Chapter 4

Digging into Accounting Basics

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!

Making Sense of Accounting Methods

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.

Cash-basis accounting

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.

Smaller companies that haven't formally incorporated and most sole proprietors use cash-basis accounting because the system is easier for them to use on their own, meaning that they don't have to hire a large accounting staff.

Accrual accounting

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.

All incorporated companies must use accrual accounting according to the generally accepted accounting principles (GAAP) because revenues are matched to expenses in the same month they occur. If you're reading a corporation's financial reports, what you see is based on accrual accounting.

Why method matters

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:

• Cash-basis accounting: Expenses and revenues aren't carefully matched on a month-to-month basis. The company doesn't recognize expenses until it actually pays the money, even if it incurs the expenses in previous months. Likewise, the business doesn't recognize the revenues it earned in previous months until it actually receives the cash. However, cash-basis accounting excels in tracking the actual cash available, as well as the cash going in and out of the business.
• Accrual accounting: Expenses and revenue are matched, giving a company a better idea of how much it's spending to operate each month and how much profit it's making. The company records (or accrues) expenses in the month incurred, even if it doesn't pay out the cash until the next month. Likewise, the company records revenues in the month it completes the project or ships the product, even if the company hasn't yet received the cash from the customer.

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 you're a small business owner looking to manage your tax bill and you use cash-basis accounting, you can ask vendors to hold payments until the beginning of the next year, to reduce your net income and thereby lower your tax payments for the year.

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.

Understanding Debits and Credits

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.

Forget everything you think you know about debits and credits! You're going to have to erase these assumptions from your mind to understand double-entry accounting, which is the basis of most accounting done in the business world.

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.

Double-entry accounting

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.

Probably at least 95 percent of businesses in the U.S. use double-entry accounting, whether they use the cash-basis or accrual accounting method. It's the only way a business can be certain that it has considered both sides of every transaction.

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:

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:

• Assets = Liabilities + Owner's equity

Profit and loss statements

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.

The effect of debits and credits on sales

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:

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

Make a copy of Table 4-1, and tack it up where you review your department's accounts until you become familiar with the differences.

Depreciation and amortization

Depreciation and amortization are accounting methods you use to track the use of an asset and record its value as it ages. Tangible assets (assets you can touch or hold in your hand, like cars or inventory) are depreciated (reduced in value by a certain percentage each year to show that the company is using up the tangible asset). Intangible assets (like intellectual property or patents) are amortized (reduced in value by a certain percentage each year to show that the company is using up the intangible asset).

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:

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:

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.

Checking Out the Chart of Accounts

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:

• Balance sheet asset accounts (usually in the number range of 1,000 to 1,999)
• Liability accounts (with numbers ranging from 2,000 to 2,999)
• Equity accounts (3,000 to 3,999)
• Income statement accounts/revenue accounts (4,000 to 4,999)
• Expense accounts (5,000 to 6,999)

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

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).

Tangible assets

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:

• Cash in checking: This account is always the first one listed. Businesses use this account most often. They deposit their cash received as revenue and their cash paid out to cover bills and debt.
• Cash in savings: This account is where firms keep cash they don't need for daily operations. It usually earns interest until the company decides how it wants to use this surplus cash.
• Cash on hand: This account tracks the actual cash the company keeps at its business locations. Cash on hand includes money in the cash registers, as well as petty cash. Most companies have several different cash-on-hand accounts. For example, a store may have its own account for tracking cash in the registers, and each department may have its own petty cash account. How these accounts are structured depends on the company and the security controls it has in place to manage the cash on hand. Companies always leave plenty of room for additions in this account category.
• Accounts receivable: In this account, businesses record transactions in which customers bought products on store or company credit. Only companies that use the accrual method of accounting need this account.
• Inventory: This account tracks the cost of products the company has available for sale, whether it purchases the products from other companies or produces them in-house. Businesses adjust this account periodically throughout the year to reflect the changes in inventory affected by sales or other factors, such as breakage or theft. Although some firms use a computerized inventory system that adjusts the account almost instantaneously, others adjust the account only at the end of an accounting period.

Long-term assets are assets that a company will hold for more than 12 months. The following are common long-term asset accounts:

• Land: This account records any purchases of land as a company asset. Companies list land separately because it doesn't depreciate in value like the building or buildings sitting on it do.
• Buildings: This account lists the value of any buildings the company owns. This value is always a positive number.
• Accumulated depreciation: This account tracks the depreciation of company-owned buildings. Each year, the firm deducts a portion of the building's value based on the building's costs and the number of years the building will have a productive life.
• Leasehold improvements: This account tracks improvements to buildings that the company leases rather than buys. In most cases, when a company leases retail or warehouse space, it must pay the costs of improving the property for its unique business use. These improvements are also depreciated, so the company uses a companion depreciation account called Accumulated depreciation — Leasehold improvements.
• Vehicles: This account tracks the cars, trucks, and other vehicles that a business owns. The initial value added to this account is the value of the vehicles when put into service. Vehicles are also depreciated, and the depreciation account is Accumulated depreciation — Vehicles.
• Furniture and Fixtures: This account tracks all the desks, chairs, and other fixtures a company buys for its offices, warehouses, and retail stores. Yes, these items, too, are depreciated, and the depreciation account is named Accumulated depreciation — Furniture and fixtures.
• Equipment: This account tracks any equipment a company purchases that's expected to have a useful life of more than one year. This equipment includes computers, copiers, cash registers, and any other equipment needs. The depreciation account is Accumulated depreciation — Equipment.

Intangible assets

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:

• Goodwill: A company needs this account only when it has bought another company. Frequently, a business that purchases another business pays more than the actual value of its assets minus its liabilities. The premium paid, which may account for factors such as customer loyalty, an exceptional workforce, and a great location, is listed on the books as goodwill.
• Intellectual property: This category includes copyrights, patents, and written work or products for which the company has been granted exclusive rights. For example, the government grants patents to a company or individual that invents a new product or process. These assets are amortized, which is similar to depreciation, because intellectual property has a limited lifespan. The amortization account is Accumulated amortization — Intellectual property.

  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.

Liability accounts

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

Current liabilities include money owed in the next 12 months. The following accounts record current liability transactions:

• Accounts payable: This account includes all the payments to suppliers, vendors, contractors, and consultants that are due in less than one year. Most of the payments made on these accounts are for invoices due in less than two months.
• Sales tax collected: This account tracks taxes collected for the state, local, or federal government on merchandise the company has sold. Firms record daily transactions in this account as they collect cash and make payments (usually monthly) to government agencies.
• Accrued payroll taxes: This account includes any taxes that the company must pay to the state or federal government, based on taxes withheld from employees’ checks. These payments are usually made monthly or quarterly.
• Credit card payable: This account tracks the payments to corporate credit cards. Some companies use these accounts as management tools for tracking employee activities and set them up by employee name, department name, or whatever method the company finds useful for monitoring credit card use.

Long-term liabilities

Long-term liabilities include money due beyond the next 12 months. Companies use the following accounts to record long-term liability transactions:

• Loans payable: This account tracks debts, such as mortgages or loans on vehicles, that are incurred for longer than one year.
• Bonds payable: This account tracks corporate bonds that have been issued for a term longer than one year. Bonds are a type of debt sold on the market that must be repaid in full with interest.

Equity accounts

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:

• Common stock: This account reflects the value of the outstanding shares of common stock. Each share of common stock represents a portion of ownership, and this portion is calculated by multiplying the number of outstanding shares by the value of each share. Even companies that haven't sold stock in the public marketplace, but have incorporated, list shareholders on the incorporation documents and list the value of their shares on the balance sheet. Each common stock shareholder has a vote in the company's operations.
• Preferred stock: This account reflects the value of outstanding shares of preferred stock, which falls somewhere between bonds and shares of stock. Although a company has no obligation to repay the preferred shareholders for their investment, it does promise these shareholders dividends. If the company can't pay the dividends for some reason, they're accrued for payment in later years. Any unpaid preferred stock dividends must be paid before a company pays dividends to common stock shareholders. Preferred shareholders don't vote in the firm's operations. If the business is liquidated, preferred shareholders receive their share of the assets before common shareholders.
• Retained Earnings: This account tracks the profits or losses for a company each year. These numbers reflect earnings retained instead of being paid out as dividends to shareholders. They show a company's long-term success or failure.

Revenue 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).

Revenue

A company records all sales of products or services in revenue accounts. The following accounts record revenue transactions:

• Sales of goods or services: This account tracks the company's revenues for the sale of its products or services.
• Sales discounts: This account tracks any discounts the company offers to increase its sales. If a company is heavily discounting its products, either it may be competing intensely or interest in the product may be falling. A company outsider probably doesn't see these numbers, but if you're reading the reports prepared for internal management, this account gives you a view of how discounting is used.
• Sales returns and allowances: This account tracks problem sales from unhappy customers. A large number here may reflect customer dissatisfaction, which could be the result of a quality-control problem. A company outsider probably doesn't see these numbers, but internal management financial reports show this information. A dramatic increase in this number is usually a red flag for company management.

Cost of goods sold

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:

• Purchases: This account tracks the cost of merchandise a company buys. A manufacturing company has an extensive tracking system for its cost of goods that includes accounts for items like raw materials, components, and labor to produce the final product.
• Purchase discounts: This account tracks any cost savings a company is able to negotiate because of accelerated payment plans or volume buying. For example, if a vendor offers a 2 percent discount when a customer pays an invoice within 10 days rather than the normal 30 days, the vendor tracks this cost saving in purchase discounts.
• Purchase returns and allowances: This account tracks any transactions involving the return of any damaged or defective products to the manufacturer or vendor.
• Freight charges: This account tracks the costs of shipping the goods sold.

Expense 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:

• Operating expenses: The largest share of expense accounts falls under the umbrella of operating expenses, which include advertising, dues and subscriptions, equipment rental, store rental, insurance, legal and accounting fees, meals, entertainment, salaries, office expenses, postage, repairs and maintenance, supplies, travel, telephone, utilities, vehicle expenses, and just about anything else that goes into the cost of operating a business and isn't directly related to selling a company's products.
• Interest expenses: Interest paid on a company's debt is reflected in the accounts for interest expenses — credit cards, loans, bonds, or any other type of debt the company may carry.
• Depreciation and amortization expenses: I discuss how depreciation is calculated in “Depreciation and amortization,” earlier in this chapter. The process for amortization is similar. The depreciation and amortization accounts track the amount written off each year for any type of asset, and the income statement shows expenses related to depreciation and amortization in each individual year.
• Taxes: A company pays numerous types of taxes. Sales taxes aren't listed in the expense area because they're paid by customers and accrued as a liability until paid. Taxes withheld from employee paychecks are also accrued as a liability and aren't listed as an expense.

  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.

Differentiating Profit Types

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.

Gross profit

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.

Operating profit

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.

Others add an additional line called EBITDA, or earnings before interest, taxes, depreciation, and amortization. Accountants started using EBITDA in the 1980s because it gave analysts a number they could use to compare profitability among companies and eliminated the effects of financing and accounting.

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.

Companies don't actually pay out cash for depreciation and amortization expenses. Instead, depreciation and amortization are an accounting requirement that comes into play when determining the value of assets.

Net profit

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.