.
»» Indirect costs: A business (such as the kitchen cabinet business) has indirect
costs (such as machine repair and maintenance). Your firm has some method
to allocate those costs to clients (refer to “Budgeting for indirect costs” earlier
in this chapter). You may not get to the allocation until after you write checks
for the cost, however. Overhead control is the term for the control account for
indirect costs.
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Walking through a manufacturing cost example
Suppose that you’re the manager of Homewood Custom Cabinets. You order
$20,000 worth of lumber. Then you take a quarter of the lumber and start making
cabinets for a customer.
When you buy the lumber, cash (an asset) goes down, but the material-control
account (as asset) goes up. The material-control account is increased (debited)
when you buy the lumber.
The material-control account balance is decreased (credited) when you take
$5,000 worth of lumber to start using the material for a customer. How does your
material-control account look now?
Material-control account
Debit
Credit
$20,000
$5,000
If the month ends with no other activity, the ending material-control balance is
$15,000 ($20,000 – $5,000).
But the $5,000 doesn’t just vanish. When you put materials into production, you
reduce (credit) the material-control account and increase (debit) the work-inprocess control account.
Work-in-process control account
Debit
Credit
$5,000
You reduce one asset (material-control account) and increase another asset
(work-in-process control account).
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Control accounts (materials, labor, and overhead), work in process, and finished
goods are inventory accounts, which are assets. Cost of goods sold (COGS) is an
expense account. When you make a sale to a customer, you use up the asset. The
asset becomes an expense. Debiting increases all these accounts, and crediting
decreases all these accounts. The balance for any of these accounts is equal to
debit balance less credit balance. For more about debits and credits, see Book 1,
Chapter 2.
Now assume that the people on the shop floor finish some cabinets and move
$2,000 of the $5,000 work in process to finished goods.
Work-in-process control account
Debit
Credit
$5,000
$2,000
You reduce one asset (work-in-process control account) and increase another
asset (finished-goods control account). If the month ends with no other activity,
the ending balance in the work-in-process account is $3,000 ($5,000 – $2,000).
Again, no money disappears. The “other side” of the transaction hits the finishedgoods control account.
Finished-goods control account
Debit
Credit
$2,000
So one more time, you reduce one asset (work-in-process control account) and
increase another asset (finished-goods control account).
At some point, you sell what you made. You have $2,000 in finished goods. Because
you make custom cabinets, you have one customer identified as the buyer. That
customer raised their hand, so to speak, and placed an order. The finished-goods
control account shows this:
Finished-goods control account
Debit
Credit
$2,000
$2,000
You’re almost home. When goods are sold, you reduce (credit) the finished-goods
account and increase (debit) the COGS account, and that’s an expense account.
At last!
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COGS account
Debit
Credit
$2,000
The difference between your sale price and COGS is your profit.
The reason you do this exercise is to fully track where your inventory money is.
For custom cabinets, it can be a big deal if you’re building for, say, 20 customers
at the same time; for off-the-shelf cabinets, it can be a very big deal. You may be
delivering 2,000 cabinets per month.
The flow lets you see where the inventory money is and spot production logjams.
Too much in the material-control account suggests that you’re overbuying or not
producing at the rate you expected. Too much in the work-in-process control
account suggests that you’re not producing completed product as planned. Too
much in the finished-goods control account suggests that you’re not selling and
that you have dead inventory.
Applying the methodology to other
control accounts
Use the same flow process for labor and indirect costs. Labor costs accumulate
in the control account until they’re traced to a customer or product line. At that
point, the cost moves to work in process. When the goods are completed, the
costs move to finished goods. When goods are sold, the cost moves to COGS. The
labor cost process mirrors the system for material costs described in the preceding section.
For more about cost allocation, refer to “Budgeting for indirect costs” earlier in
this chapter. Suppose that you’re recognizing depreciation expense and repair
costs on vehicles. Those costs are in an overhead account. You plan a budgeted
rate to apply indirect costs to products. As those costs are incurred, the overhead
control account is increased (debited).
When you allocate indirect costs to a customer or product line, you reduce (credit)
the overhead account and increase (debit) the work-in-process control account.
After that, the process is the same as with the other control accounts: Costs move
from work in process to finished goods to COGS.
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IN THIS CHAPTER
»» Understanding peanut butter costing
»» Designing and implementing an
activity-based costing system
»» Using activity-based costing to
increase profits in the budgeting
process
Chapter
2
Costing by the ABCs
A
s a business owner or manager, you can always use more information
that helps you make informed decisions. Book 7, Chapter 1 introduces
two widely used costing methods: job costing and process costing. In
this chapter, you’ll dig deeper for better information on costs, pulling apart your
product or service and finding out more about the activities that create cost. The
result is an activity-based costing system.
In this chapter we’ll discuss activity-based costing (ABC), in which you incur costs
when production and sales happen. When you take an order over the phone, manufacture a product, or place a box on a delivery truck, that activity generates costs.
The activity becomes the focus to assign costs. Because you’re connecting cost to
the activity that creates the cost, your cost per product is more accurate, and so
is your pricing.
Avoiding the Slippery Slope of Peanut
Butter Costing
Despite the benefits of ABC costing, many business managers use cost smoothing,
or peanut butter costing, which spreads costs over a broad range of cost objects.
When you spread peanut butter, you smooth it over the entire slice of bread. You
CHAPTER 2 Costing by the ABCs
445
don’t pay much attention to how much cost is assigned to any particular part of
the bread. Likewise, cost smoothing spreads the cost without paying too much
attention to how much cost is assigned to any particular cost object. The trouble is
that costs aren’t assigned as accurately as they should be.
Cost allocation is the process of allocating indirect costs to products and services.
The cost allocation base is the level of activity you use to assign costs. Maybe you
use 1,000 machine hours or 200 labor hours. Also, keep in mind that direct costs
are traced to products and services, not allocated. Stroll over to Book 7, Chapter 1
for more information.
To understand the benefits of ABC, you need to see the slippery slope of peanut
butter costing. Here’s the setup: You’re a food distributor. You have five restaurant clients that order meat, fish, and poultry every day. You take orders, package
them, and deliver the food to these businesses every day. Your restaurant clients have high expectations; they expect high-quality, fresh food to be delivered
quickly so they can prepare their meals.
Your order manager handles the details of order processing. Their salary, benefits, and other costs total $5,000 per month — an indirect cost. The cost must be
charged to the restaurant clients. You can’t trace the cost of the order manager to
your service. Instead, you need to allocate it.
The following sections explain how to allocate indirect costs by using one type of
activity. You can see that using single indirect cost allocation can lead to errors in
assigning costs.
Recognizing a single indirect cost allocation
A single indirect cost allocation uses one cost pool. (Book 7, Chapter 1 defines cost
pools.) The food distribution setup uses one pool of costs: order manager costs.
With ABC, you end up dividing the costs of order management into more cost
pools, and you’re better off for it.
Everybody pretty much starts by creating a predetermined or budgeted overhead
rate (as described in Book 7, Chapter 1). When you plan at the beginning of the
year, using a single indirect cost pool, you come up with an overhead rate for the
order manager’s cost, such as the following:
Annual budgeted indirect cost rate = Cost ÷ orders = $60,000 ÷ 1,250 =
$48 per order
The order manager’s cost of $5,000 per month amounts to $60,000 per year. The
five restaurants order nearly every business day of the year. You figure that total
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BOOK 7 Making Savvy Business Decisions
orders will be 1,250 — 250 orders per year from five customers. (Isn’t it great that
in samples, all customers order exactly the same number of times?)
The single indirect cost allocation spreads the cost (order manager) uniformly
over the cost object (orders). That’s $48 dollars per order. This scenario is an
example of peanut butter costing, in which all services receive identical or similar
amounts of cost.
If some customers or activities eat up more costs than others, peanut butter costing isn’t a true reflection of the costs. A customer or activity that demands more
effort should get a larger cost allocation. So companies that use peanut butter
costing miss the chance to allocate costs more precisely. No doubt you know from
experience that some customer orders are usually smooth as glass and that other
orders, from problem customers, often require your staff to jump through extra
hoops. Suppose that you notice that your order manager is spending a lot of time
with two customers in particular. The Steak Place and Riverside Fishery are making big demands.
These customers change their orders at the last minute at least once a week. When
they make a change, the order manager has to cancel the original invoice (the
bill), make a new one, and e-mail it. Then they have to change the shippinginstructions document; you don’t want the wrong goods put on the truck and sent
to the restaurant. So the order manager cancels the original shipping instructions
and makes new instructions.
“It’s really frustrating,” the manager says. “Sometimes, they call so late that
I have to call the driver and tell him not to leave the dock. We unload the truck and
start over.” Well, no doubt you want to be known for your high level of customer
service, but this situation is getting ridiculous.
Another issue is that when the invoice and shipping orders change, the goods
coming out of inventory also change. Your pickers are taking products off the
shelf, putting them back, and then taking different products. These changes
eventually lead to mistakes in inventory. A picker may move a product in or out
and not record it in the accounting records. Here’s another point to consider: Your
business supplies meat, fish, and poultry — items that aren’t known for having
a long shelf life. The excesses of The Steak Place and Riverside Fishery may leave
you with heaps of spoiled product.
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Costing by the ABCs
Finding a fly in the peanut butter: Dealing
with different levels of client activity
You decide to take another run at allocating the office manager cost. So you change
the cost allocation from orders placed to time spent per customer. After three
months, you review the time spent per customer. Fortunately, you’ve been tracking time carefully, and you’re using an excellent spreadsheet program.
The office manager works 24 days per month, 8 hours per day. Their total monthly
hours are 192 hours (24 days × 8 hours). Table 2-1 shows the breakdown.
TABLE 2-1
Order Manager — Monthly Hours Per Customer
Restaurant Customer
Hours for Month
Percent of Total
Apple Core Diner
30
15.6
Blue Lantern
30
15.6
Meadowbrook Grill
30
15.6
Riverside Fishery
56
29.2
The Steak Place
46
24.0
Total hours
192
100.0
Aha! The situation is just as the order manager described, but now you have some
metrics. Half the costing battle is measuring reality to confirm your instincts.
With peanut butter costing, you spread the cost evenly. You assigned 20 percent of
order-manager costs to each customer. Now you see that two customers account
for more than 50 percent (!) of the order manager’s effort. The time to reallocate
the cost has arrived.
Undercosting and overcosting
If you use cost smoothing, you’re likely to incur product undercosting or product
overcosting:
»» Product undercosting occurs when a product or service uses more resources
(costs) than you assign.
»» Product overcosting occurs when a product or service uses fewer resources
(costs) than you assign.
If either of these costing errors occurs, the cost of the product isn’t accurate, and
your profit calculation is incorrect.
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Discussing product-cost cross-subsidization
Undercosting or overcosting creates product-cost cross-subsidization, meaning that
if you undercost one product, you’ll overcost another. You have a fixed amount of
cost to assign. If you’re over in one product, you’ll be under in another. That situation throws off your cost and profit calculations.
Undercosting or overcosting direct costs is relatively easy to figure out and fix.
How do you catch mistakes? You trace direct costs so you can determine the exact
cost of material used in production. Undercosting or overcosting of indirect costs
is harder to catch. Allocating indirect costs is less precise than tracing direct costs.
Allocating utility costs in a factory, for example, is a bit difficult, but you can do it.
The secret is to invest time investigating the activities that result in utility costs. If
one of the manufacturing machines runs twice as long as another, that activity is
probably consuming twice as much electricity. The higher machine activity should
result in twice as much utility expense.
As Table 2-1 earlier in this chapter shows, investigation pays off. Two customers
are chewing up more than 50 percent of the order manager’s effort by requiring
more of the manager’s time. The investigation of the activity produces metrics,
which form the basis of a better cost allocation plan. For the tools and techniques,
see “Designing an Activity-Based Costing System” later in this chapter.
Underallocating and overallocating
Underallocating or overallocating costs affect your product price and your profit.
If your product costs aren’t accurate, you can’t price your product correctly.
Suppose that you overallocate costs for retailing a men’s dress shirt. You think
that total shirt cost is $31 in direct and indirect costs, and you want a $10 profit
per shirt. Therefore, you price your shirts at $41. But that price may not be correct! If the true cost of the shirt is $30, $1 is overallocated. As a result, your profit
is $11 ($41 – $30).
Well, what’s wrong with that profit? You’d prefer to make $11 a shirt than $10. But
with that higher price, you may lose some sales. Most people have a price point — a
maximum price they’re willing to pay based on the value they perceive. Because
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Costing by the ABCs
Suppose that you have two products, A and B. (Obviously, your marketing department needs to come up with better product names.) The total cost to be allocated
is $100. You allocate $50 of costs to product A and $50 to product B. If you overcost product A by $10, you allocate $10 too much, so you undercost product B by
$10. In other words, the actual costs should be $40 for product A and $60 for
product B. You start with $100 in your bucket of costs. When you allocate too much
for product A, too little remains to allocate to product B.
the apparel industry is highly price-driven, you could be losing sales, which would
hurt your bottom line.
If a lot of customers say to themselves, “The most I’d pay for that shirt is $40,”
you may lose sales by charging $41. Although you make another dollar per shirt at
$41, your sales may decline to the point where you make less total profit.
A bigger pricing problem may occur when a product’s cost is underallocated.
Assume that you underallocate another men’s dress shirt by $5. You think that
the total cost is $50. To make a $10 profit per shirt, you set the sale price at $60, so
everything’s fine, right? Wrong! If costs are allocated correctly, the real profit is
$5 ($60 – $55). Underallocation has resulted in a sale price that’s too low, which
reduces profit.
You can’t make up this deficiency through volume sales. Usually, shirts that sell
for $60 don’t go flying off the display table.
Designing an Activity-Based
Costing System
If your ABC system is well designed, you allocate costs more precisely. This section helps you carefully separate direct costs and indirect costs. You also consider
the specific activities that drive indirect costs higher. Finally, the indirect costs are
allocated to the activities that cause those costs to be incurred.
Refining your approach
ABC is a refined costing system— a more-specific way to assign costs to cost objects.
The system avoids using big, generic categories, such as splitting a cost evenly
between divisions; instead, it allocates indirect costs to the activities that generate
those costs. The result is likely to be more-accurate costing and product pricing.
The refined costing system requires you to perform the following three tasks:
»» Direct cost tracing: Review your direct costs and categorize more costs as
direct costs, if possible.
»» Cost pools: Review cost pools and create more pools, if necessary.
»» Cost-allocation bases: Decide on cost-allocation bases by using cause-andeffect criteria.
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Direct costs are traced to cost objects. As a result, the amount of cost is fairly easy
to determine. Determining the amount of leather used to make leather handbags,
for example, is easy.
Grouping costs by using a cost hierarchy
A cost hierarchy groups costs into cost pools based on cost drivers or cost allocation
bases. A cost hierarchy has levels, which explain how broadly you look at costs and
activities. Here are levels you might use in a cost hierarchy:
»» Unit-level costs are cost activities performed on an individual unit, whether that
unit is a product or service. If you make blue jeans, your unit is one pair of
jeans. An individual tax return is a unit if you prepare tax returns for clients.
»» Batch-level costs are cost activities that generate costs at the batch level. When
an automobile plant changes from one car model to another, it’s changing
batches and incurring setup costs. The plant is retooling, which may include
moving machinery, and certainly includes changing out the dies and reprogramming the welding robots.
»» Customer-level costs are cost activities generated for one customer. If you’re
remodeling a kitchen, your labor costs, materials used, and overhead costs
incurred for a specific customer are all customer-level costs. Customer-level
costs may include multiple orders from the same client.
»» Product-sustaining costs are cost activities that support a particular product or
service line, regardless of the number of units produced. A product-sustaining
cost extends the life of a product. Technology products are good examples. To
stay relevant with customers, software companies come out with endless new
versions of software. Extending a product’s life is supposed to keep customers
buying it. Design costs can be product-sustaining costs. To keep the technology product current, you change the design. You can allocate productsustaining costs to a product or to an entire product line (sometime called a
product family in high-tech).
»» Facility-sustaining costs are cost activities that support the overall company,
such as legal and accounting activities. The rent, insurance, and maintenance
on the company’s building are facility-sustaining costs because the building is
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Costing by the ABCs
Cost pools should be homogeneous — that is, each cost has the same cost allocation base. The costs have a similar cause-and-effect relationship. Therefore,
if you have more than one allocation base, you should have more than one cost
pool. A good example is a cost pool combining vehicle depreciation, repair and
maintenance, and fuel costs. All the costs increase when your vehicles drive more
miles. The cost allocation base should be mileage, and you simply allocate a dollar
amount of indirect cost per mile driven.
essential to keeping the entire company running. The costs should be
allocated over the entire company. Companies with multiple buildings
sometimes cost allocate for each building to see whether a building is too
expensive to occupy.
If you use fine-enough granularity, you can get really precise costing. On the
other hand, too much granularity will make you crazy. The financial benefit
of precise costing — more-accurate product costs and more precise profit
calculations — should be greater than the time and expense you incur to track the
cost information.
Testing your ABC design
The following example begins by separating direct and indirect costs. You also see
descriptions of the activities that generate indirect costs. This example allocates
indirect costs and calculates the full cost of the product.
For this example, you manage a company that makes and installs automobile
windshields. You have a forward-looking product called a smart windshield, which
uses lasers, infrared sensors, and a camera to help drivers with vision problems
drive well. You sell two products: sedan windshields and van windshields. The
company wants to implement ABC for indirect costs. Ready, set, go!
Dealing with direct costs
You begin by sitting down with the production manager to get a handle on direct
costs. You produce 1,500 windshields each year (750 for sedans and 750 for vans).
You trace $300 of direct materials per windshield and $500 in direct labor per
unit. Table 2-2 shows the direct costs.
TABLE 2-2
Windshield Direct Costs
Type of Cost
Units × Cost
Total
Direct material
1,500 units × $300
$450,000 ($225,000 per type)
Direct labor
1,500 units × $500
$750,000 ($375,000 per type)
Diving into the cost pools
Next, you and the production manager list the indirect cost activities to manufacture and install windshields. Your goal is to pull apart the cost pools. In other words,
you make sure that each cost pool is based on a specific activity. The more specific
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the cost pool is, the more likely you are to be allocating costs to products correctly.
Table 2-3 shows the indirect costs of producing and installing windshields.
TABLE 2-3
Indirect Cost Activities — Windshield Production and
Installation
Description
Molding setup
Install mold in machine to create a windshield.
Machine operation
Run machine to convert material in mold to a windshield.
Quality inspection
Review product for defects.
Packaging and delivery
Pack windshield; load it into truck for delivery to client.
Installation
Install windshield at client location.
You review to see whether any of these costs are direct costs. If so, that would be
good, because it gets you out of the cost allocation business. Using a direct cost
traced to a product results in greater precision than using an indirect cost allocated
to a product.
Applying indirect costs by using a cost
allocation base
The next step is linking the indirect costs to the cost pools (the activities) by using
a cost allocation base. At the start, you agree that labor hours should be used to
allocate indirect costs for each activity except machine operation; the machine
cost is allocated based on machine hours. Table 2-4 allocates each cost pool
(activity) based on the total hours required to complete each activity. You perform
this analysis for all products.
TABLE 2-4
Cost Allocation Rates
Activity
Allocation
Base
Total Cost
Total
Hours
Allocation
Rate/Hour
Molding setup
Labor hours
$20,000
150
$133
Machine operation
Machine hours
$500,000
5,700
$88
Quality inspection
Labor hours
$100,000
1,050
$95
Packaging and delivery
Labor hours
$50,000
525
$95
Installation
Labor hours
$30,000
900
$33
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Costing by the ABCs
Activity
ALLOCATING AND CELEBRATING: ASSIGNING THE COST
ALLOCATION RATES TO THE PRODUCTS
You have the allocation rate per hour (either machine hours or labor hours). Now
you need to decide how many hours to use to apply the rate. The goal is to tie the
cost allocation to the activity as closely as possible.
Each product has a different mold. Your company changes the windshield being
produced by changing the mold. Because of the sedan windshield’s curve, more
labor hours are required to set up the sedan’s mold.
More machine hours are required to produce the van windshield, simply because
the van windshield is bigger. The van’s larger windshield also requires more time
to inspect, package, and deliver.
Installation costs are the same for both products. Table 2-5 lists the cost allocation for each product and the percentage of the total hours for each activity.
TABLE 2-5
Cost Allocation as a Percentage of Total Hours
Activity
Allocation
Rate/Hour
Sedan Cost
(Percent Hours)
Van Cost
(Percent Hours)
Molding setup
$133
$13,333 (67%)
$6,667 (33%)
Machine operation
$88
$236,842 (47%)
$263,158 (53%)
Quality inspection
$95
$42,857 (43%)
$57,143 (57%)
Packaging
and delivery
$95
$21,429 (43%)
$28,571 (57%)
Installation
$33
$15,000 (50%)
$15,000 (50%)
At long last, you review the total product costs for sedan and van windshields (see
Table 2-6).
The cost per van windshield ($1,294.05) is slightly higher than the cost per sedan
windshield. The higher cost for vans makes sense. You can use the total costs in
Table 2-4 and the percentages in Table 2-5 to assign costs. You get the same cost
allocation that’s calculated by using the rates per hour in Table 2-5. You need the
cost allocation rates to assign costs to all your production activities, which is why
the rates per hour are important.
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TABLE 2-6
Total Costs by Type — Sedan and Van Windshields
Sedan
(750 Units)
Van (750 Units)
Total
(1,500 Units)
Direct material
$225,000
$225,000
$450,000
Direct labor
$375,000
$375,000
$750,000
Molding setup
$13,333
$6,667
$20,000
Machine operation
$236,842
$263,158
$500,000
Quality inspection
$42,857
$57,143
$100,000
Packaging and delivery
$21,429
$28,571
$50,000
Installation
$15,000
$15,000
$30,000
Total costs
$929,461
$970,539
$1,900,000
Cost per windshield
$1,239.28
$1,294.05
Costing by the ABCs
Type of Costs
Take a look at indirect costs. Installation costs are evenly split, so disregard that
cost pool. Consider the other indirect costs. Other than molding setup, all the
remaining indirect cost pools have a larger allocation to the van. That’s reasonable, because the van windshield is bigger than the sedan windshield. It costs more
to run a van windshield through a machine, inspect it, and package it.
Using Activity-Based Costing to Compute
Total Cost, Profit, and Sale Price
The only constant is change. Demand for your product is probably always changing. Material costs may increase (and rarely go down). Increased competition
may force you to lower your prices to prevent sales from slipping. Luckily for
you, ABC is a tool for managing indirect cost allocations effectively as conditions
change. The following example shows how to use cost allocation to compute total
cost, profit, and a sale price. You operate a lawn-care business that provides two
services: flower-bed planting and care, and lawn planting and care. You plan and
price your work based on a 25-square-foot area. One unit for your business is
25 square feet, whether it’s a lawn or flower bed. You refer to one unit as one
customer yard. Table 2-7 shows a summary of the cost objects for the business.
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455
TABLE 2-7
Flower-Bed and Lawn-Care Costs
Type of Costs
Flower Bed
Lawn Care
Direct materials
Mulch and fertilizer
Sod, grass seed, and fertilizer
Direct labor
Clear area, plant, or
install material
Clear area, plant, or
install material
Estimator cost
(indirect cost)
Flower-bed inspection
and analysis
Lawn inspection and analysis
Transportation cost
(indirect cost)
Depreciation, insurance
for vehicles, and mileage
Depreciation, insurance for
vehicles, and mileage
Office cost (indirect cost)
Costs for dispatcher/
accountant
Costs for dispatcher/
accountant
In planning, you determine that your business will service 500 units in the
upcoming year. Assume that the sales will be evenly split between the two services (250 yards each).
Allocating indirect costs evenly by product
Initially, you allocate indirect costs by splitting the indirect costs between the
product types. Table 2-8 shows an even allocation of indirect costs. The direct
costs are traced to each service you provide: flower-bed work or lawn care.
TABLE 2-8
456
Costs and Profit by Product — Flower Bed and Lawn Care
Cost (250 Units of Each Product)
Flower Bed
Lawn Care
Total
Direct material
$25,000
$30,000
$55,000
Direct labor
$37,500
$25,000
$62,500
Estimator cost (indirect cost)
$15,000
$15,000
$30,000
Transportation cost (indirect cost)
$7,500
$7,500
$15,000
Office cost (indirect cost)
$12,500
$12,500
$25,000
Total costs
$97,500
$90,000
$187,500
Add: Profit (10 percent of cost)
$9,750
$9,000
$18,750
Total sales
$107,250
$99,000
$206,250
Cost per unit (yard)
$390
$360
Sale price per unit
$429
$396
BOOK 7 Making Savvy Business Decisions
Estimator cost, transportation cost, and office cost are evenly split. Now think
about profit as a percentage of total costs. In Table 2-8, the flower-bed profit calculation is $9,750, or 10 percent of costs ($97,500 × 0.10). To compute your sale
price for flower beds, add the total cost to profit. That’s $107,250. Finally, divide
both the total cost and total sales by 250 yards. That provides a cost per unit of
$390 and sale price per unit of $429 for flower beds.
Analyzing and reallocating cost activities
The estimator’s job is to discuss each project with the client. They assess the
current condition of the yard and the labor and materials needed for the project.
Finally, they supervise the work to completion. You ask your estimator to track the
amount of time they spend on each type of product. The process is simple: They’ll
post their time in a flower-bed column or a lawn-care column in a spreadsheet.
After a few months, you find that the estimator spends 70 percent of their time
on flower-bed projects. They explain to you that flower-beds take more time to
discuss with the client. Based on this discussion, you realize you should assign
70 percent of the estimator’s cost to the flower-bed product.
At the same time, the estimator tracks mileage on the trucks and vehicles. The
maps illustrate that most of the flower-bed work is in the wealthier area of town,
which is farther from your office than most of the lawn work. The mileage log
indicates that 60 percent of the drive time and mileage is spent on flower-bed
work. Okay, that’s more progress! You probably should allocate 60 percent of the
transportation costs (vehicle depreciation, insurance, and fuel) to the flower-bed
product.
Your last stop is your office assistant’s desk. They tell you, “You know we get a lot
of cancellations and rescheduled work for lawn care. I think because the work isn’t
complicated, and we have a lot of competitors, people don’t take it as seriously.
They change and cancel without much thought.”
Well, a cancellation or rescheduling fee would reduce the problem, but that’s a
cost story for another day. For now, just consider the activities that generate office
costs. The office assistant’s cost (salary, office supplies, and computer) can be
allocated based on their time. When a customer cancels or reschedules, the office
assistant spends time on the phone with customers, the estimator, and employees.
In addition, the paperwork for the project has to be changed. After more analysis,
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A key point of ABC is basing each cost pool on a specific activity, which puts you
on the road to more accurate costing of your product. To find out more, ask your
staff in detail about their activities.
the two of you decide that 60 percent of the office-assistant cost should be allocated to lawn care.
Changing allocations to cost pools
You investigate indirect costs and make some changes. Table 2-9 shows the cost
allocation changes in the three indirect cost pools. The direct costs don’t change
because they’re traced directly, not allocated. Total costs are still $187,500. That
makes sense, because ABC changes cost allocations, not cost totals. Costs change
by product but not in total for the company. Sales are still $206,250.
TABLE 2-9
Activity-Based Costing by Product — Flower Bed
and Lawn Care
Cost (250 Units of Each Product)
Flower Bed
Lawn Care
Total
Direct material
$25,000
$30,000
$55,000
Direct labor
$37,500
$25,000
$62,500
Estimator cost (indirect cost)
$21,000
$9,000
$30,000
Transportation cost (indirect cost)
$9,000
$6,000
$15,000
Office cost (indirect cost)
$10,000
$15,000
$25,000
Total costs
$102,500
$85,000
$187,500
Profit (total sales less total costs)
$4,750
$14,000
$18,750
Total sales
$107,250
$99,000
$206,250
Cost per unit (yard)
$410
$340
Sale price per unit
$429
$396
Because the per unit sale prices stay the same, the profit calculations change.
Profit for flower beds is now $4,750 ($107,250 – $102,500). Profit for lawn care is
now $14,000 ($99,000 – $85,000).
In Table 2-9, the flower-bed total cost increases by $5,000 (from $97,500 to
$102,500). As a result, profit for flower beds declines by $5,000 (from $9,750 to
$4,750). ABC has the opposite effect on the lawn-care business. Lawn-care costs
go down by $5,000 (from $90,000 to $85,000). Profit increases by $5,000 (from
$9,000 to $14,000).
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BOOK 7 Making Savvy Business Decisions
Changing prices after ABC
You overcosted lawn care and undercosted flower beds. When you reallocate the
costs from lawn care to flower beds, the change throws off your profit calculation!
You want a profit of 10 percent for each product, but flower beds are producing a
profit of only 4.6 percent ($4,750 profit ÷ $102,500 in sales). The lawn-care product produces a profit of 16.5 percent ($14,000 ÷ $85,000).
Here’s the problem: 4.6 percent may be too small a profit margin. You’re spinning
your wheels for a bunch of petunias. Calculate the new sale price for flower beds,
based on the ABC and a 10 percent profit, as shown in Table 2-10.
Costing by the ABCs
TABLE 2-10
Calculating a New Sale Price for Flower Beds
Cost (250 Units of Each Product)
Flower Beds
Total costs in Table 2-9
$102,500
Profit (10 percent of total cost)
$10,250
Total sales
$112,750
Cost per unit (yard)
$410
Sale price per unit
$451
The original price per unit for flower beds was $429. The new flower-bed unit
price is $451, which is $22 higher than before ($451 to $429). To make a 10 percent
profit, change the flower-bed sale price to $451 per unit.
At the old price, you weren’t making your desired profit. Now you will. And that’s
the value of using ABC. You could make up for the lower profit on flower beds by
earning more on lawn care. But really, you should assess each product on its own
and price each one to produce the correct profit.
CHAPTER 2 Costing by the ABCs
459
IN THIS CHAPTER
»» Figuring contribution margin
»» Meeting income goals with costvolume-profit analysis
»» Analyzing your break-even point,
target profit, and margin of safety
»» Exploring operating leverage
Chapter
3
Contributing to the
Margin
W
hen you have to make a business decision about what to sell, how much
of it to sell, or how much to charge, you first need to understand how
your decision is likely to affect net income — your profit. Suppose that
you sell one refrigerator for $999.95. How does that sale affect your net income?
Now suppose that you sell 1,000 units of the same make and model at this price.
How does that sales volume affect net income? Contribution margin simplifies
these decisions.
In this chapter, you find out how to calculate contribution margin and how to
apply it to different business decisions, using both graphs and formulas. You
also find out how to prepare something called a cost-volume-profit analysis, which
explains how the number of products sold affects profits. And you discover how
to prepare a break-even analysis, which indicates exactly how many products you
must sell to break even and start earning a profit.
This chapter shows you how to estimate the number of units you need to sell
to meet your target profit (a goal for net income this period). It also explains
how to measure something called margin of safety, or how many sales you can
afford to lose before your profitability drops to zero. Finally, the chapter explains
and demonstrates operating leverage, which measures a company’s riskiness.
CHAPTER 3 Contributing to the Margin
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Computing Contribution Margin
Contribution margin measures how sales affects net income or profits. To compute
contribution margin, subtract variable costs of a sale from the amount of the sale
itself:
Contribution margin = Sales – Variable costs.
If you sell a gadget for $10, and its variable cost is $6, the contribution margin
for the sale is $10 – $6 = $4. Selling this gadget increases your profit by $4 before
fixed costs. Your contribution margin less fixed costs equals your profit.
When you’re computing the contribution margin, subtract all variable costs,
including variable manufacturing costs and variable selling, general, and administrative costs. Don’t subtract any fixed costs. You compute gross profit by subtracting cost of goods sold from sales. Because cost of goods sold usually includes
a mix of fixed and variable costs, gross profit doesn’t equal contribution margin.
You can calculate contribution margin in three forms, as discussed in the following sections: in total, per unit, or as a ratio.
Contribution margin, in any of its forms, explains how different factors in the
company — sales price, sales volume, variable costs, and fixed costs — interact.
This understanding helps you make better decisions when planning sales and costs.
Figuring total contribution margin
Total contribution margin measures the amount of contribution margin earned by
the company as a whole. You calculate it by using this formula:
Total contribution margin = Total sales – Total variable costs
To determine overall profitability, subtract total fixed costs from total contribution margin. Net income equals the excess of contribution margin over fixed costs.
You can use total contribution margin to create something called a contribution
margin income statement. This document differs from a multistep income statement (shown in Figure 3-1), in which you first subtract cost of goods sold from
sales and then subtract selling, general, and administrative costs.
A contribution margin income statement first subtracts the variable costs and
then subtracts fixed costs, as shown in Figure 3-2. Here, variable costs include
variable costs of both manufacturing and selling. Likewise, fixed costs include
more manufacturing and selling costs.
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BOOK 7 Making Savvy Business Decisions
Contributing to
the Margin
FIGURE 3-1:
Multistep income
statement.
© John Wiley & Sons, Inc.
The contribution margin income statement makes understanding cost behavior
and the way sales will affect profitability easier. In Figure 3-2, the company earns
$1,000 in sales, $400 of which goes toward variable costs. This scenario results in
$600 of contribution margin.
These amounts — sales, variable costs, and contribution margin — change in
proportion to one another. If sales increase by 10 percent, variable costs and
CHAPTER 3 Contributing to the Margin
463
contribution margin also increase by 10 percent; $1,100 in sales increases variable costs to $440 and contribution margin to $660. On the other hand, fixed
costs always remain the same: The $300 in fixed costs is $300 regardless of any
increase or decrease in sales and contribution margin.
FIGURE 3-2:
Contribution
margin income
statement.
© John Wiley & Sons, Inc.
The contribution margin income statement presents the same net income figure
as a traditional income statement. This statement, however, isn’t in accordance
with generally accepted accounting principles (GAAP). Managers can use a contribution margin income statement internally to better understand their own
companies’ operations.
Calculating contribution margin per unit
Contribution margin per unit measures how the sale of one additional unit affects
net income. You calculate it by subtracting variable costs per unit from sales price
per unit, as in this formula:
Contribution margin per unit = Sales price per unit – Variable costs per unit
Suppose that a company sells a single gadget for $100, and the variable cost
of making the gadget is $40. Contribution margin per unit on this gadget
equals $100 – $40 = $60. Therefore, selling the gadget increases net income by
$60, assuming no change in fixed costs.
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BOOK 7 Making Savvy Business Decisions
Increasing the sales price doesn’t affect variable costs, because the number of
units manufactured — not the sales price — is what usually drives variable manufacturing costs. Therefore, if the gadget company raises its sales price to $105,
the variable cost of making the gadget remains $40, and the contribution per
unit increases to $105 – $40 = $65 per unit. The $5 increase in sales price goes
straight to the bottom line as net income. Again, this example assumes that fixed
costs don’t change.
Working out contribution margin ratio
Contribution margin ratio measures the percentage of each sales dollar that represents net income. To calculate it, divide contribution margin by sales, either in
total or per unit:
Contribution margin ratio = Total contribution margin ÷ Total sales
or
Contribution margin ratio = Contribution margin per unit ÷ Sales price per unit
Contribution margin ratio = $40 ÷ $100 = 0.40 or 40%
To find out how sales affect net income, multiply the contribution margin ratio by
the amount of sales. In this example, $1,000 in gadget sales increases net income
by $1,000 × 0.40 = $400 (before fixed costs).
Preparing a Cost-Volume-Profit Analysis
Contribution margin indicates how sales affects profitability. When running a
business, a decision-maker needs to consider how four factors affect net income:
»» Sales price
»» Sales volume
»» Variable cost
»» Fixed cost
CHAPTER 3 Contributing to the Margin
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Contributing to
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Suppose that a gadget selling for $100 per unit brings in $40 per unit of contribution margin. Its contribution margin ratio is 40 percent:
Cost-volume-profit analysis helps you understand different ways to meet your
net income goals. The following sections explain cost-volume-profit analysis
by using graphical and formula techniques. These sections pay special attention
to computing net income based on different measures of contribution margin:
total contribution margin, contribution margin per unit, and contribution margin
ratio.
The graphs are helpful for visualizing the relationship among cost, volume, and
profit. When you’re solving real-life problems, however, you’ll find that plugging
numbers into formulas is much quicker and easier than creating graphs.
Drafting a cost-volume-profit graph
Figure 3-3 visually describes the relationship among cost, volume, and profit for
a company called Pemulis Basketballs which sells its basketballs for $15 apiece.
The variable cost of the basketballs is $6. Pemulis has total fixed costs of
$300 per year.
FIGURE 3-3:
Cost-volumeprofit graph.
© John Wiley & Sons, Inc.
In this figure, the fixed costs of $300 are represented by a horizontal line because
regardless of the sales volume, fixed costs stay the same. Total variable costs are
a diagonal line, starting at the origin (the point in the bottom-left corner of the
graph where sales are zero). Total costs (the sum of total variable costs and total
466
BOOK 7 Making Savvy Business Decisions
fixed costs) are a diagonal line starting at the $300 mark because when the company makes and sells zero units, total costs equal the fixed costs of $300. Total
costs increase with volume. Finally, total sales forms a diagonal line starting at
the origin and increasing with sales volume. When the sales curve exceeds total
costs, the company earns net income. If total sales are too low to exceed total
costs, however, the company incurs a net loss. The higher the sales volume is—
that is, the more sales volume moves to the right of the graph — the higher the
company’s net income.
Dropping numbers into the chart shows exactly how much income can be earned
at different sales levels. Assuming that Pemulis has a sale price of $15 per unit, a
variable cost per unit of $6, and total fixed costs of $300, what happens if Pemulis
sells 60 basketballs? Total sales come to 60 units × $15 = $900. Total variable costs
rise to 60 units × $6 = $360. Add these total variable costs to total fixed costs of
$300 to get total costs of $660.
Trying out the total contribution
margin formula
Net income = Total contribution margin – Fixed costs
Assume that Pemulis Basketballs sells 60 units at $15 each for total sales of $900.
(Refer to “Drafting a cost-volume-profit graph” earlier in this chapter for the
origins of this example.) The variable cost of each unit is $6 (so total variable costs
come to $6 × 60 = $360), and total fixed costs are $300. Using the contribution
margin approach, you can find the net income in two easy steps:
1.
Calculate total contribution margin.
Use the formula provided in the section titled “Figuring total contribution
margin” to compute total contribution margin, subtracting total variable costs
from total sales:
Total contribution margin = Total sales – Total variable costs = (60 × $15) –
(60 × $6) = $900 – $360 = $540
This total contribution margin figure indicates that selling 60 units increases
net income by $540 (before fixed costs).
CHAPTER 3 Contributing to the Margin
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Contributing to
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The following formula, based on total contribution margin, follows the same
structure as the contribution margin income statement. (Refer to “Figuring total
contribution margin” earlier in this chapter for details on total contribution margin and its related income statement.)
2.
To calculate net income, subtract the fixed costs from the total contribution margin.
Just plug in the numbers from Step 1:
Net income = Total contribution margin – Fixed costs = $540 – $300 = $240
Subtracting fixed costs of $300 from total contribution margin of $540 gives
you net income of $240.
Practicing the contribution margin
per unit formula
If you know the contribution margin per unit (see “Calculating contribution
margin per unit” earlier in this chapter), the following approach lets you use that
information to compute net income. Here’s the basic formula equating net income
with contribution margin per unit:
Net income = (Sales volume × Contribution margin per unit) – Fixed costs
Suppose that Pemulis Basketballs wants to use this formula. It can simply plug in
the numbers — 60 units sold for $15 each, variable cost of $6 per unit, fixed costs
of $300 — and solve. First, compute the contribution margin per unit:
Contribution margin per unit = Sales price per unit – Variable costs per unit =
$15 – $6 = $9
Next, plug contribution margin per unit into the net income formula to figure out
net income:
Net income = (Sales volume × Contribution margin per unit) – Fixed costs =
(60 × $9) – $300 = $540 – $300 = $240
Eyeing the contribution margin
ratio formula
If you want to estimate net income but don’t know the total contribution margin
and can’t find out the contribution margin per unit, you can use the contribution
margin ratio to compute net income.
As noted in the earlier section “Working out contribution margin ratio,” you can
compute contribution margin ratio by dividing total contribution margin by total
sales. So if your contribution margin is $540, and your sales re $900, your contribution margin ratio is 60 percent:
468
BOOK 7 Making Savvy Business Decisions
Contribution margin ratio = Total contribution margin ÷ Total sales = Contribution
margin per unit ÷ Sales price per unit = $540 ÷ $900 = 0.60 = 60%
This result means that 60 cents of every sales dollar increases net income (after
fixed costs). When you know the contribution margin ratio, you’re ready for the
net income formula:
Net income = (Sales volume in units × Contribution margin per unit) – Fixed costs
To calculate net income, plug the contribution margin ratio of 60 percent into the
formula:
Net income = (Total sales × Contribution margin ratio) – Fixed costs = ($900 × 0.60) –
$300 = $540 – $300 = $240
Generating a Break-Even Analysis
Plotting the break-even point
In a cost-volume-profit graph, the break-even point is the sales volume where
the total sales line intersects the total costs line. This sales volume is the point at
which total sales equals total costs.
Suppose that, as in the basketball example earlier in the chapter, a company sells
its products for $15 each, with variable costs of $6 per unit and total fixed costs
of $300. The graph in Figure 3-4 indicates that the company’s break-even point
occurs when the company sells 34 units.
For many products (such as basketballs), you can sell only whole units. Therefore, if you sell whole units, the break-even point must always be a whole number. If break-even analysis results in some fractional volume of sales (such as
33.33333 units), always round up (in this case, to 34 units), even if the fraction
is closer to the lower whole number than the higher number. If your break-even
point equals 33.0001, round it up to 34. If you round down (to 33 units), the actual
sales volume is below the break-even point, and at this volume level, your company reports a net loss.
CHAPTER 3 Contributing to the Margin
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Contributing to
the Margin
How much do you need to sell to break even? The break-even point is the amount
of sales needed to earn zero profit — enough sales to avoid a loss but insufficient
sales to earn a profit. This section shows you a couple of ways — graphs and
formulas — to locate your break-even point.
FIGURE 3-4:
Plotting the
break-even point.
© John Wiley & Sons, Inc.
Using the formula approach
When you need to solve actual problems, drawing graphs isn’t always practical.
For a quicker approach, you want to rely on the three formulas that use contribution margin to measure net income. (See “Preparing a Cost-Volume-Profit
Analysis” earlier in the chapter.)
The break-even point (abbreviated BE for the purpose of formulas in this book)
is where net income is zero, so just set net income equal to zero, plug whatever
given information you have into one of the equations, and then solve for sales
or sales volume. Better yet: At the break-even point, total contribution margin
equals fixed costs.
Suppose that a company has $30,000 in fixed costs. How much total contribution
margin does it have to generate to break even?
Net income = Total contribution margin – Fixed costs
0 = Total contribution marginBE – Fixed costs
0 = Total contribution marginBE – $30,000
$30,000 = Total contribution marginBE
Here, too, at the break-even point, total contribution margin equals fixed costs of
$30,000. Now suppose that a company has contribution margin per unit of $6 and
fixed costs of $600. What’s the break-even point in units?
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BOOK 7 Making Savvy Business Decisions
Net income = (Sales volume × Contribution margin per unit) – Fixed costs
0 = (Sales volumeBE × Contribution margin per unit) – Fixed costs
0 = (Sales volumeBE × $6) – $600
$600 = Sales volumeBE × $6
$600 ÷ $6 = 100 units
Another company has a contribution margin ratio of 40 percent and fixed costs of
$1,000. Sales price is $1 per unit. What’s the break-even point in dollars?
Net income = (Sales × Contribution margin ratio) – Fixed costs
0 = (SalesBE × Contribution margin ratio) – Fixed costs
0 = (SalesBE × 0.40) – $1,000
$1,000 = SalesBE × 0.40
$1,000 ÷ 0.40 = SalesBE
$2,500 = SalesBE
Shooting for Target Profit
If you’ve set a specific goal for net income, contribution margin analysis can help
you figure out the needed sales. This goal for net income is called target profit.
To compute target profit, adapt one of the three net income formulas. Then plug
target profit into one of these formulas as net income. suppose that a company is
pushing to earn $20,000 in profit and has to pay $10,000 in fixed costs. How much
total contribution margin does the company need to generate to make its target
profit of $20,000?
Net income = Total contribution margin – Fixed costs
$20,000 = Total contribution margin – $10,000
$30,000 = Total contribution marginE
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You can express break-even point in units or dollars. If your formula gives you
units, and you want dollars, multiply the number of units by the sale price. If your
formula gives you dollars and you want units, just divide by the sale price.
Total contribution margin of $30,000 will result in $20,000 worth of net income.
Now suppose that a company has set its target profit for $2,000, earns contribution margin per unit of $5, and incurs fixed costs of $500. How many units must
the company sell?
Net income = (Sales volume × Contribution margin per unit) – Fixed costs
$2,000 = (Sales volumeE × Contribution margin per unit) – Fixed costs
$2,000 = (Sales volumeE × $5) – $500
$2,500 = Sales volumeE × $5
$2,500 ÷ $5 = Sales volumeE
500 units = Sales volumeE
If the company wants to earn $2,000 in profit, it needs to sell 500 units. Consider
another company with a contribution margin ratio of 40 percent and fixed costs of
$1,000. The company is looking to earn $600 in net income. How much does that
company need in sales?
Net income = (Sales × Contribution margin ratio) – Fixed costs
$600 = (SalesE × Contribution margin ratio) – Fixed costs
$600 = (SalesE × 0.40) – $1,000
$1,600 = SalesE × 0.40
$1,600 ÷ 0.40 = SalesE
$4,000 = SalesE
Don’t confuse dollars with units. The formula that uses contribution margin per
unit gives you sales in units. But the formula that uses contribution margin ratio
gives you sales in dollars. To translate between these units, just multiply or divide
by the sale price. Also, be sure to label the numbers in your analysis so that you
don’t confuse terms. Use a dollar sign for dollars and the word units when dealing
with units, for example.
Setting a Margin of Safety
Margin of safety is the difference between your actual or expected profitability
and the break-even point. It measures how much breathing room you have —
how much you can afford to lose in sales before your net income drops to zero.
When you’re budgeting, compute the margin of safety as the difference between
472
BOOK 7 Making Savvy Business Decisions
budgeted sales and the break-even point. Doing so will help you understand the
likelihood of incurring a loss. Turn to Book 6, chapters 4 and 5 for more information about budgeting.
Using a graph to depict margin of safety
Figure 3-5 shows you how to visualize margin of safety with a graph. In this
example, margin of safety is the difference between current or projected sales
volume of 60 units and break-even sales volume of 34 units, which is 26 units.
Sales would have to drop by 26 units for existing net income of $240 to dry up.
Contributing to
the Margin
FIGURE 3-5:
Graphing margin
of safety.
© John Wiley & Sons, Inc.
Calculating the margin of safety
To compute margin of safety directly, without drawing pictures, first calculate
the break-even point and then subtract it from observed (O) or expected sales.
You can use dollars or units:
Margin of safety (in dollars) = SalesO – SalesBE
Margin of safety (in units) = Unit salesO – Unit salesBE
For guidance on finding the break-even point, check out the earlier section
“Generating a Break-Even Analysis.”
CHAPTER 3 Contributing to the Margin
473
You can compute margin of safety in sales dollars or in units but be consistent.
Don’t subtract break-even sales in units from actual sales in dollars!
Measuring Operating Leverage
Operating leverage measures how changes in sales can affect net income. For a
company with high operating leverage, a relatively small increase in sales can have
a fairly significant impact on net income. Likewise, a relatively small decrease in
sales for that same company will have a devastating effect on earnings.
Operating leverage is typically driven by a company’s blend of fixed and variable
costs. The larger the proportion of fixed costs to variable costs, the greater the
operating leverage. Airlines, for example, are notorious for their high fixed costs.
Their highest costs are typically depreciation, jet fuel, and labor — all costs that
are fixed with respect to the number of passengers on each flight. Their most significant variable cost is probably just the cost of the airline food — which, judging
from some recent flights, couldn’t possibly be very much. Therefore, airlines have
ridiculously high operating leverage and unspeakably low variable costs. A small
drop in the number of passenger-miles can have a dreadful effect on an airline’s
profitability.
Graphing operating leverage
In a cost-volume-profit graph (refer to Figure 3-3 earlier in the chapter), operating leverage corresponds to the slope of the total-costs line. The more horizontal
the slope of this line, the greater the operating leverage. Figure 3-6 compares the
operating leverage for two entities: Safe Co., which has lower operating leverage,
and Risky Co., which has higher operating leverage.
In this example, Risky Co. has higher fixed costs and lower variable costs per unit
than Safe Co. Therefore, Risky’s total cost line is more horizontal than Safe’s total
cost line. Accordingly, Risky has the potential to earn much higher income on the
same sales volume as Safe. Because its fixed costs are so high, Risky also has the
potential to incur greater losses than Safe.
Looking at the operating leverage formula
The formula for operating leverage is
Operating leverage = Total contribution margin ÷ Net income
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BOOK 7 Making Savvy Business Decisions
FIGURE 3-6:
How operating
leverage
increases risk.
© John Wiley & Sons, Inc.
Operating leverage = Total contribution margin ÷ Net income
Operating leveragea = $150 ÷ $100 = 1.5
Operating leverageb= $300 ÷ $100 = 3.0
According to these measures, Risky Co. has twice the operating leverage of
Safe Co. Although a 10 percent increase in sales boosts Safe Co.’s net income
by 15 percent, a similar 10 percent increase in sales for Risky Co. increases that
company’s net income by 30 percent!
That said, high operating leverage can work against you. For Safe Co., a 10 percent
decrease in sales cuts income by 15 percent; for Risky, a 10 percent decrease in
sales reduces net income by 30 percent.
Because automation replaces labor with machines, it usually replaces the variable
costs (from direct labor) with fixed overhead (associated with running equipment).
As a result, automation tends to increase operating leverage. Outsourcing usually
has the opposite effect, however. Companies that close factories and pay other
companies to make goods for them replace fixed costs (needed to run factories)
with variable costs (used to pay other companies to make the goods).
CHAPTER 3 Contributing to the Margin
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Contributing to
the Margin
Suppose that Safe Co. and Risky Co. each earn sales of $400 on 50 units. Assume
that on these sales, Safe Co. has $150 in contribution margin, and Risky has
$300 in contribution margin. Safe Co. has fixed costs of $50, and Risky Co. has
fixed costs of $200. Safe’s net income comes to $100 ($150 – $50). At this volume
level, Risky’s net income also works out to be $100. Here’s the math:
IN THIS CHAPTER
»» Understanding and setting standard
costs
»» Using formulas and shortcuts to
compute variances
»» Identifying variances that require
further investigation
Chapter
4
Accounting for Change
with Variance Analysis
T
he only certainty is that the future is uncertain. No matter how much
experience a person has, or how much information about past trends and
current factors is available, at best we are making educated guesses. Being
able to measure how confident we are in our estimates and identify the reasons that reality varied from expectations are a vital tool for financial planning
and control.
Variance analysis plays a similar role for business. When things go wrong, or even
when they go more right than expected, variance analysis explains why. What
caused higher-than-expected profits? What about unexpected losses? You can use
all this information to improve future operations.
In this chapter we’ll set up the basics of what makes things so variable and
uncertain. We’ll also discuss the foundations of how we can use accounting
formulas to help businesses plan for an uncertain world.
CHAPTER 4 Accounting for Change with Variance Analysis
477
Setting Up Standard Costs
You can’t measure variances without first setting standard costs or standards —
predetermined unit costs of materials, labor, and overhead. Standards are really
the building blocks of budgets; budgets predict total costs (as explained in Book 6,
chapters 4 and 5), but standards predict the cost of each unit of direct materials,
direct labor, and overhead. Standard costs provide a number of important benefits
for managers. For example, they
»» Help managers budget for the future
»» Help employees focus on keeping costs down
»» Help set sales prices
»» Give managers a benchmark for measuring variances and identifying related
problems
»» Simplify collecting and managing the cost of inventory
»» Provide useful information for variance analysis (as explained in this chapter)
Implementing standards often forces managers to face a critical dilemma: Should
standards be aspirational or realistic?
»» Ideal or aspirational standards can encourage employees to work hard to
achieve rigorous goals. However, overly aggressive standards can unduly
pressure employees, causing them to report false information or to just give
up on the standards out of frustration, deeming them unattainable.
»» Realistic standards provide more accurate cost information and are less
likely to lead to the kind of unfavorable variances that result in lower-thanexpected income. However, realistic standards don’t always encourage
employees to “go the extra mile” to improve cost control and productivity.
Therefore, the first step in variance analysis is to set up expectations: your standards. These standards must include both the cost and the quantity needed of
direct materials and direct labor, as well as the amount of overhead required.
After you establish standards, you can use them to compute variances. Whenever
actual performance strays from expectations, variances help you identify the reasons why.
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BOOK 7 Making Savvy Business Decisions
Establishing direct materials standards
Direct materials are raw materials traceable to the manufactured product, such as
the amount of flour used to make a cake. To compute the direct materials standard price (SP), consider all the costs that go into a single unit of direct materials.
Because several different kinds of direct materials are often necessary for any
given product, you need to establish separate direct materials standard prices and
quantities for every kind of direct materials needed.
Suppose that the Band Book Company usually pays $10 per pound for paper.
It typically pays $0.25 per pound for freight and another $0.10 per pound for
receiving and handling. Therefore, as shown in Figure 4-1, total cost per pound
equals $10.35.
FIGURE 4-1:
Adding up
direct materials
standard
price (SP).
©John Wiley & Sons, Inc.
Another standard to consider is the direct materials standard quantity (SQ) per unit.
This number is the amount of direct materials needed to make a single unit of
finished product. It includes not only the direct materials actually used, but also
any direct materials likely to get scrapped or spoiled in the production process.
FIGURE 4-2:
Computing
direct materials
standard quantity
(SQ) per unit.
©John Wiley & Sons, Inc.
CHAPTER 4 Accounting for Change with Variance Analysis
479
Accounting for Change
with Variance Analysis
Variance costing involves juggling many different figures and terms. To simplify
matters, use abbreviations such as SP (for direct materials standard price) and SQ
(for direct materials standard quantity). Doing so makes remembering how to calculate variances easier later in this chapter. For example, assume that Band Book
Company needs 25 pounds of paper to make a case of books. For every case, three
pounds of paper are deemed unusable because of waste and spoilage. Therefore,
the direct materials standard quantity per unit equals 28 pounds, as shown in
Figure 4-2.
Determining direct labor standards
Direct labor is the cost of paying your employees to make products. Proper planning requires setting standards with respect to two factors: the direct labor standard rate and the direct labor standard hours per unit.
To compute the direct labor standard rate or SR (the cost of direct labor), consider
all the costs required for a single hour of direct labor. For example, suppose Band
Book usually pays employees $9 per hour. Furthermore, it pays an additional
$1 per hour for payroll taxes and, on average, $2 per hour for fringe benefits.
As shown in Figure 4-3, the direct labor standard rate equals $12 per hour.
FIGURE 4-3:
Computing
the direct
labor standard
rate (SR).
©John Wiley & Sons, Inc.
You also need to estimate the amount of direct labor time needed to make a single
unit, the direct labor standard hours (SH) per unit. This measurement estimates how
long employees take, on average, to produce a single unit. Include in this rate the
time needed for employee breaks, cleanups, and setups.
For example, employees at Band Book Company need three hours to produce a
single case of books, plus an average of 30 minutes of setup time and 30 minutes
of break time. Therefore, the direct materials standard quantity equals four hours,
as shown in Figure 4-4.
FIGURE 4-4:
Computing direct
labor standard
hours (SH).
©John Wiley & Sons, Inc.
Calculating the overhead rate
Standard costs also need to account for overhead (the miscellaneous costs of running a business) in addition to direct materials and direct labor. Overhead is much
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more difficult to measure than direct materials or direct labor standards because
overhead consists of indirect materials, indirect labor, and other costs not easily
traced to units produced. Therefore, measuring how much overhead should be
applied to different units produced is very challenging. To assign overhead costs
to individual units, you need to compute an overhead allocation rate.
Remember that overhead allocation entails three steps:
1.
Add up total overhead.
Add up estimated indirect materials, indirect labor, and all other product costs
not included in direct materials and direct labor. This amount includes both
fixed and variable overhead.
For example, assume that total overhead for Band Book Company is estimated
to cost $100,000.
2.
Compute the overhead allocation rate.
The allocation rate calculation requires an activity level. You choose an activity
that closely relates to the cost incurred. The most common activity levels used
are direct labor hours or machine hours. Divide total overhead (calculated in
Step 1) by the number of direct labor hours.
Assume that Band Book plans to use 4,000 direct labor hours:
Overhead allocation rate = Total overhead ÷ Total direct labor hours =
$100,000 ÷ 4,000 hours = $25.00
Therefore, for every hour of direct labor needed to make books, Band Book
applies $25 worth of overhead to the product.
3.
Apply overhead.
Multiply the overhead allocation rate by the number of direct labor hours
needed to make each product.
Adding up standard cost per unit
To find the standard cost, you first compute the cost of direct materials, direct
labor, and overhead per unit, as explained in the previous sections. Then you add
up these amounts.
Figure 4-5 applies this approach to Band Book Company. To calculate the standard cost of direct materials, multiply the direct materials standard price of $10.35
by the direct materials standard quantity of 28 pounds per unit. The result is a
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Suppose a department at Band Book actually worked 20 hours on a product.
Apply 20 hours × $25 = $500 worth of overhead to this product.
direct materials standard cost of $289.80 per case. To compute direct labor standard cost per unit, multiply the direct labor standard rate of $12 per unit by the
direct labor standard hours per unit of 4 hours. The standard cost per unit is
$48 for direct labor. Now multiply the overhead allocation rate of $10 per hour by
the direct labor standard hours of 4 hours per unit to come to a standard cost of
overhead per unit of $40.
FIGURE 4-5:
Summing up
standard cost
per unit.
©John Wiley & Sons, Inc.
Add together direct materials, direct labor, and overhead to arrive at the standard
cost per unit of $289.80 + $48 + $40 = $377.80. Making a single case of books costs
Band Book $377.80.
Understanding Variances
A variance is the difference between the actual cost and the standard cost that you
expected to pay. (Standard costs are covered earlier in this chapter.) When actual
cost exceeds the standard, then the resulting variance is considered unfavorable
because it reduces net income. On the other hand, when actual costs come in
under standard costs, then the resulting variance is considered favorable because
it increases net income.
Variances can arise from direct materials, direct labor, and overhead. In fact, the
variances arising from each of these three areas, when added together, should
equal the total variance:
Total variance = Direct materials variance + Direct labor variance + Overhead
variance
In turn, you can further break down direct materials and direct labor variances
into additional price and quantity variances to understand how changes in materials prices, materials quantities used, direct labor rates, and direct labor hours
affect overall profitability.
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Generally, you incur a variance for one of two reasons: Either you used more or
less than you planned (a quantity variance), or you paid more or less than you
planned (a price or rate variance).
Computing direct materials variances
A direct materials variance results from one of two conditions: differences in the
prices paid for materials or discrepancies in the quantities used in production.
To find these variances, you can use formulas or a simple diagram approach.
Using formulas to calculate direct
materials variances
The total direct materials variance is composed of two components: the direct
materials price variance and the direct materials quantity variance.
To compute the direct materials price variance, take the difference between the
standard price (SP) and the actual price (AP), and then multiply that result by the
actual quantity (AQ):
Direct materials price variance = (SP – AP) × AQ
To get the direct materials quantity variance, multiply the standard price by the
difference between the standard quantity (SQ) and the actual quantity:
Direct materials quantity variance = SP × (SQ – AQ)
The total direct materials variance equals the difference between total actual cost
of materials (AP × AQ) and the budgeted cost of materials, based on standard costs
(SP × SQ):
Consider the Band Book Company example described in “Setting Up Standard
Costs” earlier in the chapter. Band Book’s standard price is $10.35 per pound. The
standard quantity per unit is 28 pounds of paper per case. This year, Band Book
made 1,000 cases of books, so the company should have used 28,000 pounds of
paper, the total standard quantity (1,000 cases × 28 pounds per case). However,
the company purchased 30,000 pounds of paper (the actual quantity), paying
$9.90 per case (the actual price).
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Total direct materials variance = (SP × SQ) – (AP × AQ)
Based on the given formula, the direct materials price variance comes to a positive
$13,500, a favorable variance:
Direct materials price variance = (SP – AP) × AQ = ($10.35 – $9.90) × 30,000 =
$13,500 favorable
This variance means that savings in direct materials prices cut the company’s
costs by $13,500.
The direct materials quantity variance focuses on the difference between the standard quantity and the actual quantity, arriving at a negative $20,700, an unfavorable variance:
Direct materials quantity variance = SP × (SQ – AQ) = $10.35 × (28,000 – 30,000) =
–$20,700 unfavorable
This result means that the 2,000 additional pounds of paper used by the company
increased total costs $20,700. Now, you can plug both parts in to find the total
direct materials variance. (You could just plug in the final results, but I show you
the longer math here.) Compute the total direct materials variance as follows:
Total direct materials variance = (SP × SQ) – (AP × AQ) = ($10.35 × 28,000) – ($9.90 ×
30,000) = $289,800 – $297,000 = –7,200 unfavorable
Diagramming direct materials variances
Figure 4-6 provides an easier way to compute price and quantity variances. To
use this diagram approach, just compute the totals in the third row: actual cost,
actual quantity at standard price, and the standard cost. The actual cost less the
actual quantity at standard price equals the direct materials price variance. The
difference between the actual quantity at standard price and the standard cost is
the direct materials quantity variance. The total of both variances equals the total
direct materials variance.
To apply this method to the Band Book example, take a look at Figure 4-7. Start
at the bottom. Direct materials actually cost $297,000, even though the standard
cost of the direct materials is only $289,800. The actual quantity of direct materials at standard price equals $310,500.
To compute the direct materials price variance, subtract the actual cost of direct
materials ($297,000) from the actual quantity of direct materials at standard price
($310,500). This difference comes to a $13,500 favorable variance, meaning that
the company saves $13,500 by buying direct materials for $9.90 rather than the
original standard price of $10.35.
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FIGURE 4-6:
Diagram of
how price
and quantity
variances
contribute to
direct materials
variance.
©John Wiley & Sons, Inc.
Accounting for Change
with Variance Analysis
FIGURE 4-7:
Computing
direct materials
variances by
using a diagram.
©John Wiley & Sons, Inc.
CHAPTER 4 Accounting for Change with Variance Analysis
485
To compute the direct materials quantity variance, subtract the actual quantity
of direct materials at standard price ($310,500) from the standard cost of direct
materials ($289,800), resulting in an unfavorable direct materials quantity variance of $20,700. Because the company uses 30,000 pounds of paper rather than
the 28,000-pound standard, it loses an additional $20,700.
This setup explains the unfavorable total direct materials variance of $7,200 —
the company gains $13,500 by paying less for direct materials, but loses $20,700
by using more direct materials.
Calculating direct labor variances
A direct labor variance is caused by differences in either wage rates or hours
worked. As with direct materials variances, you can use either formulas or a diagram to compute direct labor variances.
Using formulas to figure out direct
labor variances
To estimate how the combination of wages and hours affects total costs, compute
the total direct labor variance. As with direct materials, the price and quantity
variances add up to the total direct labor variance. To compute the direct labor
price variance (also known as the direct labor rate variance), take the difference
between the standard rate (SR) and the actual rate (AR), and then multiply the
result by the actual hours worked (AH):
Direct labor price variance = (SR – AR) × AH
To get the direct labor quantity variance (also known as the direct labor efficiency
variance), multiply the standard rate (SR) by the difference between total standard
hours (SH) and the actual hours worked (AH):
Direct labor quantity variance = SR × (SH – AH)
The direct labor variance equals the difference between the total budgeted cost
of labor (SR × SH) and the actual cost of labor, based on actual hours worked
(AR × AH):
Total direct labor variance = (SR × SH) – (AR × AH)
Now you can plug in the numbers for the Band Book Company example from earlier in the chapter. Band Book’s direct labor standard rate (SR) is $12 per hour. The
standard hours (SH) come to 4 hours per case. Because Band made 1,000 cases of
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books this year, employees should have worked 4,000 hours (1,000 cases × 4 hours
per case). However, employees actually worked 3,600 hours, for which they were
paid an average of $13 per hour.
With these numbers in hand, you can apply the formula to compute the direct
labor price variance:
Direct labor price variance = (SR – AR) × AH = ($12.00 – $13.00) × 3,600 =
–$1.00 × 3,600 = –$3,600 unfavorable
According to the direct labor price variance, the increase in average wages from
$12 to $13 causes costs to increase by $3,600. Now plug the numbers into the formula for the direct labor quantity variance:
Direct labor quantity variance = SR × (SH – AH) = $12.00 × (4,000 – 3,600) =
$12.00 × 400 = $4,800 favorable
Employees worked fewer hours than expected to produce the same amount of output. This change saves the company $4,800 — a favorable variance. To compute
the total direct labor variance, use the following formula:
Total direct labor variance = (SR × SH) – (AR × AH) = ($12.00 × 4,000) – ($13.00 ×
3,600) = $48,000 – $46,800 = $1,200 favorable
According to the total direct labor variance, direct labor costs were $1,200 lower
than expected, a favorable variance.
Employing diagrams to work out direct
labor variances
Take a look at Figure 4-9 to see this diagram in action for Band Book: Starting
from the bottom, the actual cost of direct labor amounts to $46,800. The actual
hours of direct labor at standard rate equals $43,200. The standard cost of direct
labor comes to $48,000.
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Figure 4-8 shows you how to use a diagram to compute price and quantity
variances quickly and easily. First, compute the totals in the third row: actual
cost, actual hours at standard rate, and the standard cost. To get the direct labor
price variance, subtract the actual cost from the actual hours at standard. The
difference between the standard cost of direct labor and the actual hours of direct
labor at standard rate equals the direct labor quantity variance. The total of both
variances equals the total direct labor variance.
FIGURE 4-8:
How price
and quantity
variances add up
to direct labor
variance.
©John Wiley & Sons, Inc.
FIGURE 4-9:
Computing the
direct labor
variances the
easy way with
a diagram.
©John Wiley & Sons, Inc.
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To compute the direct labor price variance, subtract the actual hours of direct
labor at standard rate ($43,200) from the actual cost of direct labor ($46,800)
to get a $3,600 unfavorable variance. This result means the company incurs an
additional $3,600 in expense by paying its employees an average of $13 per hour
rather than $12.
To compute the direct labor quantity variance, subtract the standard cost of direct
labor ($48,000) from the actual hours of direct labor at standard rate ($43,200).
This math results in a favorable variance of $4,800, indicating that the company saves $4,800 in expenses because its employees work 400 fewer hours than
expected.
The $1,200 favorable variance arises because of two factors: the company saves
$4,800 from fewer hours worked but incurs an additional $3,600 expense by paying its employees more money per hour than planned. This scenario begs the
question “Are higher-paid workers more productive?” But that’s a discussion for
the human resources experts.
Computing overhead variances
Whenever you see direct labor and direct materials, overhead can’t be far behind.
To compute overhead applied, multiply the overhead application rate by the standard number of hours allowed:
Overhead applied = Overhead application rate × SH
So you can determine overhead variance by subtracting actual overhead from
applied overhead:
Overhead variance = Overhead applied – Actual overhead
SH equals 1,000 cases produced × 4 direct labor hours per case, or 4,000 direct
labor hours. This amount results in overhead applied of $100,000:
Overhead applied = Overhead application rate × SH = $25.00 × 4,000 = $100,000
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Band Book Company incurs actual overhead costs of $95,000. The company’s
overhead application rate is $25 per hour. (You can find the math for that calculation in the earlier section “Calculating the overhead rate.”) In that prior section,
you use direct labor hours as the activity level for applying overhead. In order for
Band Book’s workers to produce 1,000 cases, you can expect them to work standard hours of 4 direct labor hours per case.
To compute the variance, subtract actual overhead from the overhead applied:
Overhead variance = Overhead applied – Actual overhead = $100,000 – $95,000 =
$5,000
Because actual overhead is less than overhead applied, the $5,000 variance is
favorable.
Spending too much or too little on overhead — or using overhead inefficiently —
often causes overhead variance.
Like direct labor and direct materials, overhead, too, can have price and quantity
variables. However, fixed and variable cost behaviors considerably complicate the
calculation of overhead variances. These complexities are outside the scope of
this book.
The unfavorable and favorable labels describe variances only in terms of how they
affect income; favorable variances aren’t necessarily always good, and unfavorable variances aren’t necessarily always bad. For example, a favorable variance may
result because a company purchases cheaper direct materials of poorer quality.
These materials lower costs, but they also hurt the quality of finished goods, damaging the company’s reputation with customers. This kind of favorable variance
can work against a company. On the other hand, an unfavorable variance may
occur because a department chooses to scrap poor-quality goods. In the long run,
the company benefits from incurring a short-term unfavorable variance to provide better-quality goods to its customers.
Teasing Out Variances
In your business, variance analysis helps you identify problem areas that require
attention, such as
»» Poor productivity
»» Poor quality
»» Excessive costs
»» Excessive spoilage or waste of materials
Identifying and working on these problems helps managers improve production
flow and profitability. Managers and accountants often talk about management
by exception — using variance analysis to identify exceptions, or problems, where
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actual results significantly vary from standards. By paying careful attention to
these exceptions, managers can root out and rectify manufacturing problems and
inefficiencies, thereby improving productivity, efficiency, and quality.
Interpreting variances in action
The previous sections in this chapter lay out what happens to the costs of the Band
Book Company over the course of a year. Figure 4-10 summarizes Band Book’s
variances.
FIGURE 4-10:
Band Book’s
variances.
©John Wiley & Sons, Inc.
A complete analysis of Band Book’s variances provides an interesting story to
explain why the company has a $1,000 unfavorable variance. The following events
transpire:
favorable $13,500 direct materials price variance.
»» Perhaps because of the cheaper, lower-quality direct materials, the company
uses an excessive amount of direct materials. This overage results in a
$20,700 unfavorable direct materials quantity variance.
»» The company pays its employees a higher wage rate, resulting in an unfavorable direct labor price variance of $3,600.
»» The company saves money because employees work fewer hours than
expected, perhaps because they’re more productive, higher-paid workers.
The favorable direct labor quantity variance is $4,800.
»» The company saves $5,000 in reduced overhead costs.
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»» The company pays less than expected for direct materials, leading to a
Focusing on the big numbers
Management by exception directs managers to closely investigate the largest
variances. For example, the two largest variances in Figure 4-10 are the direct
materials quantity variance ($20,700 unfavorable) and the direct materials price
variance ($13,500 favorable). Band Book’s managers should focus on how the
company buys and uses its direct materials.
Here, the direct materials quantity variance resulted because the company should
have used 28,000 pounds of paper but actually used 30,000 pounds of paper. Why?
Here are a few possibilities:
»» The paper was poor quality, and much of it needed to be scrapped.
»» The company underestimated the amount of paper needed (the standard
quantity needs to be changed).
»» Someone miscounted the amount of paper used; 2,000 pounds of paper are
sitting in the back of the warehouse (oops).
»» A new employee misused the machine, shredding several thousand pounds
of paper.
Management by exception directs managers to where the problem may have
occurred so that they can investigate what happened and take corrective action.
Now take a look at the favorable direct materials price variance of $13,500.
How did the purchasing department come to purchase direct materials for only
$9.90 a pound, rather than the $10.35 standard? Did the purchased materials meet
all of the company’s quality standards? Should the company reduce its standard
price in the future?
Consider setting control limits to determine which items are sufficiently large
enough to investigate. A variance exceeding its control limit takes priority over
less significant variances.
Tracing little numbers back to big problems
Don’t focus exclusively on the big numbers and ignore the little numbers. Big
problems can also hide in the small numbers. For example, although many frauds
(such as stealing raw materials) may trigger large variances, a well-planned fraud
may be designed to manipulate variances so that they stay low, below the radar,
where managers won’t notice them.
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For example, knowing the standard price of a raw material is $100 per unit, a
crooked purchasing manager may arrange to purchase the units for exactly that
price — $100 per unit — while receiving $10 per unit as a kick-back gratuity from
the supplier. This scheme results in a direct materials price variance of zero, but
it doesn’t reflect what should be the company’s actual cost of doing business.
A more scrupulous purchasing manager would have arranged a purchase price of
$90, resulting in a large positive direct materials price variance.
To avoid these problems, managers should still investigate all variances, even
while focusing most of their time on the largest figures.
Accounting for Change
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IN THIS CHAPTER
»» Understanding the importance of
product differentiation
»» Addressing absorption costing
»» Using cost-plus pricing
»» Taking risks with variable-cost pricing
»» Aiming for target costing
Chapter
5
Pricing Wisely
A
well-set price for any product or service, if it’s set for the right reasons rather than by accident, results from an understanding of human
behavior. How much will customers be willing to pay? Will charging more
alienate customers or make your product appear to be more valuable? Can you
charge enough to pay for the costs of doing business or have your suppliers been
increasing their own prices lately? Are you attempting to maximize your revenues
or your profits and why? To answer these questions, you must understand both
market forces and the cost structure of your business.
In this chapter we’ll discuss how to use your knowledge of cost behavior to make
savvy pricing decisions, how to model internal costing, and even how to develop
outsourcing strategies.
Differentiating Products
Product differentiation allows consumers to see differences among companies’
products, which makes them willing to spend more money for some brands than
for others. A company that successfully differentiates its products can charge a
higher price than its competitors, making it a price maker. Companies that don’t
differentiate their products need to use low prices to get a leg up on the competition. Marketers call these companies price takers.
CHAPTER 5 Pricing Wisely
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Customers usually have trouble seeing any difference among the products offered
by different mainstream supermarkets. Therefore, all supermarkets — price
takers — need to price their products competitively in line with one another. On
the other hand, premium supermarkets such as Whole Foods have done a brilliant
job of differentiating themselves from competitors, so much so that customers
often pay significantly more money to shop there. Whole Foods is a price maker.
Regardless of how well a company differentiates its products, its prices must take
into account both market forces and the company’s own cost behavior.
Taking All Costs into Account
with Absorption Costing
Absorption costing (sometimes also called full costing) is the predominant method of
costing goods that companies manufacture and sell. Generally accepted accounting principles (GAAP) require all U.S. companies to use absorption costing in their
financial statements. International accounting standards have similar requirements worldwide.
Absorption costs include all product costs — the costs of making products. Product
costs include a variable component that increases and decreases with volume and
a fixed component that doesn’t change regardless of how much or how little you
produce.
The costs of direct materials — raw materials that you can trace directly to the
manufactured product — are variable. After all, the more units you make, the more
direct materials you need to make them. The same goes for direct labor — the cost
of paying employees to make your products.
Overhead costs, such as the miscellaneous costs of running a factory, usually consist of a mixture of fixed and variable costs. Absorption costing requires you to
spread out the fixed costs over all units produced. (See Book 7, Chapter 4 for
details on direct and overhead costs.)
Suppose that your factory makes T-shirts. Each T-shirt requires $8 worth of variable costs (direct materials, direct labor, and variable overhead), and your factory
pays $100,000 in fixed costs each year for rent and utilities. This year, you plan to
make 50,000 T-shirts. How much will each T-shirt cost?
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The fixed component of $100,000 applies to all the shirts, however, so you need to
spread it out among them. Divide the total fixed costs of $100,000 by the number
of units you plan to produce (50,000) to get a fixed cost per unit of $2. Therefore, each T-shirt includes $8 worth of variable costs and $2 worth of fixed costs,
resulting in total cost per unit of $10.
Pricing at Cost Plus
Many retailers and manufacturers set their prices at cost plus by adding a fixed
markup to their absorption cost. Cost-plus pricing ensures that prices are high
enough to meet profit goals. Figure 5-1 illustrates how cost-plus pricing computes the sales price by adding markup to a product’s fixed and variable costs.
FIGURE 5-1:
Cost-plus
pricing includes
absorption cost
of the product
plus a markup.
© John Wiley & Sons, Inc.
Computing fixed markups
To figure out the markup for cost-plus pricing, divide total desired profit by the
number of units produced. Suppose that Saint Co. wants to earn $100,000 on the
production of 100 Model 51 robots:
Desired profit ÷ Units produced = Markup = $100,000 ÷ 100 = $1,000
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According to absorption costing, the cost of a T-shirt includes both variable and
fixed components. You know that the variable component per shirt is $8.
Dividing the desired profit by units produced results in a planned markup of
$1,000 per unit. To set the price, add this planned markup to the cost. Assume
that Saint’s cost to produce each robot is $4,000:
Cost + Markup = Sale price = $4,000 + $1,000 = $5,000
If Saint Co. wants to earn a total $100,000, it should set the price at $5,000 per
unit.
Setting a cost-plus percentage
Because companies often sell many products at different prices, they commonly
use a cost-plus percentage or percentage markup on cost that applies to all their
products. To figure this percentage, you divide the markup, in dollars, by the
total product cost. Then, to determine the products’ sales prices, you apply this
percentage to all products or to different categories of products. Saint Co.’s Model
51 robot has a $1,000 markup on a cost of $5,000:
Markup ÷ Product cost = $1,000 ÷ $4,000 = 0.25 or 25%
Here, Saint earns a 25 percent cost-plus percentage. The company can apply the
same cost-plus percentage to set the prices of other products. Another robot,
Model 6, costs Saint Co. $6,000 to produce. The markup on this robot amounts to
$6,000 × 0.25 percent = $1,500, pricing it at $6,000 + $1,500 = $7,500.
Considering problems with cost-plus pricing
Cost-plus pricing works because it’s easy to use, but it carries a few drawbacks:
»» Cost-plus pricing ignores market factors. Just because you like to mark up
your merchandise by 20 percent doesn’t necessarily mean that your customers are willing to pay this price or that your competitors will cooperate with
you by setting their prices even higher.
»» Because cost-plus pricing relies on absorption costing, it treats fixed
costs as though they’re variable. Saint Co. wants to sell 100 Model 51
robots, which means that it can distribute its fixed costs over 100 units. But
the fixed costs remain the same regardless of how many units Saint sells. If
the company sells only 50 robots, the fixed costs are spread over fewer units
(50 robots rather than 100), and the cost per unit rises.
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FIGURE 5-2:
Cost-plus pricing
gone wild.
© John Wiley & Sons, Inc.
Look on the bright side: If your sales volume is higher than you expected, spreading fixed costs will have a disproportionately positive effect on income, delivering
profits way beyond your wildest dreams. That happens because you spread the
fixed costs over more units, lowering the total cost per unit sold.
Accounting Extremes: Trying
Variable-Cost Pricing
Variable-cost pricing offers an adventurous variation on cost-plus pricing (refer to
the earlier section “Pricing at Cost Plus”). Instead of adding a markup on total
cost, variable-cost pricing adds a markup on just the variable cost, disregarding
fixed costs. Figure 5-3 compares variable-cost pricing with boring old cost-plus
pricing. The following sections show you how variable-cost pricing works and
point out the drawbacks of this system.
Working out variable-cost pricing
When you use variable-cost pricing, your markup must cover both the desired
profit and the expected fixed costs. Therefore, to figure out your markup, divide
the total desired profit plus expected fixed costs by the number of units produced.
Suppose that Sparl Industries makes the Red Rover model. The entire production
run of Red Rover requires $900,000 worth of fixed costs. Each unit costs another
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If production drops to 50 robots, the cost per unit increases to $6,000 per
unit. (Check out Figure 5-2.) This change puts Saint in a tight bind. Figure 5-2
shows how this miscalculation causes the company’s profits to vaporize into a
$50,000 loss.
$90,000 in variable costs. Sparl wants to earn $400,000 in profit on the production and sale of 20 units of this model.
FIGURE 5-3:
Comparing
cost-plus (a) and
variable-cost
pricing (b).
© John Wiley & Sons, Inc.
First, figure out how much markup you need on each unit to cover both the
desired profit and the fixed costs:
(Desired profit + Fixed costs) ÷ Units produced = Markup = ($400,000 + $900,000) ÷
20 = ($1,300,000) ÷ 20 = $65,000
The markup is $65,000 per unit. Now set the price at this planned markup plus
the variable cost:
Variable cost + Markup = $90,000 + $65,000 = $155,000
According to this analysis, if Sparl Industries wants to earn $400,000 in profit
and cover $900,000 worth of fixed costs by selling 20 units, it should set the sale
price at $155,000.
Spotting the hazards of
variable-cost pricing
Variable-cost pricing is especially useful for companies pricing special orders
when they have excess capacity, meaning that they have sufficient resources to
produce more goods. When you’re operating at full capacity, however, variablecost pricing may be hazardous to the health of your business.
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If your hotel has vacancies (that is, excess capacity), and a customer walks in
without a reservation, offering to pay $52 for a room for the night, variable-cost
pricing indicates that you should take them in. After all, $52 exceeds the variable cost of $10, increasing your profits by $42. Cost-plus pricing would tell you
to refuse the offer. Each room costs $100 per night, so why would you willingly
lose $48? But if your hotel is completely booked, the only way to house the $52
customer would be to turn away a full-price-paying customer, reducing revenue.
Variable-cost pricing poses another severe danger: To earn a profit, your sales
must exceed costs. Because variable-cost pricing doesn’t fully account for fixed
costs, it can trick managers into setting prices so low that they hurt profits or,
worse, cause net losses. As explained in the preceding example, occasionally selling a room for $52 may increase your profits. But selling too many rooms at such
low prices (even if you’re never at full capacity) causes you to lose a lot of money.
Hitting the Bull’s-Eye (Your Target Cost)
Many industries use price points — special “magic” price levels that customers
expect to pay. You’ve probably seen these prices in the store: $99.99, $26.99,
$19.95, and so on. Understanding customer expectations and competitor pricing,
manufacturers design products specifically so that the products can be produced
and sold at the magic price points.
Although traditionally, you first design the product and then set the price, target
costing requires you to set the price before you design the product. After you
know the price, you can engineer the product so that its cost is low enough to
ensure that you earn the expected profit margin. Done right, target costing prevents problems caused by products that are priced too high for consumers or are
too expensive to make. Target costing engineers the price, the profit margin, and
the cost right into the product.
Calculating your target cost
With target costing, the company uses market price and markup to figure out the
product’s cost and specifications. By contrast, cost-plus pricing uses product cost
and desired profit information to set the price. (Refer to “Pricing at Cost Plus”
earlier in this chapter for more information on this topic.)
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Suppose that you operate a hotel with vacant rooms. Each room has a variable
cost of $10 per night and a fixed cost of $90 per night. Cost-plus pricing requires
you to base your price on a total cost of $100 per night. But variable-cost pricing
allows you to base your price on a variable cost of only $10 per night.
To figure out the target cost, subtract the desired profit from the market price:
Market price – Desired profit = Target cost
Figure 5-4 illustrates how this process works.
FIGURE 5-4:
In target costing,
the market price
determines the
product’s cost.
© John Wiley & Sons, Inc.
Suppose that you head to a big-box store to buy a new desktop computer, and
you’re determined to pay no more than $750 plus tax. You discover four desktop models, priced at $599.99, $749.99, $999.99, and $1,299.99. You take the
$749.99 model because you want the best computer you can get for $750 or less.
Assume that the store sets prices so that gross profit equals 10.51 percent of the
company’s sales price. An inventory item that sells for $100 typically includes
gross profit worth $100 × 0.1051 = $10.51, costing the company $100.00 – $10.51
= $89.49. Gross profit is defined as sales less cost of sales. Check out Book 7,
Chapter 3 for more detail.
The company’s desired profit on your computer model equals $749.99 × 0.1051 =
$78.82. Plug it into the formula
Market price – Desired profit = $749.99 – $78.82 = $671.17
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Target costing works both for retailers (such as that big-box store) and for
manufacturers (such as the maker of your new computer). Therefore, after the
store determines that it’s willing to pay $671.17 for these computers, the maker
needs to figure out how to make computers with all the right bells and whistles
that it can sell for $671.17.
The computer maker works to earn a 22.7 percent profit margin on sales. Therefore, the company’s desired profit equals $671.17 × 22.7 percent = $152.36:
Market price – Desired profit = $671.17 – $152.36 = $518.81
After subtracting the desired profit of $152.36 from its expected sale price of
$671.17, the computer maker works out that it needs to engineer and produce
computers that cost $518.81. Armed with this knowledge, the engineers choose
various specifications and features to cook up a computer that costs exactly this
amount.
Target costing works especially well for companies whose products aren’t well
differentiated (such as electronic accessories and economy automobiles), because
price is often a key consideration for customers deciding which brand to buy. This
technique ensures that the company can sell a competitive product with all the
features — and at the price — that customers expect.
Transferring price
When you consider that your organization’s operations generate their own unique
sets of costs and additional value to the work in process, it’s very useful to use
transfer pricing. The transfer price represents the price that one division of an
organization charges another division for the transfer of resources through the
value chain. In this system, one department would record that they received $X in
resource value, performed $Y of value-added work, and transferred $Z in resource
value to the next department in the value chain. You can take several potential
approaches to price transfers.
The total resource value being recorded as a transaction between departments
may represent merely the cost of the resources plus the value-added work that
was performed. This scenario is typical when the motivation for transfer pricing
is noncompetitive. Managing taxation, especially when operations cross political
borders, is arguably the most common use of transfer pricing. Many nations tax
imports/exports on the additional value added to a work in process rather than
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The math indicates that the store should pay $671.17 for computers that it can
sell for $749.99.
on the full value of the inventory. This approach to transfer pricing is also useful
for monitoring efficiency within the organization’s operations.
Outsourcing decisions
When the goal is competitive in nature, transfer prices may reflect the market
price of the resources or work being completed. In other words, whatever the
organization would charge external customers for a product or service (or what
your organization would have to pay an external supplier to obtain) is the price
recorded during transfer pricing. This is usually done only for one reason: deciding whether it’s more cost-effective to outsource operations. If another company
can perform one of your own organization’s operations just as well but more
cheaply than keeping it in-house, it may be time to outsource that operation.
Operations that are critical to the strategy or competitive advantage of an organization can be very risky to outsource. Trusting another organization to perform
some operation that’s vital to the success of a company is hard enough; trusting it
not to steal or sell the secrets of this vital operation can be disastrous.
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IN THIS CHAPTER
»» Calculating profit margin and rate of
return
»» Making the most of a company’s
existing assets
»» Wrapping your brain around the
concept of liquidity