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Accounting

FOR

DUMmIES

4 TH EDITION

By John A. Tracy, CPA

Accounting

FOR

DUMmIES

4 TH EDITION

Accounting For Dummies®, 4th Edition Published by Wiley Publishing, Inc. 111 River St. Hoboken, NJ 07030- www.wiley.com Copyright © 2008 by Wiley Publishing, Inc., Indianapolis, Indiana Published by Wiley Publishing, Inc., Indianapolis, Indiana Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600. Requests to the Publisher for permission should be addressed to the Legal Department, Wiley Publishing, Inc., 10475 Crosspoint Blvd., Indianapolis, IN 46256, 317-572-3447, fax 317-572-4355, or online at http:// www.wiley.com/go/permissions. Trademarks: Wiley, the Wiley Publishing logo, For Dummies, the Dummies Man logo, A Reference for the Rest of Us!, The Dummies Way, Dummies Daily, The Fun and Easy Way, Dummies.com and related trade dress are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries, and may not be used without written permission. All other trademarks are the property of their respective owners. Wiley Publishing, Inc., is not associated with any product or vendor mentioned in this book.

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Library of Congress Control Number: 2008926448

ISBN: 978-0-470-24600-

Manufactured in the United States of America

10 9 8 7 6 5 4 3 2 1

Dedication

For our grandchildren — Alexander, Ryan, Mitchel, Paige, Katrina, Claire, Eric, MacKenzie, Madison, Tanner, Karsen, and Brody.

Author’s Acknowledgments

I’m deeply grateful to everyone at Wiley Publishing who helped produce this book. Their professionalism, courtesy, and good humor were much appreci- ated. I supplied some words, and the editors and production staff at Wiley molded them into the finished product.

Out of the blue, I got a call in 1996 from Kathy Welton, then Vice President and Publisher for the Consumer Publishing Group of the For Dummies books. Kathy asked if I’d be interested in doing this book. It didn’t take me very long to say yes. Thank you again, Kathy!

I can’t say enough nice things about Pam Mourouzis, who was project editor on the first edition of the book. The book is immensely better for her insights and advice. The two copyeditors on the book — Diane Giangrossi and Joe Jansen — did a wonderful job. Mary Metcalfe provided valuable suggestions on the manuscript. Thanks to Holly McGuire and Jill Alexander who encour- aged me to revise the book. The second edition benefited from the editing by Norm Crampton and Ben Nussbaum.

I thank Stacy Kennedy, acquisitions editor, for asking me to do this and the previous revision. Joan Friedman was the project editor on this and the previous edition. Evidently, Wiley assigned me the best editor they have. Joan kept a steady hand on the tiller as we sailed through the choppy waters of the revisions. Joan was a delight to work with, and it goes without saying that she made the book much better. Thank you most sincerely Joan, and I hope to work with you again on the next revision.

One reason I like to write books goes back to an accounting class in my undergraduate days at Creighton University in Omaha. I took a course taught by the Dean of the Business School, Dr. Floyd Walsh. I turned in a term paper, and he said that it was very well written. I have never forgotten that compli- ment. I think my old Prof would be proud of this book and might even give me an “A” on the assignment.

Contents at a Glance

• Introduction .................................................................
• Part I: Opening the Books on Accounting......................
• Chapter 1: Accounting: The Language of Business, Investing, Finance, and Taxes....
• Chapter 2: Financial Statements and Accounting Standards......................................
• Chapter 3: Bookkeeping and Accounting Systems.......................................................
• Part II: Figuring Out Financial Statements ...................
• Chapter 4: Reporting Revenue, Expenses, and the Bottom Line................................
• Chapter 5: Reporting Assets, Liabilities, and Owners’ Equity....................................
• Chapter 6: Reporting Cash Flows .................................................................................
• Chapter 7: Choosing Accounting Methods: Different Strokes for Different Folks....
• Part III: Accounting in Managing a Business ..............
• Chapter 8: Deciding the Legal Structure for a Business............................................
• Chapter 9: Analyzing and Managing Profit ..................................................................
• Chapter 10: Financial Planning, Budgeting, and Control...........................................
• Chapter 11: Cost Concepts and Conundrums ............................................................
• Part IV: Preparing and Using Financial Reports ..........
• Chapter 12: Getting a Financial Report Ready for Release .......................................
• Chapter 13: How Lenders and Investors Read a Financial Report...........................
• Chapter 14: How Business Managers Use a Financial Report ..................................
• Chapter 15: Audits and Accounting Fraud ..................................................................
• Part V: The Part of Tens ............................................
• Chapter 16: Ten Accounting Tips for Managers .........................................................
• Chapter 17: Ten Tips for Reading a Financial Report ................................................
• Jargon Jungle ........................................................... Glossary: Slashing Through the Accounting
• Index .......................................................................
• Introduction..................................................................
• About This Book...............................................................................................
• Conventions Used in This Book .....................................................................
• What You’re Not To Read ................................................................................
• Foolish Assumptions .......................................................................................
• How This Book Is Organized...........................................................................
• Part I: Opening the Books on Accounting ...........................................
• Part II: Figuring Out Financial Statements...........................................
• Part III: Accounting in Managing a Business .......................................
• Part IV: Preparing and Using Financial Reports .................................
• Part V: The Part of Tens.........................................................................
• Glossary...................................................................................................
• Icons Used in This Book..................................................................................
• Where to Go from Here....................................................................................
• Part I: Opening the Books on Accounting ......................
• Investing, Finance, and Taxes. Chapter 1: Accounting: The Language of Business,
• Accounting Is Not Just for Accountants......................................................
• Affecting both insiders and outsiders ...............................................
• Overcoming the stereotypes of accountants....................................
• Relating accounting to your personal financial life .........................
• Looking for Accounting in All the Right Places..........................................
• Taking a Peek into the Back Office...............................................................
• Focusing on Transactions .............................................................................
• Taking the Pulse of a Business: Financial Statements ...............................
• Meeting the balance sheet and the accounting equation ...............
• Reporting profit and loss, and cash flows.........................................
• Respecting the importance of this trio..............................................
• Considering Accounting Careers .................................................................
• Certified public accountant (CPA) .....................................................
• The controller: The chief accountant in an organization................
• A springboard to other careers ..........................................................
• Chapter 2: Financial Statements and Accounting Standards.
• Introducing the Information Content of Financial Statements.................
• Setting up the business example........................................................
• The income statement .........................................................................
• The balance sheet ................................................................................
• The statement of cash flows ...............................................................
• How Profit and Cash Flow from Profit Differ ..............................................
• Gleaning Key Information from Financial Statements ...............................
• How’s profit performance?..................................................................
• Is there enough cash? ..........................................................................
• Are the books cooked?..................................................................... Can you trust the financial statement numbers?
• Why no cash distribution from profit? ..............................................
• Keeping in Step with Accounting and Financial Reporting Standards ....
• Recognizing U.S. standards .................................................................
• Getting to know the U.S. standard setters ........................................
• Going worldwide...................................................................................
• Noting a divide between public and private companies.................
• accounting methods......................................................................... Recognizing how income tax methods influence
• Following the rules and bending the rules........................................
• Chapter 3: Bookkeeping and Accounting Systems.
• Bookkeeping and Beyond..............................................................................
• Pedaling Through the Bookkeeping Cycle ..................................................
• Managing the Bookkeeping and Accounting System.................................
• Categorize your financial information: The chart of accounts.......
• Standardize source document forms and procedures ....................
• Hire competent, trained personnel....................................................
• Enforce strong — I mean strong! — internal controls .....................
• Complete the process with end-of-period procedures....................
• Leave good audit trails ........................................................................
• Look out for unusual events and developments ..............................
• Design truly useful reports for managers .........................................
• Double-Entry Accounting for Single-Entry Folks........................................
• Juggling the Books to Conceal Embezzlement and Fraud ........................
• Using Accounting Software ...........................................................................
• Part II: Figuring Out Financial Statements ....................
• Chapter 4: Reporting Revenue, Expenses, and the Bottom Line.
• Presenting a Typical Income Statement ......................................................
• Taking care of some housekeeping details .......................................
• Your job: Asking questions!.................................................................
• Finding Profit ..................................................................................................
• Getting Particular about Assets and Liabilities..........................................
• Making sales on credit → Accounts receivable asset......................
• Selling products → Inventory asset ...................................................
• Prepaying operating costs → Prepaid expense asset......................
• Fixed assets → Depreciation expense ...............................................
• payable, and income tax payable .................................................. Unpaid expenses → Accounts payable, accrued expenses
• Summing Up the Financial Effects of Profit.................................................
• Reporting Extraordinary Gains and Losses................................................
• Closing Comments .........................................................................................
• Chapter 5: Reporting Assets, Liabilities, and Owners’ Equity.
• Understanding That Transactions Drive the Balance Sheet.....................
• Presenting a Balance Sheet.........................................................................
• Kicking balance sheets out into the real world ..............................
• Internal balance sheets............................................................
• External balance sheets ...........................................................
• Judging solvency ................................................................................
• Current (short-term) assets ....................................................
• Current (short-term) liabilities ...............................................
• Current ratio..............................................................................
• Preparing multiyear statements .......................................................
• Coupling the Income Statement and Balance Sheet ................................
• Sizing up assets and liabilities ..........................................................
• Sales revenue and accounts receivable...........................................
• Cost of goods sold expense and inventory.....................................
• Fixed assets and depreciation expense...........................................
• SG&A expenses and their three balance sheet accounts..............
• Intangible assets and amortization expense ..................................
• Debt and interest expense ................................................................
• Income tax expense and income tax payable .................................
• Net income and cash dividends (if any)..........................................
• Financing a Business....................................................................................
• Costs and Other Balance Sheet Values......................................................
• Chapter 6: Reporting Cash Flows.
• Seeing the Big Picture of Cash Flows.........................................................
• Meeting the Statement of Cash Flows .......................................................
• Dissecting the Difference Between Cash Flow and Net Income .............
• Accounts receivable change .............................................................
• Inventory change................................................................................
• Prepaid expenses change..................................................................
• The depreciation factor.....................................................................
• Changes in operating liabilities ........................................................
• Putting the cash flow pieces together .............................................
• Sailing Through the Rest of the Statement of Cash Flows ......................
• Investing activities .............................................................................
• Financing activities ............................................................................
• Trying to Pin Down “Free Cash Flow”........................................................
• Being an Active Reader ...............................................................................
• Different Strokes for Different Folks. Chapter 7: Choosing Accounting Methods:
• Reading Statements with a Touch of Skepticism .....................................
• Recognizing a business’s bias...........................................................
• Contrasting aggressive and conservative numbers.......................
• Figuring Out Why Financial Statements Differ .........................................
• Cash balance .......................................................................................
• Accounts receivable balance ............................................................
• Inventory and cost of goods sold expense .....................................
• and depreciation expense ............................................................. Cost of fixed assets, accumulated depreciation,
• Accrued expenses payable liability balance...................................
• Wrapping things up ............................................................................
• Calculating Cost of Goods Sold and Cost of Inventory ...........................
• The FIFO (first-in, first-out) method.................................................
• The LIFO (last-in, first-out) method .................................................
• The average cost method..................................................................
• or Market (LCM) Rule .............................................................................. Recording Inventory Losses under the Lower of Cost
• Appreciating Depreciation Methods..........................................................
• Scanning the Expense Horizon ...................................................................
• Part III: Accounting in Managing a Business...............
• Chapter 8: Deciding the Legal Structure for a Business.
• Studying the Sources of Business Capital.................................................
• Deciding on debt ................................................................................
• Tapping two sources of owners’ equity...........................................
• Recognizing the Legal Roots of Business Entities ...................................
• 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........
• Considering Partnerships and Limited Liability Companies..................
• Going It Alone: Sole Proprietorships .........................................................
• Choosing the Right Legal Structure for Income Tax ................................
• C corporations ....................................................................................
• S corporations ....................................................................................
• Partnerships and LLCs ......................................................................
• Chapter 9: Analyzing and Managing Profit.
• Helping Managers Do Their Jobs ...............................................................
• Following the organizational structure............................................
• Centering on profit centers ...............................................................
• Presenting a P&L Template.........................................................................
• of expenditure basis ....................................................................... Reporting operating expenses on the object
• Reporting operating expenses on their cost behavior basis........
• Separating variable and fixed expenses ..........................................
• Variable expenses .....................................................................
• Fixed expenses..........................................................................
• Stopping at operating earnings ........................................................
• Focusing on margin — the catalyst of profit...................................
• Answering Two Critical Profit Questions ..................................................
• How did you make profit? .................................................................
• How did you increase profit? ............................................................
• Looking More Closely at the Profit Center P&L Report ..........................
• Sales volume .......................................................................................
• Sales revenue ......................................................................................
• Cost of goods sold..............................................................................
• Variable operating expenses.............................................................
• Fixed operating expenses..................................................................
• Using the P&L Template for Decision-Making Analysis...........................
• Tucking Away Some Valuable Lessons ......................................................
• operating expenses ........................................................................ Recognize the leverage effect caused by fixed
• changes in sales price .................................................................... Don’t underestimate the impact of small
• Know your options for improving profit .........................................
• Closing with a Boozy Example....................................................................
• Chapter 10: Financial Planning, Budgeting, and Control.
• Exploring the Reasons for Budgeting ........................................................
• Modeling reasons for budgeting.......................................................
• Planning reasons for budgeting........................................................
• Management control reasons for budgeting...................................
• Additional benefits of budgeting, and a note of caution ...............
• Realizing That Not Everyone Budgets.......................................................
• Avoiding budgeting ............................................................................
• Relying on internal accounting reports...........................................
• Making reports useful for management control ...................
• Making reports useful for decision-making ...........................
• Making reports clear and straightforward ............................
• Watching Budgeting in Action ....................................................................
• Developing your profit strategy and budgeted profit report........
• Budgeting cash flow for the coming year........................................
• Considering Capital Expenditures and Other Cash Needs .....................
• Chapter 11: Cost Concepts and Conundrums.
• Looking down the Road to the Destination of Costs ...............................
• Are Costs Really That Important? ..............................................................
• Becoming More Familiar with Costs ..........................................................
• Direct versus indirect costs ..............................................................
• Fixed versus variable costs...............................................................
• Relevant versus irrelevant costs ......................................................
• Actual, budgeted, and standard costs .............................................
• Product versus period costs.............................................................
• Assembling the Product Cost of Manufacturers ......................................
• Minding manufacturing costs ...........................................................
• Classifying costs properly.................................................................
• Calculating product cost ...................................................................
• Examining fixed manufacturing costs and production capacity......
• The burden rate ........................................................................
• Idle capacity ..............................................................................
• The effects of increasing inventory........................................
• Puffing Profit by Excessive Production .....................................................
• Shifting fixed manufacturing costs to the future............................
• Cranking up production output........................................................
• of kilter with sales volume............................................................. Being careful when production output is out
• Part IV: Preparing and Using Financial Reports...........
• Chapter 12: Getting a Financial Report Ready for Release.
• Recognizing Management’s Role................................................................
• Keeping in Mind the Purpose of Financial Reporting..............................
• Staying on Top of Accounting and Financial Reporting Standards .......
• Making Sure Disclosure Is Adequate .........................................................
• Footnotes: Nettlesome but needed ..................................................
• Other disclosures in financial reports .............................................
• Putting a Spin on the Numbers (But Not Cooking the Books) ...............
• Window dressing for fluffing up the cash balance .........................
• Sanding the rough edges off profit ...................................................
• The pressure on public companies ........................................
• Compensatory effects ..............................................................
• Two profit histories ..................................................................
• of revenue and expenses...................................................... Management discretion in the timing
• Going Public or Keeping Things Private ...................................................
• Reports from publicly owned companies .......................................
• Reports from private businesses .....................................................
• Dealing with Information Overload............................................................
• Browsing based on your interests....................................................
• Recognizing condensed versions .....................................................
• Using other sources of business information.................................
• Statement of Changes in Owners’ Equity..................................................
• Chapter 13: How Lenders and Investors Read a Financial Report.
• Knowing the Rules of the Game .................................................................
• Becoming a More Savvy Investor...............................................................
• Comparing Private and Public Business Financial Reports....................
• Analyzing Financial Statements with Ratios.............................................
• Gross margin ratio..............................................................................
• Profit ratio ...........................................................................................
• Earnings per share (EPS), basic and diluted...................................
• Price/earnings (P/E) ratio .................................................................
• Dividend yield .....................................................................................
• Book value and book value per share..............................................
• Return on equity (ROE) ratio............................................................
• Current ratio .......................................................................................
• Acid-test ratio .....................................................................................
• Return on assets (ROA) ratio and financial leverage gain ............
• Frolicking Through the Footnotes .............................................................
• Checking for Ominous Skies in the Auditor’s Report ..............................
• Chapter 14: How Business Managers Use a Financial Report.
• Building on the Foundation of the External Financial Statements ........
• Seeking out problems and opportunities........................................
• Avoiding information overload.........................................................
• Gathering Financial Condition Information ..............................................
• Cash......................................................................................................
• Accounts receivable...........................................................................
• Inventory .............................................................................................
• Prepaid expenses ...............................................................................
• Fixed assets and accumulated depreciation...................................
• Accounts payable ...............................................................................
• Accrued expenses payable ...............................................................
• Income tax payable ............................................................................
• Interest-bearing debt..........................................................................
• Owners’ equity....................................................................................
• Culling Profit Information............................................................................
• Margin: The catalyst of profit ...........................................................
• Sales revenue and expenses .............................................................
• Digging into Cash Flow Information...........................................................
• from operating cash flows ............................................................. Distinguishing investing and financing cash flows
• Managing operating cash flows ........................................................
• Chapter 15: Audits and Accounting Fraud.
• Exploring the Need for Audits ....................................................................
• What’s in an Auditor’s Report ....................................................................
• The clean (unqualified) opinion .......................................................
• Other kinds of audit opinions ...........................................................
• Who’s Who in the World of Audits.............................................................
• Standing Firm When Companies Massage the Numbers, or Not ...........
• Discovering Fraud, or Not...........................................................................
• Who Audits the Auditors?...........................................................................
• Part V: The Part of Tens .............................................
• Chapter 16: Ten Accounting Tips for Managers.
• Reach Break-Even, and Then Rake in Profit..............................................
• Set Sales Prices Right...................................................................................
• Distinguish Profit from Cash Flow .............................................................
• Call the Shots on Accounting Policies.......................................................
• Budget Wisely ...............................................................................................
• Get the Accounting Information You Need ...............................................
• Tap into Your CPA’s Expertise.....................................................................
• Critically Review Your Fraud Controls ......................................................
• Lend a Hand in Preparing Your Financial Reports...................................
• Sound Like a Pro in Talking about Your Financial Statements ...............
• Chapter 17: Ten Tips for Reading a Financial Report.
• Get in the Right Frame of Mind ..................................................................
• Decide What to Read ...................................................................................
• Improve Your Accounting Savvy ................................................................
• Judge Profit Performance............................................................................
• Track Profit into Earnings per Share .........................................................
• Confront Extraordinary Gains and Losses................................................
• Compare Cash Flow and Profit ...................................................................
• Look for Signs of Financial Distress ...........................................................
• Recognize the Risks of Restatement and Fraud .......................................
• Remember the Limits of Financial Reports ..............................................
• Jargon Jungle............................................................ Glossary: Slashing Through the Accounting
• Index........................................................................