Introduction

You may know individuals who make their living as accountants. You may be thankful that they’re the accountants and you’re not. You may prefer to leave accounting to the accountants, and think that you don’t need to know anything about accounting. This attitude reminds me of the old Greyhound Bus advertising slogan “Leave the Driving to Us.” Well, if you could get around everywhere you wanted to go on the bus, that would be no problem. But if you have to drive most places, you’d better know something about cars. Throughout your life you do a lot of “financial driving,” so you should know something about accounting.

Sure, accounting involves numbers. So does watching your car mileage, knowing your blood pressure, keeping track of your bank balance, negotiating the interest rate on your home mortgage, monitoring your retirement fund, and bragging about your kid’s grade point average. You deal with numbers all the time. Accountants provide financial numbers. These numbers are very important in your financial life. Knowing nothing about financial numbers puts you at a serious disadvantage. In short, financial literacy requires a working knowledge of accounting, which this book provides.

About This Book

This book, like all For Dummies books, consists of freestanding chapters, like boats tied up to a dock. Each chapter floats on its own but the boats are all tied to the same dock. You can read the chapters in any order you please. You can tailor your reading plan to give priority to the chapters of most interest to you, and read other chapters as time permits. Of course, you could start on page 1 and continue straight through until the last page. The choice is yours.

I’ve written this book for a wide audience. You may be a small business manager who has experience with financial statements, for example, but you need to know more about how to use accounting information in analyzing your profit performance and cash flow. Or, you may be an investor who needs to know more about financial statements, so your chief interest probably will be the chapters that explain those statements. You could be an accounting student who needs shorter and clearer explanations of topics than in your textbook. (Unfortunately accounting textbooks, even introductory texts, tend to be excessively technical and convoluted.)

This book offers several advantages:

I explain accounting in plain English and I keep jargon and technical details to a minimum.

I carefully follow a step-by-step approach in explaining topics.

I include only topics that non-accountants should understand; I avoid topics that only practicing accountants have to know.

I include frank discussions of certain sensitive accounting topics, which go unmentioned in many books.

I should mention one thing: This book is not an accounting textbook. Introductory accounting textbooks are ponderous, dry as dust, and overly detailed (in my judgment). However, textbooks have one useful feature: They include exercises and problems. You can learn much by reading this book without doing problems. If you have the time, you can gain additional insights and test your understanding of accounting by working the exercises and short problems in my Accounting Workbook For Dummies (Wiley).

Conventions Used in This Book

Learning accounting means learning about financial statements, because these reports are how accountants communicate to the managers and stakeholders of a business, the insiders and the outsiders. Accountants don’t present the actual accounting journals and accounts of the business to its managers, lenders, and investors. Rather the accounting records are summarized in the form of financial statements. Financial statements are the nexus between accountants and the users of these accounting reports. Financial statements are designed for non-accountants. But here’s a Catch 22: To know how to read financial statements, you need a basic working knowledge of accounting. One of my main goals in writing this book is to provide you with this basic working knowledge to make you a savvy user of financial statements.

Financial statements are presented according to established (one could say entrenched) conventions. Uniform styles and formats for reporting financial statements have evolved over the years and have become generally accepted. The conventions for financial statement reporting can be compared to the design rules for highway signs and traffic signals. Without standardization there would be a lot of accidents.

I present financial statement examples throughout the book. Therefore, I take a moment now to explain the conventions for presenting financial statements. To illustrate these points I use the following example of an income statement for a business, which summarizes its sales revenue, expenses, and bottom-line profit for a period. See the following figure.

Income Statement Illustrative Example

Here are several conventions and customs in reporting financial statements to keep in mind:

It may be obvious, but you read the income statement from the top down. Sales revenue is listed first, which is the total income from the sale of products and services during the period before different expenses in the period are deducted. If the main revenue stream of the business is from selling products, the first expense deducted from sales revenue is cost of goods sold expense, as in this income statement example.

Deducting the cost of goods sold expense from sales revenue gives gross margin (also called gross profit). The number of other expense lines in an income statement varies from business to business. In the example, three expenses are given in addition to cost of goods sold expense. A common practice is to show operating earnings (or a similar title), which equals profit before interest income tax expense.

An amount that is deducted from another amount — such as the cost of goods sold expense — may be placed in parentheses to indicate that it is being subtracted from the amount above it. Alternatively, the accountant who prepares the financial statement may assume that readers know that expenses are deducted from sales revenue, so no parentheses are put around the number. You see expenses presented both ways in financial reports, but you hardly ever see a minus (negative) sign in front of expenses. With rare exceptions, the color red is not used to report negative items; financial statements are in black and white.

Notice the use of dollar signs in the income statement example. In this illustrative example all amounts have a dollar sign prefix. However, financial reporting practices vary quite a bit on this matter. The first number in a column always has a dollar sign, but from here down it’s a matter of personal preference.

To indicate that a calculation is being done, a single underline is drawn under a number, as you see under the $3,143,000 cost of goods sold expense number in the example. This means that the expense amount is being subtracted from sales revenue. The number below the underline is a calculated amount. Calculated amounts, such as gross profit and operating earnings, are not accounts. Sales revenue and the four expenses in the illustrative example are the accounts.

Note that there are three calculated amounts in the example: $2,093,000 gross margin; $747,000 operating earnings; and, $369,000 net income.

Dollar amounts in a column are always aligned to the right, as you see in the income statement example. Trying to read down a jagged column of numbers that are not right-aligned would be asking too much; the reader might develop vertigo.

In the income statement example, dollar amounts are rounded to the nearest thousand for ease of reading, which is why you see zeros in the last three places of each number. Really big businesses round off to the nearest million. Instead of including a lot of zeros in a financial statement the accountant could chop off the last three digits and include a notation that dollar amounts are in thousands (or millions, as the case may be).

Some accountants don’t like rounding off amounts reported in a financial statement, so you see every amount carried out to the last dollar, and sometimes even to the last penny. However, this gives a false sense of precision. Accounting for business transactions cannot be accurate down to the last dollar; this is nonsense. The late Kenneth Boulding, a well-known economist, once quipped that accountants would rather be precisely wrong than approximately correct. Ouch! That stings because there’s a strong element of truth behind the comment.

The final number in a column typically is double underlined, as you see for the $369,000 bottom-line profit number in the income statement. This is about as carried away as accountants get in their work — a double underline. Instead of a double underline for a bottom-line number, it may appear in bold. For an accountant this is rather a bold thing to do (pun intended).

What You’re Not to Read

While you’re reading, I assume you’re on the edge of your seat and can hardly wait to get to the next exciting sentence. Well, perhaps I get more pumped up about accounting than you. So, one question you may have is this: Do I really have to read every sentence in the book? To be honest, you can skip the paragraphs marked with the Technical Stuff icon. You can simply leapfrog over these sections without missing a beat. If you have time, you can return to these topics later. Also, the sidebars in the chapters are interesting, but not absolutely essential for understanding the topics at hand. Sidebars are like in a conversation when you say, “By the way, did you know . . . ?”

There’s reading, and then there’s remembering what you read. You should read the examples I use throughout the book, but you don’t have to remember the numbers in each example. For instance, consider the income statement example in the previous section. You should understand that the bottom-line profit is the amount remaining after all expenses are deducted from sales revenue. But, of course, you don’t need to remember the specific amount of the bottom-line profit in the example.

Foolish Assumptions

I assume that you have a basic familiarity with the business world, but I take nothing for granted regarding how much accounting you know. I start at the beginning. Even if you have some knowledge of accounting and financial statements, I think you’ll find this book useful. The book should provide insights you haven’t thought of before. I gained many new insights about accounting while writing this book, that’s for sure.

I have written this book with a wide audience in mind. You should find yourself more than once in the following list of potential readers:

Accountants to be: This book is a good first step for anyone considering a career in professional accounting. If the content turns you off, you might want to look for another vocation.

Active investors: Investors in marketable securities, real estate, and other ventures need to know how to read financial statements, both to stay informed about their investments and to spot any signs of trouble.

Passive investors: Many people let the pros manage their money by investing in mutual funds or using investment advisors to handle their money; even so, they need to understand the investment performance reports they get, which use plenty of accounting terms and measures.

People who want to take control of their personal finances: Many aspects of managing your personal finances involve the accounting vocabulary and accounting-based calculation methods.

Business managers (at all levels): Trying to manage a business without a good grip on financial statements can lead to disaster. How can you manage the financial performance of your business if you don’t understand the financial statements of your business?

Anyone interested in following economic, business, and financial news: Articles in The Wall Street Journal and other financial news sources are heavy with accounting terms and measures.

Administrators and managers of government and not-for-profit entities: Although making profit is not the goal of these entities, they have to stay within their revenue limits and keep on a sound financial footing.

Politicians at local, state, and federal levels: These men and women pass many laws having significant financial consequences, and the better they understand accounting, the better informed their votes should be (we hope).

Bookkeepers: Strengthening their knowledge of accounting should improve their effectiveness and value to the organization and advance their careers.

Entrepreneurs: As budding business managers, they need a solid grasp of accounting basics.

Business buyers and sellers: Anyone thinking of buying or selling a business should know how to read its financial statements and how to “true up” these accounting reports that serve as a key point of reference for setting a market value on the business.

Investment bankers, institutional lenders, and loan officers: I don’t really have to tell these folks that they need to understand accounting; they already know.

Business and finance professionals: This includes lawyers and financial advisors, of course, but even clergy counsel their flock on financial matters occasionally.

I could put others in the above list. But I think you get the idea that many different people need to understand the basics of accounting. Perhaps someone who leads an isolated contemplative life and renounces all earthly possessions does not need to know anything about accounting. But, then again, I don’t know.

How This Book Is Organized

This book is divided into parts, and each part is further divided into chapters. The following sections describe what you can find in each part.

Part I: Opening the Books on Accounting

In Chapters 1 and 2, I introduce the business financial statements gradually, one step at a time. Rather than throwing you in the deep end of the pool, hoping that you learn to swim before drowning in too many details, I make sure you first learn to float and then move on to some basic strokes. The information source for financial statements is the bookkeeping system of the entity (also called the recordkeeping system). The financial statements of an entity are no more reliable and accurate than the reliability and accuracy of its bookkeeping system — and the integrity of the company’s managers, of course. So, in Chapter 3, I offer a brief overview of bookkeeping and accounting systems. You could jump over this chapter, if you must. But I recommend at least a quick read.

Part II: Exploring Financial Statements

In Part II, I complete the explanations of the financial statements of businesses (see Chapters 4, 5, and 6). In Chapter 7, I explain that businesses are not put in a straitjacket when it comes to deciding which accounting methods to use for recording their revenue and expenses. They can select from alternative methods for recording certain revenues and expenses. The choices of accounting methods affects the values recorded for assets and liabilities and, most importantly, directly affect the amount of profit recorded for the period.

Part III: Accounting in Managing a Business

To start a business and begin operations, its founders must first decide on which legal structure to use. Chapter 8 explains the different types of legal entities for carrying on business activities. Each has certain advantages and disadvantages and each is treated differently under the income tax law, which is always an important factor to consider.

Chapter 9 explains a very important topic: designing a profit performance report for business managers that serves not only as a good digest of profit performance but also serves as a good profit model, one that focuses on the chief variables that drive profit and changes in profit. A hands-on profit model is essential for management decision-making. A manager depends on the profit model to determine the effects of changes in sales prices, sales volume, product costs, and the other fundamental factors that drive profit.

In Chapter 10, I discuss accounting-based planning and control techniques, through the lens of budgeting. Managers in manufacturing businesses should clearly understand how their product costs are determined, as Chapter 11 explains. Compared with retailers, the product costs of manufacturers are much more complicated and arbitrary. The chapter also explains other economic and accounting cost concepts relevant to business managers.

Part IV: Preparing and Using Financial Reports

In Part IV, I first explain how a financial report is made ready for release outside the business (see Chapter 12). Next I discuss how investors and lenders read financial statements (see Chapter 13). Business managers need more information than is included in an external financial report to investors and lenders. In Chapter 14, I survey the additional information that managers need.

Part V: The Part of Tens

In the For Dummies style, I close the book with a pair of chapters in “The Part of Tens.” I condense the main lessons from the book’s chapters into two lists of ten vital points each. Chapter 15 reviews ten important ways business managers should manage the accounting system of their business and how to use accounting information. Chapter 16 gives business investors handy tips for getting the most out of reading a financial report — tips on how to be efficient in reading a financial report and the key factors to focus on.

Glossary

The accounting terminology in financial statements is a mixed bag. Many terms are straightforward, but accountants also use esoteric terms that you don’t see outside of financial statements. Sometimes it must seem like accountants are speaking a foreign language. I must admit that accountants use jargon more than they should. In some situations accountants resort to arcane terminology to be technically correct, much like lawyers use arcane terminology in filing lawsuits and drawing up contracts.

Where I use jargon in the book, I pause and clarify what the terms mean in plain English, using street language where I can. Also, I present a helpful glossary at the end of the book that can assist you on your accounting safari. This glossary provides succinct definitions of key accounting and financial terms, with relevant commentary and an occasional editorial remark. This is better than your average glossary.

Icons Used in This Book

This icon points out especially important accounting ideas and concepts that are particularly deserving of your attention. The material marked by this icon describes concepts that are the undergirding and building blocks of accounting — concepts that you should be very clear about and that clarify your understanding of accounting principles in general.

I use this icon sparingly; it refers to very specialized accounting stuff that is heavy going, which only a CPA could get really excited about. However, you may find these topics important enough to return to when you have the time. Feel free to skip over these points the first time through and stay with the main discussion.

This icon calls your attention to useful advice on practical financial topics. It saves you the cost of buying a yellow highlighter pen.

This icon is like a caution sign that warns you about speed bumps and potholes on the accounting highway. Taking special note of this material can steer you around a financial road hazard and keep you from blowing a fiscal tire. In short — watch out!

Where to Go from Here

There’s no law against you starting on page 1 and reading through to the last page. However, you may first want to scan the book’s Contents at a Glance and see which chapters pique your interest.

Perhaps you’re an investor who is very interested in learning more about financial statements and the key financial statement ratios for investors. You might start with Chapters 4, 5, and 6, which explain the three primary financial statements of businesses, and finish with Chapter 13 on reading a financial report. (And don’t overlook Chapter 16.)

Perhaps you’re a small business owner/manager with a basic understanding of your financial statements, but you need to improve how you use accounting information for making your key profit decisions, and for planning and controlling your cash flow. You might jump right into Chapters 9 and 10, which explain analyzing profit behavior and budgeting cash flows.

The book is not like a five-course dinner in which you have to eat in the order the food is served to you. It’s more like a buffet line from which you can pick and choose, and eat in whatever order you like.