Chapter 4
In This Chapter
Understanding the two main accounting methods
Deciphering debits and credits
Examining the Chart of Accounts
Looking at the different types of profit
Ah, the language of financial accounting — debits, credits, double-entry accounting! Just reading the words makes your heart beat faster, doesn't it? The language and practices of accountants can get the best of anyone, but there's a method to the madness. Figuring out that method is a crucial first step to understanding financial reports.
In this chapter, I help you understand the logic behind the baffling and unique world of financial accounting. And you don't even need a pocket protector!
Officially, two types of accounting methods dictate how a company records its transactions in its financial books: cash-basis accounting and accrual accounting. The key difference between the two types is how the company records cash coming into and going out of the business.
Within that simple difference lies a lot of room for error — or manipulation. In fact, many of the major corporations involved in financial scandals have gotten into trouble because they played games with the nuts and bolts of their accounting method. I talk more about those games in Chapter 23.
In cash-basis accounting, companies record expenses in financial accounts when the cash is actually laid out, and they book revenue when they actually hold the cash in their hot little hands — or, more likely, in a bank account. For example, if a painter completes a project on December 30, 2012, but doesn't get paid for it until the owner inspects it on January 10, 2013, the painter reports those cash earnings on his 2013 tax report. In cash-basis accounting, cash earnings include checks, credit card receipts, and any other form of revenue from customers.
If a company uses accrual accounting, it records revenue when the actual transaction is completed (such as the completion of work specified in a contract agreement between the company and its customer), not when it receives the cash. In other words, the company records revenue when it earns it, even if the customer hasn't paid yet. So the painter who finishes a job in 2012 but doesn't get the cash for that job until 2013 still reports the income on his 2012 taxes. He enters the income into the books when the job is completed.
Companies handle expenses in the same way. A company records any expenses when they're incurred, even if it hasn't yet paid for the supplies. For example, when a carpenter buys lumber for a job, he may likely do so on account and not actually lay out the cash for the lumber until a month or so later, when he gets the bill.
The accounting method a business uses can have a major impact on the total revenue it reports, as well as on the expenses it subtracts from the revenue to get the bottom line. Here's how:
The way a company records payment of payroll taxes, for example, differs with these two methods. In accrual accounting, each month the company sets aside the amount it expects to pay toward its quarterly tax bills for employee taxes using an accrual (a paper transaction in which no money changes hands). The entry goes into a tax liability account (an account for tracking tax payments that the company has made or must still make). If the company incurs $1,000 of tax liabilities in March, it enters that amount in the tax liability account even if it hasn't yet paid out the cash. That way, the expense is matched to the month in which it's incurred.
In cash accounting, the company doesn't record the liability until it actually pays the government the cash. Although it incurs tax expenses each month, a company using cash accounting shows a higher profit during two months every quarter, and possibly even shows a loss in the third month when the taxes are paid.
To see how these two methods can result in totally different financial statements, imagine that a carpenter contracts a job with a total cost to the customer of $2,000. The carpenter's expected expenses for the supplies, labor, and other necessities are $1,200, so his expected profit is $800. He contracts the work on December 23, 2012, and completes the job on December 31, 2012, but he isn't paid until January 3, 2013. The contractor takes no cash up front and instead agrees to be paid in full upon completion.
If he uses the cash-basis accounting method, then because no cash changes hands, he doesn't have to report any revenues from this transaction in 2012. But say he lays out the cash for his expenses in 2012. In this case, his bottom line is $1,200 less, with no revenue to offset it, and his net profit (the amount of money his company earns, minus expenses) for the business in 2012 is lower. This scenario may not necessarily be bad if he's trying to reduce his tax hit for 2012.
If the same carpenter uses accrual accounting, his bottom line is different. In this case, he books his expenses when they're actually incurred. He also records the income when he completes the job on December 31, 2012, even though he doesn't get the cash payment until 2013. He increases his net income with this job — and also his tax hit. Chapter 7 covers the ins and outs of reporting income on the income statement.
You probably think of the word debit as a reduction in your cash. Most nonaccountants see debits only when they're taken out of their banking account. Credits likely have a more positive connotation in your mind. You see them most frequently when you've returned an item and your account is credited.
Both cash-basis and accrual accounting use this method, in which a credit may be added to or subtracted from an account, depending on the type of account. The same is true with debits; sometimes they add to an account, and sometimes they subtract from an account.
When you buy something, you do two things: You get something new (say, a chair) and you have to give up something to get it (most likely, cash or your credit line). Companies that use double-entry accounting show both sides of every transaction in their books, and those sides must be equal.
For example, if a company buys office supplies with cash, the value of the office supplies account increases, while the value of the cash account decreases. If the company purchases $100 in office supplies, here's how it records the transaction on its books:
Account |
Debit |
Credit |
Office supplies |
$100 |
|
Cash |
|
$100 |
In this case, the debit increases the value of the Office supplies account and decreases the value of the Cash account. Both accounts are asset accounts, which means both accounts represent things the company owns that are shown on the balance sheet. (The balance sheet is the financial statement that gives you a snapshot of the assets, liabilities, and shareholders’ equity as of a particular date. I cover balance sheets in greater detail in Chapter 6.)
The assets are balanced or offset by the liabilities (claims made against the company's assets by creditors, such as loans) and the equity (claims made against the company's assets, such as shares of stock held by shareholders). Double-entry accounting seeks to balance these assets and claims. In fact, the balance sheet of a company is developed using this formula:
In addition to establishing accounts to develop the balance sheet and make entries in the double-entry accounting system, companies must set up accounts that they use to develop the income statement (also known as the profit and loss statement, or P&L), which shows a company's revenue and expenses over a set period of time. (See Chapter 7 for more on revenue and expenses.) The double-entry accounting method impacts not only the way assets and liabilities (balance sheet accounts) are entered, but also the way revenue and expenses (income statement accounts) are entered.
If you're a sales manager tracking how your department is doing for the year, you want to be able to decipher debits and credits. If you think you've found an error, your ability to read reports and understand the impact of debits and credits is critical. For example, anytime you think the income statement doesn't accurately reflect your department's success, you have to dig into the debits and credits to be sure your sales are being booked correctly. You also need to be aware of the other accounts — especially revenue and expense accounts — that are used to book transactions that impact your department.
A common entry that impacts both the balance sheet and the income statement is one that keeps track of the amount of cash customers pay to buy the company's product. If the customers pay $100, here's how the entry looks:
Account |
Debit |
Credit |
Cash |
$100 |
|
Sales revenue |
|
$100 |
In this case, both the Cash account and the Sales revenue account increase. One increases using a debit, and the other increases using a credit. Yikes — I know, accounting can be so confusing! Whether an account increases or decreases from a debit or a credit depends on the type of account it is. See Table 4-1 to find out when debits and credits increase or decrease an account.
Table 4-1 Effect of Debits and Credits
Account |
Debits |
Credits |
Assets |
Increases |
Decreases |
Liabilities |
Decreases |
Increases |
Income |
Decreases |
Increases |
Expenses |
Increases |
Decreases |
For example, each vehicle a company owns loses value throughout the normal course of business every year. Cars and trucks are usually estimated to have five years of useful life, which means the number of years the vehicle will be of use to the company.
Suppose a company pays $30,000 for a car. To calculate its depreciation on a five-year schedule, divide $30,000 by 5 to get $6,000 in depreciation. Each of the five years this car is in service, the company records a depreciation expense of $6,000.
When the company makes the initial purchase of the vehicle using a loan, it records the purchase this way:
Account |
Debit |
Credit |
2008 ABC company car |
$30,000 |
|
Loans payable — Vehicles |
|
$30,000 |
In this transaction, both the debit and the credit increase the accounts affected. The debit recording the car purchase increases the total of the assets in the vehicle account, and the credit recording the new loan also increases the total of the loans payable for cars.
The company records its depreciation expenses for the car at the end of each year this way:
Account |
Debit |
Credit |
Depreciation expense |
$6,000 |
|
Accumulated depreciation — Vehicles |
|
$6,000 |
In this case, the debit increases the expense for depreciation. The credit increases the amount accumulated for depreciation. The line item Accumulated depreciation — Vehicles is listed directly below the asset Vehicles on the balance sheet and is shown as a negative number to be subtracted from the value of the Vehicles assets. This way of presenting the information on the balance sheet helps the financial report reader quickly see how old an asset is and how much value and useful life it has. Some financial reports only show the net value of an asset with deprecation already subtracted. In those cases the financial report reader may need to find the detail in the Notes to the Financial Statement.
A similar process, amortization, is used for intangible assets, such as patents. Just as with depreciation, a company must write down the value of a patent as it nears expiration. Amortization expenses appear on the income statement, and the balance sheet shows the value of the asset. The line item Patent is shown first on the balance sheet, with another line item called Accumulated amortization below it. The Accumulated amortization line shows how much has been written down against the asset in the current year and any past years. The financial report reader thus has a way to quickly calculate how much value is left in a company's patents.
A company groups the accounts it uses to develop the financial statements in the Chart of Accounts, which is a listing of all open accounts that the accounting department can use to record transactions, according to the role of the accounts in the statements. All businesses have a Chart of Accounts, even if it's so small that they don't even realize they do and have never formally gone about designing it.
The Chart of Accounts for a business sort of builds itself as the company buys and sells assets for its use and records revenue earned and expenses incurred in its day-to-day operations.
If you work for a company and have responsibility for its transactions, you'll have a copy of the Chart of Accounts so that you know which account you want to use for each transaction. If you're a financial report reader with no internal company responsibilities, you won't get to see this Chart of Accounts — but you still need to understand what goes into these different accounts to understand what you're seeing in the financial statements.
Each account in a Chart of Accounts is assigned a number. This clearly defined structure helps accountants move from job to job and still quickly get a handle on the Chart of Accounts. Also, because most companies use computerized accounting, the software is developed with these numerical definitions. Some companies make up an alphabetical listing of their Chart of Accounts with numbers in parentheses to make finding accounts easier for managers who are unfamiliar with the structure.
The accounts in the Chart of Accounts appear in the following order:
In the old days, these accounts were recorded on paper, and finding a specific transaction on the dozens or even hundreds of pages was a nightmare. Today, because most companies use computerized accounting, you can easily design a report to find most types of transactions electronically by grouping them according to account type, customer, salesperson, product, or almost any other configuration that helps you decipher the entries.
To help you become familiar with the types of accounts in the Chart of Accounts and the types of transactions in those accounts, I review the most common accounts in this section in the order in which you're most likely to read them in a financial report. I assign the accounts numbers that computer programs most commonly generate, but you may find that your company uses a different numbering system.
Asset accounts come first in the Chart of Accounts, with the most current accounts (ones that the company will use in less than 12 months) listed before the long-term accounts (ones that the company will use in more than 12 months).
Assets that you can hold in your hand are tangible assets, and they include current assets and long-term assets. Current assets are assets that the company will use up in the next 12 months. The following are examples of current-asset accounts:
Long-term assets are assets that a company will hold for more than 12 months. The following are common long-term asset accounts:
Companies also hold intangible assets, which have value but are often difficult to measure. The following are the most common intangible assets in the Chart of Accounts:
Having exclusive rights to a product allows a company to hold off competition, which can mean a lot of extra profits. Patented products can often command a much higher price than products that aren't patented.
Money a company owes to creditors, vendors, suppliers, contractors, employees, government entities, and anyone else who provides products or services to the company is called a liability.
Current liabilities include money owed in the next 12 months. The following accounts record current liability transactions:
Long-term liabilities include money due beyond the next 12 months. Companies use the following accounts to record long-term liability transactions:
Equity accounts reflect the portion of the assets that isn't subject to liabilities and is therefore owned by a company's shareholders. If the company isn't incorporated, the ownership of the partners or sole proprietors is represented in this part of the balance sheet in an account called Owner's equity or Shareholders’ equity. The following is a list of the most common equity accounts:
At the top of every income statement is the revenue the company brings in. This revenue is offset by any costs directly related to it. The top section of the income statement includes sales, cost of goods sold, and gross margin. Below this section, and before the profit and loss section, are the expenses. In this section, I review the key accounts in the Chart of Accounts that make up the income statement (see Chapter 7).
A company records all sales of products or services in revenue accounts. The following accounts record revenue transactions:
A company tracks the costs directly related to the sale of goods or services in cost of goods sold accounts. The details usually appear only on internally distributed income statements and aren't distributed to company outsiders. Cost of goods sold is usually shown as a single line item, but it includes the transactions from all these accounts:
Any costs not directly related to generating revenue are considered expenses. Expenses fall into four categories: operating, interest, depreciation or amortization, and taxes. A large company can have hundreds of expense accounts, so I don't name each one. Instead, I give you a broad overview of the types of expense accounts that fall into each of these categories:
The types of taxes that are expenses for a company include the employer's half of Social Security and Medicare taxes, unemployment taxes and other related payroll taxes that vary depending on state, and corporate taxes, if the company has incorporated. Businesses that aren't incorporated don't have to pay taxes on income. Instead, the owners report that income on their personal tax returns. I talk more about taxes and company structure in Chapter 3.
A company doesn't actually make different kinds of profits, but it has different ways to track a profit and compare its results with similar companies. The three key profit types are gross profit, operating profit, and net profit. In Chapter 11, I discuss how these profit types can test a company's viability.
The gross profit reflects the revenue earned minus any direct costs of generating that revenue, such as costs related to the purchase or production of goods before any expenses, including operating, taxes, interest, depreciation, and amortization. The gross profit isn't actually part of the Chart of Accounts. You calculate the number for the income statement to show the profit a company makes before expenses.
The operating profit is the next profit figure you see on the income statement. This number measures a company's earning power from its ongoing operations. The operating profit is calculated by subtracting operating expenses from gross profit. Some companies include depreciation and amortization expenses in this calculation, calling this line item EBIT, or earnings before interest and taxes.
Interest is a financial decision. A company has the choice to finance new product development or other major projects by selling bonds, taking loans, or issuing stock. If the company chooses to raise money using bonds or loans, it has to pay interest. Money raised by issuing stock doesn't have interest costs. I talk more about this difference and the impact on a company's profits in Chapter 11.
Believe it or not, taxes are also an accounting game. Most corporations report different tax numbers on their financial statements than they pay to the government because of various tax write-offs they're able to use to reduce their tax bill.
Net profit is the bottom line after all costs, expenses, interest, taxes, depreciation, and amortization have been deducted. Net profit reflects how much money a company makes. If the company isn't incorporated, it can pay out the profit to shareholders or company owners, or it can reinvest the money in growing itself. Firms add reinvested money to the retained earnings account on the balance sheet.