Accounting Basics in Easy Language

Accounting Basics
DR.WAYNEA.LABEL,CPA
Thefastandeasywaytolearnthe
basics
Demystifydebitsandcredits
Readafinancialstatement
Understandqualityofearnings
Understandcorporatetransactions
Howtoputtogetheranincomestatement
Thecashflowstatement
Createandmanagebudgetseffectively
Workwithauditors
Whatarethekeyratiosinunderstandingyourbusiness
Manageyourbusinessbetter
throughexpertaccountingexplanations,examples,techniquesandtips!
Manageyourbusinessbetter
throughexpertaccountingexplanations,examples,techniquesandtips!
ACCOUNTING
NONACCOUNTANTS
http://elib.ntt.edu.vn/
Thefastandeasyway
tolearnthebasics
DR.WAYNEA.LABEL,CPA
Copyright2006byWayneA.Label
Coverandinternaldesign2006bySourcebooks,Inc.
Copyright2005StationCasinos,Inc;Design:KuhlmannLeavitt,Inc.,St.Louis
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Label,WayneA.(WayneAllan)
Accountingfornonaccountants:thefastandeasywaytolearnthebasics/Wayne
Label.
p.cm.ISBN13:9781402214837
Includesbibliographicalreferencesandindex.
ISBN13:9781402206573
ISBN10:1402206577
1.Accounting.2.Financialstatements.I.Title.II.Title:Accountingfornonaccoun
tants.
HF5636.L332006
657dc22
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PrintedandboundintheUnitedStatesofAmerica.
DR10987654321
Contents
ACKNOWLEDGMENTS.......................................ix
INTRODUCTION.............................................1
CHAPTER1:IntroducingAccountingandFinancialStatements......3
WhatIsAccounting?
WhoUsesAccountingInformation?
FinancialStatements
HowDifferentBusinessEntitiesPresentAccountingInformation
CHAPTER2:GenerallyAcceptedAccountingPrinciples...........13
WhoAretheSEC,AICPA,andtheFASB?
GenerallyAcceptedAccountingPrinciples(GAAP)
CHAPTER3:TheBalanceSheetandItsComponents.............25
UnderstandingtheBalanceSheet
TheAccountingEquation
TheComponentsoftheBalanceSheet
TheTransactionsBehindtheBalanceSheet
CHAPTER4:TheIncomeStatement...........................45
UnderstandingtheIncomeStatement
TheIncomeStatementIllustrated
TransactionsThatEffecttheIncomeStatement
CHAPTER5:PreparingandUsingaStatementofCashFlows.....65
WhatIsaStatementofCashFlows?
CashandCashEquivalents
TheStatementofCashFlowsIllustrated
CHAPTER6:DoubleEntryAccounting.........................75
TheGeneralJournal
TheGeneralLedger
AdjustingJournalEntries
ClosingJournalEntries
CHAPTER7:TheCorporation...............................101
TheCorporationDefined
WhatIsCapitalStock?
DividendsandSplits
IncorporatingSolanaBeachBicycleCompany
WhatIsTreasuryStock?
CHAPTER8:UsingFinancialStatementsforShortTermAnalysis..125
UsingShortTermRatios
CurrentandQuickRatios
WorkingCapital
CompositionofAssets
CHAPTER9:UsingFinancialStatementsforLongTermAnalysis..137
QualityofEarnings
RateofReturnonInvestment
SalesBasedRatiosorPercentages
EarningsData
LongTermDebtPosition
DividendData
Footnotes
CHAPTER10:BudgetingforYourBusiness....................149
WhatIsaBudget?
PlanningandControl
AdvantagesofBudgeting
TheMasterBudget
SalesBudget
CapitalBudget
BudgetedIncomeStatement
TheCashBudget
CHAPTER11:AuditsandAuditors...........................159
WhatIsanAudit?
TypesofAuditors
TheStandardAuditOpinionIllustrated
ThePartsoftheReport
OtherTypesofAuditReports
WhyAuditsAreUsefultoYou
APPENDIXA:InternetforAccountants.......................171
APPENDIXB:FinancialStatementsStationCasinos,Inc.........175
INDEX..................................................221
ABOUTTHEAUTHOR......................................227
Acknowledgments
IwouldliketothankEwuramaEwusiMensahandRachelJayat
Sourcebooksfortheirtirelesseffortstomakethisbookreadableandunder
standabletothenonaccountantsoftheworld.
IwouldalsoliketothankDrs.BruceLubichandRichardSamuelsonfor
theirtimeandeffortinreadingthemanuscript,addingvaluableinsights,
andmakingthebookabetterread.
Finally,Iwouldliketothankthethousandsofstudentsandusersofmy
previousbookonthissametopicwhosecommentsandsuggestionshave
helpedtoimprovethisbook.
Introduction
Whatisaccounting?Whoneedsit?Howdoesitbenefitbusinesses?Thisbookanswersthosequestionsforthe
nonaccountant.Accountingprovidesinformationthathelpspeopleinbusinessincreasetheirchancesof
makingdecisionsthatwillbenefittheircompanies.Accountingisthelanguageofbusiness,andlikeother
languages,ithasitsowntermsandrules.Understandingthislanguageandlearningtointerpretitisyourfirst
steptobecomingsuccessfulinyourownbusinessandinyourpersonalfinanciallifeaswell.Inyourpersonal
lifeyoucanuseaccountinginformationtomakedecisionsaboutinvestinginthestockmarket,applyingfora
loan,andevaluatingpotentialjobs.Banksuseaccountinginformationtomakedecisionsaboutgrantingloans.
Governmentagenciesbasetheirregulationsonaccountinginformation.Accountinginformationcanevenbe
usefultononbusinessentitieswithaninterestinhowbusinessesaffectlocal,national,orforeigncommunities
andcommunitymembers.Businessesuseaccountinginformationforplanningandbudgetingandformaking
decisionsaboutborrowingandinvesting.
Overall,accountingaidsbusinessesintheprocessofmakingbetterdecisions.
Thebasicsofaccountingarethesameregardlessofthesizeortypeofbusiness.InAccountingforNon
Accountants,youwilllearnthebasicsofaccountingthroughtheexaminationofanimaginarysmallbusiness,
SolanaBeachBicycleCompany.Formorecomplexbusinesses,theeconomictransactionsbecomemore
variedandcomplexasdoestheprocessofreportingthemtovarioususers.Thefoundationofitall,however,
remainsthesame.Thisbookwillgiveyouasolidfoundationyouwillbeabletouseinanyaccounting
situationyouencounter.Whetheryouownabusinessordonot,evenifyouveneverhadanyexperiencewith
accountingandfinancialstatements,thisisthebookforyou.
Ihopethatyoufindthisbookusefulinhelpingyoutounderstandtheseaccountingissuesastheyapplytoyour
smallbusinessandtoyourpersonallife.Pleasefeelfreetocontactmeatwayne@waynelabel.comwithyour
thoughtsonthebook.
WhatIsAccounting?
FinancialStatements
HowDifferentBusinessEntitiesPresent
AccountingInformation
Introducing
Accountingand
FinancialStatements
Chapter
1
WhatIsAccounting?
Thepurposeofaccountingistoprovideinformationthatwillhelpyou
makecorrectfinancialdecisions.Youraccountantsjobistogiveyouthe
informationyouneedtorunyourbusinessasefficientlyaspossiblewhile
maximizingprofitsandkeepingcostslow.
QUICKTip
FindinganAccountant:Hiringaprofessionalandethicalaccountanttoaid
inyourbusinessoperationscanbecriticaltothesuccessofyourcompany.
Meetwithafewaccountantsbeforemakingafinalchoicesothatyouknow
youroptionsandcanselectonewhoseexperienceandworkstylewillbe
bestsuitedtoyourneedsandtheneedsofyourbusiness.Localchaptersof
yourstatesocietiesofCPAsofferreferralservicesthatcanhelpwiththis.
Accountingplaysaroleinbusinessesofallsizes.Yourkidslemonade
stand,aonepersonbusiness,andamultinationalcorporationallusethe
samebasicaccountingprinciples.Accountingislegislated;itaffectsyour
taxes;eventhepresidentplaysaroleinhowaccountingaffectsyou.Thelist
goesonandon.
Accountingisthelanguageofbusiness.Itistheprocessofrecording,
classifying,andsummarizingeconomiceventsthroughcertaindocuments
orfinancialstatements.Likeanyotherlanguage,accountinghasitsown
termsandrules.Tounderstandhowtointerpretandusetheinformation
accountingprovides,youmustfirstunderstandthislanguage.
Understandingthebasicconceptsofaccountingisessentialtosuccessin
business.
Differenttypesofinformationfurnishedbyaccountantsareshownin
Figure1.1onthenextpage.
Figure1.1:TYPESOFINFORMATION
PROVIDEDBYACCOUNTANTS
Informationpreparedexclusivelybypeoplewithinacompany
(managers,employees,orowners)fortheirownuse.
Financialinformationrequiredbyvariousgovernmentagenciessuch
astheInternalRevenueService(IRS),SecuritiesandExchange
Commission(SEC),andtheFederalTradeCommission(FTC).
Generalinformationaboutcompaniesprovidedtopeopleoutsidethe
firmsuchasinvestors,creditors,andlaborunions.
AccountingandBookkeeping
Bookkeepingproceduresandbookkeepersrecordandkeeptrackofthe
businesstransactionsthatarelaterusedtogeneratefinancialstatements.
Mostbookkeepingprocedureshavebeensystematized,and,inmany
cases,canbehandledbycomputerprograms.Bookkeepingisavery
importantpartoftheaccountingprocess,butitisjustthebeginning.
Thereiscurrentlynocertificationrequiredtobecomeabookkeeperin
theUnitedStates.
Accountingistheprocessofpreparingandanalyzingfinancialstatements
basedonthetransactionsrecordedthroughthebookkeepingprocess.
Accountantsareusuallyprofessionalswhohavecompletedatleastabache
lorsdegreeinaccounting,andoftenhavepassedaprofessionalexamination,
liketheCertifiedPublicAccountantExamination,theCertifiedManagement
AccountantExamination,ortheCertifiedFraudAuditorExamination.
Accountinggoesbeyondbookkeepingandtherecordingofeconomic
informationtoincludethesummarizingandreportingofthisinformation
inawaythatismeanttodrivedecisionmakingwithinabusiness.
Intheworldofbusiness,accountingplaysanimportantroletoaidinmak
ingcriticaldecisions.Themorecomplexthedecision,themoredetailedthe
informationmustbe.Individualsandcompaniesneeddifferentkindsof
informationtomaketheirbusinessdecisions.
IntroducingAccountingandFinancialStatements
Letsstartwithyouasanindividual.Whywouldyoubeinterestedin
accounting?Accountingknowledgecanhelpyouwithinvestinginthestock
market,applyingforahomeloan,evaluatingapotentialjob,balancinga
checkbook,andstartingapersonalsavingsplan,amongotherthings.
Managerswithinabusinessalsouseaccountinginformationdailyto
makedecisions,althoughmostofthesemanagersarenotaccountants.Some
ofthedecisionstheymightmakeforwhichtheywilluseaccountinginfor
mationareillustratedbelowinFigure1.2
Figure1.2:AREASINWHICH
MANAGERSUSEACCOUNTINGINFORMATION
Marketing(Whichlineofgoodsshouldthecompanyemphasize?)
Production(ShouldthecompanyproduceitsgoodsintheUnited
StatesoropenanewplantinMexico?)
ResearchandDevelopment(Howmuchmoneyshouldbesetasidefor
newproductdevelopment?)
Sales(Shouldthecompanyexpandtheadvertisingbudgetandtake
moneyawayfromsomeotherpartofthemarketingbudget?)
Withouttheproperaccountinginformationthesetypesofdecisions
wouldbeverydifficult,ifnotimpossible,tomake.
Bankerscontinuallyuseaccountinginformation.Theyareinthebusiness
oftakingcareofyourmoneyandmakingmoneywithyourmoney,sothey
absolutelymustmakegooddecisions.Accountingisfundamentaltotheir
decisionmakingprocess.Figure1.3looksatsomeofthedecisionsbankers
makeusingaccountinginformation.
Figure1.3:AREASINWHICHBANKERS
USEACCOUNTINGINFORMATION
Grantingloanstoindividualsandcompanies
Investingclientsmoney
Settinginterestrates
Meetingfederalregulationsforprotectingyourmoney
AccountingforNonAccountants
GovernmentagenciessuchastheInternalRevenueService(IRS),the
SecuritiesandExchangeCommission(SEC),theFederalTradeCommission
(FTC),andtheBureauofAlcohol,Tobacco,andFirearms(ATF)basetheir
regulationenforcementandcomplianceontheaccountinginformationthey
receive.
AccountabilityinAccounting
Abusinesssfinancialstatementscanalsobeofgreatinteresttoothermem
bersofthelocalornationalcommunity.Laborgroupsmightbeinterested
inwhatimpactmanagementsfinancialdecisionshaveontheirunionsand
otheremployees.Localcommunitieshaveaninterestinhowabusinesss
financialdecisions(forexample,layoffsorplantclosings)willimpacttheir
citizens.
Astheeconomybecomesmorecomplex,sodothetransactionswithina
business,andtheprocessofreportingthemtovarioususersandmaking
themunderstandablebecomesmorecomplexaswell.Asolidknowledgeof
accountingishelpfultoindividuals,managers,andbusinessownerswhoare
makingtheirdecisionsbasedontheinformationaccountingdocuments
provide.
FinancialStatements
Accountantssupplyinformationtopeoplebothinsideandoutsidethefirm
byissuingformalreportsthatarecalledfinancialstatements.
Thefinancialstatementsareusuallyissuedatleastonceayear.Inmany
casestheyareissuedquarterlyormoreoftenwherenecessary.Asetofrules,
calledGenerallyAcceptedAccountingPrinciples,governthepreparationof
thefinancialstatements.GenerallyAcceptedAccountingPrinciples
(GAAP)hasbeendefinedasasetofobjectives,conventions,andprinciples
togovernthepreparationandpresentationoffinancialstatements.These
rulescanbefoundinvolumesofdocumentsissuedbytheAmerican
InstituteofCertifiedPublicAccountants(AICPA),theFinancial
AccountingStandardsBoard(FASB),theInternalRevenueService(IRS),
theSecuritiesandExchangeCommission(SEC),andotherregulatorybod
ies.Inchapter2welookatsomeoftheoverridingprinciplesofaccounting
astheyapplytoallbusinessesandindividuals.
TheBasicFinancialStatements
ThebasicfinancialstatementsincludetheBalanceSheet,theIncome
Statement,theStatementofCashFlows,andtheStatementofRetained
Earnings.Wewilllookattheseindepthinthefollowingchaptersandsee
howtheyallinteractwitheachother.Aswediscussthesefinancialstate
ments,youwillseetheyarenotasscaryasyoumighthavethoughtthey
wouldbe.Manyoftheconceptswillalreadybefamiliartoyou.
Intheappendix,youcanseeexamplesofthesefinancialstatementsfrom
StationCasinos,Inc.,apubliclytradedcompanywhichoperatesseveral
casinosandhotelsintheLasVegas,Nevada,area.
TheBalanceSheetisthestatementthatpresentstheAssetsofthecom
pany(thoseitemsownedbythecompany)andtheLiabilities(thoseitems
owedtoothersbythecompany).
TheIncomeStatementshowsalloftheRevenuesofthecompanylessthe
Expenses,toarriveatthebottomline,theNetIncome.
TheStatementofCashFlowsshowshowmuchcashwestartedtheperi
odwith,whatadditionsandsubtractionsweremadeduringtheperiod,and
howmuchcashwehaveleftoverattheendoftheperiod.
TheStatementofRetainedEarningsshowshowthebalanceinRetained
Earningshaschangedduringtheperiodoftime(year,quarter,month)for
whichthefinancialstatementsarebeingprepared.Normallythereareonly
twotypesofeventsthatwillcausethebeginningbalancetochange:1)the
companymakesaprofit,whichcausesanincreaseinRetainedEarnings(or
thecompanysuffersaloss,whichwouldcauseadecrease)and2)theown
ersofthecompanywithdrawmoney,whichcausesthebeginningbalanceto
decrease(orinvestmoremoney,whichwillcauseittoincrease).
Alert!
SeeingtheBiggerPicture:Noneofthesefinancialstatementsalonecantellthe
wholestoryaboutacompany.Weneedtoknowhowtoread,understand,and
analyzethesestatementsasapackageinordertomakeanykindofdecisions
aboutthecompany.Inadditiontothefinancialstatements,youmustunderstand
theindustryyouareoperatinginandthegeneraleconomy.
Financialstatementsvaryinformdependinguponthetypeofbusiness
theyareusedin.Ingeneraltherearethreeformsofbusinessoperatingin
theUnitedStatesproprietorships,partnerships,andcorporations.
HowDifferentBusinessEntitiesPresent
AccountingInformation
Proprietorshipsarebusinesseswithasingleownerlikeyouandme.These
typesofbusinessestendtobesmallretailbusinessesstartedbyentrepreneurs.
Theaccountingfortheseproprietorshipsincludesonlytherecordsofthe
businessnotthepersonalfinancialrecordsoftheproprietorofthebusiness.
Alert!
DontMixandMatch:Thefinancialrecordsofanindividualownerofabusi
nessshouldneverbecombinedwiththoseofthebusiness.Theyaretwosepa
rateentitiesandneedtobeaccountedforseparately.Takingmoneyfromone
oftheseentities(thebusiness)fortheother(theowner),mustbeaccountedfor
bybothentities.
Partnershipsareverysimilartoproprietorships,exceptthatinsteadof
oneowner,therearetwoormoreowners.Ingeneralmostofthesebusi
nessesaresmalltomediumsized.However,therearesomeexceptions,
suchaslargenationaloreveninternationalaccountingorlawfirmsthat
mayhavethousandsofpartners.Aswiththeproprietorships,accounting
treatstheseorganizationsrecordsasseparateanddistinctfromthoseofthe
individualpartners.
Finally,therearecorporations.Thesearebusinessesthatareownedby
oneormorestockholders.Theseownersmayormaynothaveamanageri
alinterestinthecompany.Manyofthesestockholdersaresimplyprivate
citizenswhohavemoneyinvestedinthecompanybywayofstocksthat
theyhavepurchased.
Inacorporationapersonbecomesanownerbybuyingsharesinthecom
panyandthusbecomesastockholder.Thestockholdersmayormaynot
haveavoteinthecompanyslongtermplanningdependingonthetypeof
stocktheyhavepurchased.However,simplybybeingstockholders(own
ers),theydonothavedecisionmakingauthorityinthedaytodayopera
tions.Theseinvestors(orstockholders)arenotmuchdifferentthanthe
bankersthatloanmoneytoaproprietorshiporapartnership.Thesebankers
haveafinancialinterestinthebusiness,butnodailymanagerialdecision
makingpower.Asisthecasewiththestockholderswhohaveinvested
moneyintothecorporation,ingeneraltheyhaveanonmanagerialinterest
inthebusiness.Aswiththeothertwotypesofbusinessorganizationsdis
cussedhere,theaccountingrecordsofthecorporationaremaintainedsep
aratelyfromthoseoftheindividualstockholdersorowners.
Theaccountingrecordsofaproprietorshiparelesscomplexthanthose
ofacorporationinthatthereisasimplecapitalstructureandonlyone
owner.Inthecaseofacorporation,therearestockholderswhobuyapiece
oftheownershipofacompanybybuyingstock.Aswewilldiscusslater,
becauseofthisstockownership,thefinancialstatementsbecomemore
complex.Someofthebasicdifferencesbetweenthesethreetypesofbusi
nessesareshowninFigure1.4.
Figure1.4:DIFFERENCESINTHETHREETYPESOFBUSINESSES
10
BusinessType
Proprietorship
Partnership
Corporation
Number
ofOwners
One
Twoormore
Oneormore
Accounting
Records
Maintained
separately
fromowners
records
Maintained
separately
fromowners
records
Maintained
separately
fromowners
records
OwnerHas
Managerial
ResponsibilitiesYes
Usually
Usuallynot
Inthischapteryouhavelearnedwhataccountingis,whyyouandother
peopleinbusinessneedtounderstandaccounting,whatbusinessesuse
accountingfor,andwhatthebasicfinancialstatementsusedinthesebusi
nessesare.Inchapter2youwilllearnaboutthepracticalandethicalprin
ciplesaccountantsuseonaregularbasis.
GLOSSARY
Accounting:Theprocessofrecording,classifying,andsummarizing
economiceventsthroughthepreparationoffinancialstatementssuchas
theBalanceSheet,theIncomeStatement,andtheStatementofCash
Flows.
AmericanInstituteofCertifiedPublicAccountants(AICPA):The
professionalorganizationofCPAsintheUnitedStates.TheAICPAis
chargedwithpreparationoftheCPAExamination,theestablishmentand
enforcementofthecodeofprofessionalethics,andworkingwiththe
FinancialAccountingStandardsBoardintheproclamationofaccounting
standards.
Corporations:Corporationsarebusinessesthataregiventherightto
existbyanindividualstateintheUnitedStates.Withthisrighttoexist,the
corporationisthenallowedtosellstock.Thosebuyingthisstockbecome
ownersofthecorporation.Corporationscanbesetupasforprofitornot
forprofit,andmakethatdecisionwhenapplyingfortheircharterwiththe
state.
FinancialAccountingStandardsBoard(FASB):TheFASBsetsthe
accountingstandardstobefollowedforthepreparationoffinancialstate
ments.AllrulingsfromtheFASBareconsideredtobeGAAP.
FinancialStatements:Reportspreparedbycompaniesonthefinan
cialstatusoftheirbusiness;examplesareBalanceSheets,Income
Statements,StatementofCashFlow,andStatementofRetained
Earnings.
GenerallyAcceptedAccountingPrinciples(GAAP):Therulesthat
governthepreparationoffinancialstatements.Theserulesaredeveloped
bytheAmericanInstituteofCertifiedPublicAccountants,theFinancial
AccountingStandardsBoard,theSecurityandExchangeCommission,
andothergovernmentagencies.
InternalRevenueService(IRS):Thegovernmentagencycharged
withthecollectionoffederaltaxesintheUnitedStates.Therearediffer
entaccountingrulesforthepreparationoftaxesintheUnitedStatesthan
forthepresentationoffinancialstatements.
Partnerships:Abusinessentitywithoneormoreowners.Theaccount
ingforpartnershipsissimilartothatofproprietorships.
Proprietorships,SoleProprietorships:Businesseswithonesingle
owner.Eventhoughthereisonlyoneowner,therecordsoftheowners
personalfinancialaffairsarekeptseparatefromthoseoftheaccounting
recordsofthebusiness.Separatetaxreturnsarepreparedforthebusiness
andfortheindividual.
12
GenerallyAcceptedAccounting
Principles(GAAP)
GenerallyAccepted
AccountingPrinciples
Chapter
2
ItisimportantthatyouunderstandtheconceptsofGenerallyAccepted
AccountingPrinciples(GAAP),whichformthebasisofaccountingandare
partofthelanguageofaccountingandbusiness.
Thischapterwillintroducetheagenciesresponsibleforstandardizingthe
accountingprinciplesthatareusedintheUnitedStatesanditwilldescribe
thoseprinciplesinfulldetail.Onceyouunderstandtheseguidingprinci
ples,youwillhaveasolidfoundationonwhichtobuildacompletesetof
accountingskills.Itisusefulandnecessarythatwhetheraninternational
companyisreportingtoitsstockholdersoraproprietorispresentinginfor
mationtoabankforaloan,thesereportsfollowaconsistentsetofrulesthat
everyoneunderstandsandagreesto.
(orWhatIsThis,AlphabetSoup?)
CongresscreatedtheSecuritiesandExchangeCommission(SEC)in1934.At
thattime,theCommissionwasgiventhelegalpowertoprescribethe
accountingprinciplesandpracticesthatmustbefollowedbythecompanies
thatcomewithinitsjurisdiction.Generallyspeaking,companiescomeunder
SECregulationswhentheysellsecuritiestothepublic,listtheirsecuritieson
anyoneofthesecuritiesexchanges(NewYorkStockExchangeorAmerican
Exchangeforexample),orwhentheybecomegreaterthanaspecifiedsizeas
measuredbythefirmsAssetsandnumberofshareholders.Thus,since1934,
theSEChashadthepowertodeterminetheofficialrulesofaccountingprac
ticethatmustbefollowedbyalmostallcompaniesofanysignificantsize.
Instead,forthemostpart,theSECassignedtheresponsibilityofidenti
fyingorspecifyingGAAPtotheAmericanInstituteofCertifiedPublic
Accountants(AICPA).ThatrolehasnowbeentransferredtotheFinancial
AccountingStandardsBoard(FASB).AllrulingsfromtheFASBarecon
sideredtobeGAAP.TheFASBiscurrentlycollaboratingonaprojectwith
theInternationalAccountingStandardsBoardtomakeiteasierforcompa
niestoreportfinancialstatements,sothatseparatestatementsarenotneed
edforU.S.andinternationalmarkets.
AfirmmustadopttheaccountingpracticesrecommendedbytheFASB
ortheSECunlesstheycanidentifyanalternativepracticethathassub
stantialauthoritativesupport.Evenwhenacompanycanfindsubstantial
14
authoritativesupportforapracticeituseswhichdiffersfromtheonerec
ommended,thecompanymustincludeinthefinancialstatementfootnotes
(orintheauditorsreport)astatementindicatingthatthepracticesusedare
nottheonesrecommendedbyGAAP.Wherepracticable,thecompany
mustexplainhowitsfinancialstatementswouldhavebeendifferentifthe
companyhadusedGenerallyAcceptedAccountingPrinciples.
GenerallyAcceptedAccountingPrinciples
(GAAP)
Financialstatementsmustpresentrelevant,reliable,understandable,suffi
cient,andpracticablyobtainableinformationinordertobeuseful.
RelevantInformation
Relevantinformationisthatinformationwhichhelpsfinancialstatementusers
estimatethevalueofafirmand/orevaluatehowwellthefirmisbeingman
aged.Thefinancialstatementsmustbestatedintermsofamonetaryunit,
sincemoneyisourstandardmeansofdeterminingthevalueofacompany.
IntheUnitedStates,accountantsusethestablemonetaryunitconcept,
whichmeansthateventhoughthevalueofthedollarchangesovertime
(duetoinflation),thevaluesthatappearonthefinancialstatementsnor
mallyarepresentedathistoricalcost.Historicalcostpresentstheinforma
tiononthefinancialstatementsatamountstheindividualorcompanypaid
forthemoragreedtopaybackforthematthetimeofpurchase.This
methodofaccountingignorestheeffectofinflation.Inmanyothercountries
throughouttheworld,theaccountingprofessiondoesaccountforinflation.
Alert!
ChangesintheWorks:Aspartoftheconvergenceprojectdiscussedabove,the
FASBhasstartedtransitioningfromtheprinciplesofhistoricalcosttofairvalue.
Withfairvalue,theAssetswouldbeshownontheBalanceSheetatwhatthey
couldbereplacedfor,oratavaluethathasbeenappraised.Thisnormally
wouldbeavaluehigherthanthehistoricalcost,ortheamountpaidfortheAsset
bythecompany.Manyaccountantsarguethatthisvaluebetterrepresentsthe
truevalueoftheAssetsontheBalanceSheet.
Notallinformationaboutafirmisrelevantforestimatingitsvalueor
evaluatingitsmanagement.Forexample,youdontneedtheinformationof
howmanyindividualsoverfortyyearsofageworkforthecompany,orwhat
colorthemachineryispaintedinordertomakefinancialdecisionsabouta
company.Evensomefinancialinformationisnotrelevant,likehowmuch
moneytheownerofacorporationhasinthebank,becauseaswereviewed
inchapter1,thebusinesssaccountingrecordsarekeptseparatefromits
owners,andtheownersfinancialinformationisirrelevanttothebusiness.
ReliableInformation
Reliableinformationiskeyinaccounting.Sufficientandobjectiveevidence
shouldbeavailabletoindicatethattheinformationpresentedisvalid.In
addition,theinformationmustnotbebiasedinfavorofonestatementuser
oronegroupofuserstothedetrimentofotherstatementusers.Theneed
forreliableinformationhascausedthefederalgovernmenttopasslaws
requiringpubliccompaniestohavetheirrecordsandfinancialstatements
examined(audited)byindependentauditorswhowillmakesurethatwhat
companiesreportisaccurate.Thiswillbethetopicofchapter11.
VerifiableInformation
Theneedforverifiableinformationdoesnotprecludetheuseofestimates
andapproximation.Ifyouweretoeliminatefromaccountingallestimates,
theresultingstatementswouldnotbeusefulprimarilybecausethestate
mentswouldnotprovidesufficientinformation.Theapproximationsthat
areused,however,cannotbewildguesses.Theymustbebasedonsuffi
cientevidencetomaketheresultingstatementsareliablebasisforevaluat
ingthefirmanditsmanagement.
Oneexampleofaplaceinthefinancialstatementswhereweestimate
thevalueiswithdepreciation.OncewepurchaseaLongTermAsset(any
thingthatthecompanyownsthatwilllastlongerthanoneyear;forexam
ple,abuilding),wethenneedtospreadthecostofthisbuildingoverthe
lifeoftheAsset.Thisiscalleddepreciation.Inordertodothiswemustesti
matethelifeofthatparticularAsset.Wecantknowexactlyhowlongthat
willbe,butsincewedohaveexperiencewiththesetypesofAssets,wecan
estimatetheAssetslife.Weassumethatthebuildingwillbeuseableforsay
16
twentyyearsanddepreciate(orspread)thecostofthebuilding(theAsset)
overtwentyyears(theestimatedlife).
Forexample,ifwebuythisbuildingfor$100,000andassumethatitis
goingtolasttwentyyears,theannualdepreciationwouldbe$5,000per
year($100,000/20).This$5,000becomesoneoftheExpensesforthecom
panyandisshownontheIncomeStatementalongwiththeotherExpenses.
Wewilllookatthistopicindepthinchapter4.
UnderstandableInformation
Tobeunderstandable,thefinancialinformationmustbecomparable.Any
itemontheBalanceSheetthatanaccountantlabelsasanAssetorLiability,
usersofthefinancialstatementsshouldalsocallAssetsandLiabilities.
Statementusersmustcomparefinancialstatementsofvariousfirmswithone
another,andtheymustcomparestatementsofanindividualfirmwithprior
yearsstatementsofthatsamefirminordertomakevaliddecisions.Thus,the
accountingpracticesthatafirmusesforaparticulartransactionshouldbethe
sameasotherfirmsusefortheidenticaltransaction.Thispracticeshouldalso
bethesamepracticethefirmusedinpreviousperiods.Thisconceptiscalled
Consistency.Together,informationthatiscomparableandconsistentbecomes
understandabletotheusersofthefinancialinformation.
QuantifiableInformation
Informationiseasiertounderstandanduseifitisquantified.Mostinformation
thataccountantsandusersoffinancialinformationuseisrepresentedbynum
bers.Theinformationthatispresentedinthefinancialstatementsispresented
inanumericalform;however,wherethatisimpossible,theinformation(ifit
isrelevant,reliable,understandable,andpracticablyobtainable)willbepre
sentedinnarrativeform,usuallyinafootnotetothestatements.Accountants
includenarrativeinformationalongwiththequantifiableinformationbecause
oftheneedforadequateorfulldisclosure;statementusersmusthavesufficient
informationaboutafirm.
Anexampleofnonquantifiableinformationthatmightbeincludedin
thefootnotestothefinancialstatementswouldbedetailsofanoutstanding
patentinfringementlawsuitagainstthecompany,whichwouldbeconsid
eredacontingentLiability.
ObtainableInformation
Furthermore,tobeuseful,informationmustbereasonablyeasytoobtain.
Thisfitsintotheconceptofcostvs.benefit.Theinformationmustbeworth
morethanwhatitwillcosttoobtainitandmustbesecuredonatimely
basis.Financialstatementsmustbepreparedatleastonceayear(inmany
cases,quarterlyormonthly)andattemptingtoincorporateunobtainable
informationcouldseriouslydelaytheseschedules.
Anexampleofobtainableinformationisthenumberofsharessoldby
thecorporationduringtheyear.Anotherexamplewouldbetheamountof
salesbythebusinessduringtheyear.Anexampleofinformationthatmight
notbeconsideredobtainablewouldbethenittygrittydetailsofthepen
sionplansystemsusedineachofthesubsidiariesofamultinationalcorpo
ration.Amorereasonableandeasilyobtainablepieceofdatamightbethe
totalamountofmoneythatisbeingspentonthecompanyspensions
aroundtheworld.
TheEntityConcept
Financialstatementsmustalsopresentinformationrepresentingeachsepa
rateentity.(ThisideaiscalledtheEntityConcept).Inotherwords,the
transactionsofeachbusinessorpersonarekeptseparatefromthoseofother
organizationsorindividuals.Therefore,thetransactionsofthesubsidiaries
ofamultinationalcorporationmustallbekeptseparatefromeachother.
Eventhoughattheendoftheyear,therecordsofallofthesubsidiaries
mightbeconsolidatedintoonesetoffinancialstatements,therecordsand
transactionsofeachsubsidiaryarekeptseparateduringtheyear.
TheGoingConcern
Itisnormallyassumedthatacompanywillcontinueinbusinessintothe
future.ThisconceptiscalledtheGoingConcernPrinciple.Therearesever
alestimatesthatwemakeinordertocompletethefinancialstatementpre
sentations(forexample,depreciationofanAssetoveritslife),andifwedid
notassumethatthecompanywasgoingtoremaininbusinessintheindef
initefuture,wecouldnotusethissortofinformation.
ThealternativetotheGoingConcernPrincipleistoassumethatman
agementplanstoliquidatethebusiness.Whenthisisknownforsureabout
18
abusiness,adifferentsetofaccountingprinciplesandrulesareused.Ingen
eral,whenacompanyliquidates,theAssetsofthecompanywillbelistedat
whattheycanbesoldatrapidly.Thisamountwillusuallybebelowtheirval
uesstatedontheBalanceSheet,sincetheywillbesoldatfiresaleprices.
RealizableValue
AssetsnormallyarenotshownontheBalanceSheetatmorethaneithertheir
historicalcostoranamountforwhichtheycanbesoldbelowhistoricalcost.
Forexample,ifacompanyhasInventorythatislistedatahistoricalcostof
$100,000,butduetotheeconomy,thecompetition,ornewtechnology,is
todayonlyworth$8,000,thisAssetshouldbewrittendownandshownon
theBalanceSheetat$8,000.Thesectiononconservatism(page20)sheds
morelightonthistopic.Anexampleofanexceptiontothisruleiswithmar
ketablesecurities(stocks).TheseAssetsareshownontheBalanceSheetat
theircurrentmarketprice.
Alert!
AccountingOutsidetheU.S.:IntheUnitedStates,forthepurposeofpreparing
financialstatements,accountantsarenotallowedtowriteupAssetstovalue
higherthanthehistoricalcost(definedonpage29).Thisisnottrueinallcoun
triesoftheworld,whereaccountantsmayarguethatifyoucanwritedownan
Assettoreflectreality,whynotdothesamewhenanAssetincreasesinvalue?
Thus,inmanycountriesoutsideoftheUnitedStates,theaccountantsare
allowedtowriteupAssetswhentheyincreaseinvaluetoreflectmarketvalue,
aswellaswritethemdownwhenthemarketvalueislowerthanhistoricalcost.
Thisisanimportantpointtokeepinmindwhenreviewingfinancialstatements
preparedincompaniesdomiciledoutsideoftheUnitedStates.
Materiality
Financialstatementsdatamustbeassimpleandconciseaspossible.An
itemisconsideredmaterialwhenitsinclusionorexclusioninthefinan
cialstatementswouldchangethedecisionofastatementuser.Aruleof
thumbinaccountingmightbethatanyitemworth10percentofthe
businessNetIncomeisconsideredmaterialandshouldbereportedin
financialstatements;thereisnofirmdollaramounttobefollowedhere.
Theimportantfactortorememberiswhethertheamountinquestionwill
changetheusersdecision.ThisconceptiscalledtheMaterialityPrinciple.
Itemsthatarenotmaterialshouldnotbeincludedonthestatements
separately.Iftheseitemswereincludedinthefinancialstatementsthey
wouldobscuretheimportantitemsofinteresttothereader.Thus,insome
cases,manyimmaterialitemsshouldbegroupedtogetherandcalledmis
cellaneousortheitemscouldbeaddedtootheritems,sothatthetotal
becomesmaterial.Thatis,theitemscanbelumpedintogetherwithother
itemsthatarematerialandtheentirebundlecanbeconsideredmaterial.
20
Conservatism
Anothertraditionalpracticethataccountantsusetoguidetheminpreparing
financialstatementsiscalledConservatism.Whenevertwoormoreaccount
ingpracticesappeartobeequallysuitabletorecordthetransactionunder
consideration,theaccountantshouldchoosetheonethatresultsinthelower
orlowestAssetfigureontheBalanceSheetandthehigherorhighestExpense
ontheIncomeStatement,soastonotbeoverlyoptimisticaboutfinancial
events.Thisprincipleofaccountingishighlycontroversialsincewhilebeing
conservative,wemaybeviolatingothergenerallyacceptedaccountingprinci
pleslikeconsistency.Inaddition,itisoftenasked,Whyisthelowervaluebet
ter,ifthehighervaluebetterrepresentsthetruevalueoftheAsset?
AnexampleoftheConservatismPrincipleinactionmightbeinthe
presentationofInventoryontheBalanceSheet.Thereareseveraldifferent
QUIZ
Theownersofabusinessdecidetowriteupthevalueoftheirland,
whichtenyearsagocost$10,000topurchaseandtodaysitsina
primelocationofthecityandhasbeenappraisedat$40,000.Should
theyvaluetheirlandontheBalanceSheetat$10,000or$40,000?
Seepage21foranswers.
generallyacceptedaccountingmethodsthatareallowedtoassignavalue
toInventory.Theaccountantshouldchoosetheonethatpresents
InventoryatthelowestvaluesoasnottooverstatethisparticularAsset.
Theconservatismideaismisused,however,whentheaccountantchoos
esapracticethatisnotassuitabletothesituationasanalternativepractice
merelytoreportlowerAssetsandhigherExpenses.
ANSWER
IntheUnitedStatesacompanycannotwritethevalueoftheirAssets
abovethehistoricalcostofthatAsset.Theargumentisthatiftheydo
writethevalue,itleavestoomuchroomformanipulatingthefinancial
statements,whichcouldmisleadtheusersofthefinancialstatements.
ThepracticeofwritingupAssets,eventhoughacceptedinotherforeign
countries,wouldviolatesuchgenerallyacceptedaccountingprinciples
as:1)conservatism,2)reliability,and3)verifiability.
GLOSSARY
AmericanInstituteofCertifiedPublicAccountants(AICPA):The
professionalorganizationoftheAccountingprofession.Thisgrouphas
theresponsibilitytosettheethicsregulationsfortheprofessionaswellas
writingandgradingtheCertificationPublicAccountantsExamination
(CPAExamination).
ConservatismPrinciple:Whenevertwoormoreaccountingpractices
appeartobeequallysuitabletothetransactionunderconsideration,the
accountantshouldalwayschoosetheonethatresultsinthelowerorlow
estAssetfigureontheBalanceSheetandthehigherorhighestExpense
ontheIncomeStatement.
Consistency:Practicesandmethodsusedforpresentationonthefinan
cialstatementsshouldbethesameyeartoyearandprocesstoprocess.
Ifforanyreasonthecompanyandtheiraccountantsdecidetochangethe
methodofpresentationforanyitemonthefinancialstatements,theymust
presentafootnotetothefinancialstatementsexplainingwhythemethods
werechanged.
22
EntityConcept:Theprinciplethatrequiresseparationofthetransac
tionsofeachbusinessorpersonfromthoseofotherorganizationsorindi
viduals.Soforexample,whenacompanyisownedbyoneperson,the
personalfinancesoftheindividualwhoownsthecompanyarenotinclud
edonthecompanysfinancialstatements.Theoppositeisalsotrue;the
financialinformationofthecompanyisnotincludedinthefinancialstate
mentsoftheindividualowner.
FinancialAccountingStandardsBoard(FASB):TheFASBsetsthe
accountingstandardstobefollowedforthepreparationoffinancialstate
ments.AllrulingsfromtheFASBareconsideredtobeGAAP.
GenerallyAcceptedAccountingPrinciples(GAAP):Astandard
izedsetofaccountingrulesusedintheUnitedStatesandprescribedby
variousorganizations,liketheFASBandtheSEC.Theserulesguidethe
uniformpreparationoffinancialstatements.
GoingConcernPrinciple:Thisprincipleassumesthatacompanywill
continueinbusinessintothefuture.Withoutthisassumptionmostofthe
accountinginformationcouldnotbepresentedinthefinancialstatements
sincewearealwaysmakingassumptions(e.g.,whatisthelifeofaLong
TermAsset).Theonlywaytomakethisassumptionistofurtherassumethat
thebusinesswillbeinexistenceintotheindefinitefuture.
HistoricalCostPrinciple:Accordingtothisrule,mostAssetsand
LiabilitiesshouldberepresentedontheBalanceSheetattheamountthat
waspaidtoacquiretheAsset,orfortheLiabilities,attheamountthatwas
contractedtobepaidinthefuture.Noaccountistakenforeitherinflation
orchangingvalueofAssetsovertime.
MaterialityPrinciple:Thisprinciplestatesthatanitemshouldonlybe
includedontheBalanceSheetifitwouldchangeanydecisionsofastate
mentuser.If,forexample,amultimilliondollarcorporationweretodonate
$100toacharity,thisinformationwouldnotchangeanydecisionthat
managementoranownerwouldmake.However,sincecorporatemoney
wasspent,thisdistributionofthe$100mustbecombinedwithothersmall
expendituresandreportedasamiscellaneousExpense.
ObtainableInformation:Informationreportedinfinancialstatements
mustbeaccessibleinatimelymannerwithoutanunreasonableexpendi
tureofresourcesforexample,time,effort,andmoneytobeincluded
inthefinancialstatements.
QuantifiableInformation:Informationiseasiertounderstandand
useifitisquantified.However,whentheinformationcannotbequantified
butisstillrelevanttotheusersofthefinancialstatements,itmustbeshown
inthefinancialstatementsinnarrativeforminthefootnotes.
RealizableValuePrinciple:ThisindicatesthatAssetsshouldnormal
lynotbeshownontheBalanceSheetatavaluegreaterthantheycan
bringtothecompanyifsold.Iftheoriginalhistoricalcostforexampleis
$5,000,andthemaximumthatthecompanycansellthatAssetfortoday
is$4,000,thisAssetshouldbeshownontheBalanceSheetatthelower
amountbecauseofthisprinciple.
RelevantInformation:Informationreportedonfinancialstatements
mustberelevantinthatithelpsstatementuserstoestimatethevalueofa
firmand/orevaluatethefirmsmanagement.Notallinformationabouta
companyisrelevanttothisdecisionmakingprocess.Forexample,the
numberofwomenversusmencurrentlyemployedatthecompanywould
notbeconsideredrelevant,eventhoughitmightbeimportantdatain
othercontexts.Thus,thistypeofinformationisnotincludedinthefinan
cialstatements.
SecuritiesandExchangeCommission(SEC):Thebodycreatedby
Congressin1934.Oneofitsdutiesistoprescribetheaccountingprinci
plesandpracticesthatmustbefollowedbythecompaniesthatcomewith
initsjurisdiction.
RecognitionPrinciple:ThisistheprocessofrecordingRevenueinto
thefinancialstatements.Revenueisrecordedatthepointofthetransferof
themerchandiseorservice,andnotatthepointofreceivingthecash.
Thatmeans,forexample,thatonceaserviceisprovidedforwhicha
chargehasbeenincurred,thatserviceshouldbeshownonthefinancial
statementsregardlessofwhethermoneyhasactuallychangedhands.
Similarly,Expensesarerecognizedwhenincurred,notwhenthemoneyis
exchangedforthatparticularExpense.
ReliableInformation:Thereshouldbesufficientandobjectiveevi
denceavailabletoindicatethattheinformationpresentedisvalid.
SeparateEntities:SeeEntityConcept
StableMonetaryUnitConcept:Eventhoughthevalueofthedollar
changesovertime(duetoinflation),thevaluesthatappearonthefinan
cialstatementsintheUnitedStatesarenormallypresentedathistorical
costanddonottakeinflationintoaccount.
UnderstandableInformation:Financialinformationmustbecompa
rableandconsistent.IfoneaccountantcallsaparticularitemanAsset,the
accountantmustfollowthesetofrulesknownasgenerallyaccepted
accountingprinciplestoarriveatthedefinitionofthatAsset.Thus,when
anyuserofthefinancialstatementsreadsthesestatements,heunder
standsthemeaningandclassificationoftheAsset.
VerifiableInformation:Informationonthefinancialstatementsmust
bebasedonsufficientevidencethatcanbesubstantiatedandprovidesa
reliablebasisforevaluatingthefirmanditsmanagement.
TheTransactionsBehindtheBalance
Sheet
TheBalanceSheet
andItsComponents
Chapter
3
Imaginethatyoumakealistofeverythingthatisimportanttoyou.Along
withthislistyouattachvaluestoalloftheseitems.Thenyoumakealistof
everythingthatyouowetoothers,andagainyouattachvaluestothese
items.Thenyousubtractthetotalvalueofthesecondlistfromthetotal
valueofthefirst.Voila!Youhavejustcreatedthebasiccomponentsofa
BalanceSheet.
Inabusiness,thefirstlistofitemsiscalledAssets.Assetsarevaluable
resourcesownedbythebusinessandcanbeeithershortorlongtermin
nature.
YoursecondlistofitemsiscalledLiabilities.Liabilitiesarewhatyouowe
toothersforresourcesthatwerefurnishedtothebusiness.Thepartiesto
whomthecompanyowesmoneyarenormallycalledcreditors.Thecredi
torsaresaidtohaveaclaimagainsttheAssets.Figure3.1illustratesthe
originofsomeLiabilitiesacompanyorindividualmightincur.
Figure3.1:WHEREDOLIABILITIESCOMEFROM?
YourthirdlistcanbelabeledOwnersEquity.OwnersEquityreflects
theamounttheownerhasinvestedinthefirm.Therearetwosourcesof
OwnersEquity:
Theamountofmoneyprovideddirectlybytheownerorother
investors,calledOwnersInvestment;and,
Theamountretainedfromprofits,calledRetainedEarnings.
26
WhatTheyAreCalled
Accountspayable
Wagespayable
Utilitiespayable
Notespayable
Rentpayable
WhereLiabilitiesOriginate
Purchaseofitems
Servicesfromemployees,not
yetpaid
Utilitiesused,notyetpaidfor
IOUs
Unpaidrent
TheBalanceSheetandItsComponents
27
Profittakesmanyforms:Profitsarenotalways
cash;profitcanbemadeupofpromisestopaymoney
aswell.Forexample,whenthereisasaleforareceiv
able,therewillbeRevenue,butnocashcomingintothe
company.Themoneywillcomeinduringalatertime
periodbutcanbeconsideredprofitforthecompany.
Letslookatanexample.TheSolanaBeachBicycleCompanyisasmall
businessthatmakes,repairs,andsellsbicycles.Thecompanywasstartedby
SamanthaFernandezinJanuary2006.Sam(asallofherfriendscallher)has
beenanavidbikeriderformanyyearsandalwaysfeltshecouldbuilda
bettermousetraporbicycle,thatis.Saminvestedsomemoneyshehad
savedandsomethatshehadinheritedintoherbusiness.
TakealookatthebicyclecompanysBalanceSheetinFigure3.2.Thisis
aproprietorship,becauseSamanthaisthesoleownerofthecompany.The
BalanceSheetwouldlookalittledifferentforacorporation.Thesediffer
encesarediscussedinchapter7.(SeeAppendixBforareallifeexampleof
aBalanceSheetfromStationCasinos,Inc.)
Figure3.2:SOLANABEACHBICYCLECOMPANY
BalanceSheet
December31,2006
Assets
Cash........................................$17,385
AccountsReceivable...............................9,175
AllowanceforBadDebts.............................(175)
Inventory......................................23,000
PrepaidInsurance.................................1,000
Truck..........................................8,000
Building.......................................25,000
Land.........................................10,000
TotalAssets....................................$93,385
continued
LiabilitiesAndOwnersEquity
Liabilities:
AccountsPayable...................$3,000
MortgagePayable..................20,000
TotalLiabilities.................................$23,000
OwnersEquity:
OwnersInvestment................$60,000
RetainedEarnings..................10,385
TotalOwnersEquity.............................$70,385
TotalLiabilities&OwnersEquity.....................$93,385
BylookingatthebicyclecompanysBalanceSheet,youcanseethatthere
areseveralAssetsbelongingtothecompanythattogetherarevaluedat
$93,385.YoucanalsoseethatthecompanyhasseveralLiabilities,valuedat
$23,000.Finally,whenyousubtracttheLiabilitiesfromtheAssets,youcan
seethatthecompanyhasequity(alsoreferredtoasnetworth)of$70,385.
Thisrepresentsacombinationoftheamountofmoneythattheownerhas
investedintoherbusiness($60,000),andtheprofitthatwasearnedand
retainedinthebusinesssinceitsinception($10,385).Sincethisisthefirst
yearofbusiness,alloftheprofitmusthavebeenearnedthisyear.
WhatDoestheDateontheBalanceSheetMean?
Thereisagreatdealofdisagreementastohowaccountantsarriveatthe
valuesthatareshownaboveontheBalanceSheet.Ofmostconcernare
thevaluesattachedtotheAssets,andconsequentlytotheOwners
Equityornetworthofthebusiness.TheBalanceSheetrepresentsa
snapshotofthefinancialpositionofthebusinessonthatspecificdate.
InthecaseofSolanaBeachBicycleCompany,thispointintimeis
December31,2006.
28
29
Alert!
TheBalanceSheetIsaSnapshot:ThenumbersthatarerepresentedinaBalance
Sheetonlyrepresentthefinancialpositionofthebusinessattheexactpointin
timeforwhichtheBalanceSheetwaspreparedandnoother.InFigure3.2,this
meansDecember31,2006,only,notDecember30orJanuary1.Onanyother
datetheremightbemoreorlessAssetsandLiabilities,andthustheBalance
Sheetwouldlookdifferent.
WhatIsHistoricalCost?
Asyousawabove,alloftheitemsontheBalanceSheethavevaluesattached
tothem,butwheredidthesenumberscomefrom?IntheUnitedStates,
accountantsandotherusersoffinancialstatementshaveagreedthatfinan
cialstatements(includingBalanceSheets)mustbebasedonhistoricalcost.
ThismeansthatthevaluesontheBalanceSheetforSolanaBeachBicycle
CompanydonotrepresentwhattheAssetsortheLiabilitieswouldbe
worthtodayiftheyweretobesold.Instead,thevaluesrepresentwhatwas
paidfortheAssetsandwhatthebusinessagreedtopaytothecreditorson
thedateoftheobligation.
Doesthisconfusethereaderofthefinancialstatements?No.Because
everyonehasagreedtofollowthisconvention,everyonepreparingand
usingthesefinancialstatementsunderstandsthelanguagethatisbeingspo
ken.
OftentherelationshipsbetweenAssets(A),Liabilities(L),andOwners
Equity(OE)areshownintermsofaformula.
A=L+OE
Assets=Liabilities+OwnersEquity
ThetotalAssetsofthecompanyequalthesumoftheLiabilitiesandthe
OwnersEquity.
Theformuladepictstherelationshipsofthevariouselementsofthe
BalanceSheet.BalanceSheetsareoftensetupwiththeAssetsononeside
(theleftside)andtheLiabilitiesandequityontheother(therightside).
Thesameformulacanbestatedthisway:
AL=OE
AssetsLiabilities=OwnersEquity
IfyousubtracttheLiabilitiesfromtheAssets,youareleftwiththe
OwnersEquityofthebusiness.
Assets
Aswasdiscussedabove,Assetsareitemsthatareofvalueandareownedby
theentityforwhichyouareaccounting.Letsmakethisideamorespecific.
ForanAssettobelistedonaBalanceSheetofacompany,theitemmust
passthreetests.
Figure3.3:HOWDOWEKNOWWHEN
ANASSETGOESONTHEBALANCESHEET?
Thefollowingitemsgiveussomehints.
Thecompanymustcontroltheitem.(Thisusuallymeansownership.)
Theitemmusthavesomevaluetothecompany.
Theitemmusthavevaluethatcanbemeasured.
Letslookatsomeexamples.Becauseofthefirsttest,atraditional
BalanceSheetdoesnotlisttheemployeesofacompany,eventhoughwe
mayrefertothemasAssetsinanonaccountingsense,becausethe
30
companydoescontrol,toacertainextent,butdoesnotowntheseindi
viduals.Butwhataboutbasketballplayersorotherprofessionalathletes?
Doesnttheteamownthem?Theanswerisno.Whattheteamownsis
nottheplayersthemselves,buttheplayerscontracts.Therefore,inthis
situation,thebasketballteamownershipwouldlistthecontractsofthe
playersasanAsset.
Withthesecondtestalmostanythingthatisusedinthebusinesstoearn
incomeandtogeneratecashdoeshavesomevalue.Certainitemsthatdo
meetthefirstrequirementmightbeeliminatedfrombeinglistedasAssets
bythistest.Examplesmightincludeanoldtruckthatdoesnotworkor
Inventorythatcannotbesoldanylongerbecauseitisnowoutdated;for
example,oldversionsofcomputersoftware.
Anexampleofthethirdtestwouldbewhenthecompanypurchasesa
usedmachine.Thecompanypurchaseditforafixedamountofmoneyand
hasarecordofthistransactionthatclearlyindicatesthevalueofthe
machine.(Note:NeitherthecompanynortheBalanceSheetdealswithan
overorunderpaidamountforthemachine.TheBalanceSheetreflects
onlyhistoricalcost,whichiswhatisrecordedastheamountpaidforthe
machine,whetherthecompanypaidtoomuchorgotabargain!)
Letsassumethatacompanyhasbuiltupathrivingbusiness,andsome
ofthereasonsforthisgrowtharethereputationoftheownerandtheloca
tionofthecompany.Neitherthereputationoftheownernorthelocation
ofthecompanyhasbeenpaidfor.Wealsodonothaveanywayofmeasur
ingavaluetoputontotheseitems.Therefore,theyfailthethirdtest,and
cannotbelistedasAssetsofthebusiness.
AnotherexampleofanAssetthatwouldfailthetestisanyAssetthatwas
giventothecompany.Inthissituation,thereisnohistoricalcosttothe
companyandthustheAssetwouldnotbereflectedontheBalanceSheet,
sinceitdoesnotmeetthisthirdtest.Now,youmightsaythatwecandeter
mineamonetaryvalueforthisAsset.Andyouareright!Inmanycountries,
thisAssetwouldthenbereflectedontheBalanceSheetatthatvalue.
However,undergenerallyacceptedaccountingprinciplesintheUnited
States,sincetherewasnohistoricalcosttothisAsset,itwouldnotbelist
edasoneofthecompanysAssets.
31
QUIZ
BelowisalistofitemsthatmightbeconsideredAssetsbyacompany.
IndicatewhethertheyshouldbelistedontheBalanceSheetasanAsset
andwhyorwhynot.
1.Abicyclethatbelongstotheownerofthecompany
2.Abuildingusedtobuildandsellthebicyclesofthecompany
3.Abrokentoolthatisnotusedinthebusinessanylonger
4.Employees
5.Moneyowedtothecompanyfromsalesofbicycles
6.Moneyowedbythecompanytothegascompany
7.Thelandthatthecompanysbuildingison
8.Atruckusedtodeliverthebicyclestocustomers
9.Moneyinthepersonalbankaccountoftheowner
10.Moneypaidinadvanceforathreeyearinsurancepolicyonthe
business
ShortTermAssets
AssetsarenormallysubdividedontheBalanceSheetintotwocategories.
ThefirstiscalledShortTermAssets(orCurrentAssets).Theseitemswill
beusedorconvertedintocashwithinaperiodofoneyearorless.
LongTermAssets
LongTermAssets(alsocalledNonCurrentAssets)arenotexpectedtobe
convertedtocashortotallyusedupinayearorless.Rather,theyare
expectedtobeofvaluetothecompanyformorethanayear.LongTerm
Assetswouldincludeequipment,land,andbuildings.
IntangibleAssets
IntangibleAssetsareAssetsthatcannotbephysicallytouched.Theymust
stillmeetthethreetestsmentionedearlierinordertobelistedonthe
32
BalanceSheetasanAsset;however,theydonothaveanytangiblecharac
teristics.SomeexamplesofintangibleAssetsincludetrademarks,copy
rights,andpatents,aslongastheyhavebeenpurchasedfromtheprior
ownerofthebusiness.Youmightbeinclinedtocallgoodwillanintangible
Asset;goodwillisbasedonlocationofthebusiness,reputationoftheown
ers,andnamerecognitionbythepublic,andisofgreatvaluetoabusiness.
Keepinmind,though,thatbecauseoftheGenerallyAcceptedAccounting
Principlesdiscussedinchapter2,thisandanyvaluableitemwhichwasnot
paidforandthusdoesnothaveahistoricalcost,cannotbelistedonthe
BalanceSheetasanAsset.
Liabilities
RefertotheBalanceSheetofSolanaBeachBicycleCompany(fig3.2).The
TotalLiabilitiesofthebusinessareequalto$23,000.AswiththeAssets,the
Liabilitieslistrepresentsbothshorttermandlongtermitems.Again,simi
lartothelistofAssets,theShortTermLiabilitieswillbepaidoffinaperi
odnottoexceedoneyear.TheLongTermLiabilitieswillremainasdebtto
thecompanyforlongerthanoneyear.
Withthisoranylongtermdebt,aportionofitbecomesdueand
payableeachyear.Thus,mostcompaniesBalanceSheetsshowthecur
rentportionofalllongtermdebtseparatelyintheShortTermLiabilities
section.
OwnersEquity
Aswehavediscussedabove,theequityofSolanaBeachBicycleCompany
comesfromtwosources.TheOwnersInvestmentof$60,000represents
theamountinvestedinthebusinessbytheownerthroughthepurchaseof
variousAssetsorasmoneyinthebankthatismeantforthebusiness.The
RetainedEarningsof$10,385representtheamountofprofitearnedbythe
businesssinceitsinceptionminusanymoneythattheownermayhave
takenoutforhisorherpersonaluse.
Alert!
Alert!
UnderstandingCashandRetainedEarnings:Letstakeamomenttoclari
fyaveryimportantpointaboutRetainedEarningsthatoftencausescon
fusionamongownersofsmallandlargebusinessesalike.TheRetained
Earningsinabusinessarenotequaltocash,thatis,moneyinthebank.
Justbecauseacompanyhaskeptprofitsinthebusinessovertheyears
doesnotmeanthatalloftheseprofitshavebeenretainedintheformof
cash.Forexample,afterthecompanyearnsaprofit,itmaytakethatcash
andpurchaseAssetsorpayoffsomeofitsLiabilities.Businessowners
oftenassumethattheyaredoingwellbecausetheyaremakingprofits
withouttakingintoaccounttheamountofcashtheyhaveattheirdispos
al.Iftheydonothavesufficientcash,however,theywillfindthemselves
indirestraitssincetheymaynotbeabletomakethepayroll,paytheir
taxes,orpayforotherLiabilities.Itisabsolutelyessentialthatbusinesses
haveagoodcashmanagementplan.
ArevisedBalanceSheetforSolanaBeachBicycleCompanyusingthe
mostcommonsubheadingswouldlookliketheoneshowninFigure3.4.
Figure3.4:THEEXPANDEDBALANCESHEET
SOLANABEACHBICYCLECOMPANY
BalanceSheet
December31,2006
Assets
ShortTermAssets:
Cash...........................$17,385
AccountsReceivable..................9,175
AllowanceforDoubtfulAccounts..........(175)
Inventory.........................23,000
PrepaidInsurance...................1,000
TotalShortTermAssets............................$50,385
LongTermAssets:
Truck.........................................$8,000
Building.......................................25,000
Land.........................................10,000
TotalLongTermAssets............................$43,000
TotalAssets....................................$93,385
LiabilitiesandOwnersEquity
ShortTermLiabilities:
AccountsPayable......................$3,000
CurrentPortionofMortgagePayable.........1,000
TotalShortTermLiabilities...........................$4,000
LongTermLiabilities:
MortgagePayable..............................$19,000
TotalLiabilities.................................$23,000
OwnersEquity:
OwnersInvestment....................$60,000
RetainedEarnings......................10,385
TotalOwnersEquity.............................$70,385
TotalLiabilities&OwnersEquity.....................$93,385
TheTransactionsBehindtheBalanceSheet
ReferringtotheBalanceSheetinFigure3.4,letsexaminethetransactions
thatcreatedit.
SamInvestsMoneyintheCompany(OwnersInvestment)
First,letsassumethatonJanuary1,2006,Saminvests$60,000inherbicy
clecompany.Inotherwords,shetakes$60,000outofherpersonalbank
accountandsetsupanewaccountwiththebankforthenewbusiness.
Afterthistransaction,thecompanysBalanceSheetlooksliketheonepre
sentedinFigure3.5:
BalanceSheet
January1,2006
Assets
Liabilities&OwnersEquity
Liabilities:............$0
Cash........................................$60,000
OwnersInvestment..............................$60,000
TotalAssets....................................$60,000
OntheBalanceSheetthecashandOwnersInvestmentareincreased
by$60,000.NotethattheBalanceSheetcontinuestobalance,i.e.,
Assets=Liabilities+OwnersEquity.
SamPurchasesLand,aBuilding,andaTruck
(LongTermAssets)
Next,onJanuary1,thebicyclecompanybuysapieceoflandwithabuild
ingandatruckinordertooperateherbusiness.Thelandhasavalueof
$10,000,thebuildingsvalueis$25,000,andthetruckthatwillbeused
forpickupsanddeliveriesis$8,000.Allofthesevaluesaretheactual
amountsthatthecompanypays.Becausethecompanydoesnothavesuf
ficientcashtopayforalloftheseAssetsatthecurrenttime,itdecidesto
borrowsomemoney.Itpays$23,000incashandtakesoutamortgageon
thelandandbuildingfor$20,000topurchasetheseAssets.Thisisatwen
tyyearloan.Onethousanddollarsofthisloanisdueandpayablewithin
oneyear.Afterthesetransactions,thecompanysBalanceSheetlookslike
theonepresentedinFigure3.6:
36
ShortTermAssets:
Cash............$60,000
TotalAssets........$60,000
OwnersEquity:
OwnersInvestment..$60,000
TotalLiabilitiesand
OwnersEquity.....$60,000
BalanceSheet
January1,2006
Assets
ShortTermAssets:
AsyoucanseeinFigure3.6thecashbalancehasdecreasedby$23,000
(theamountofcashcontributedtothepurchaseoftheland,building,and
truck),theotherAssetshaveincreasedto$43,000(thetruck,building,and
land),andtwonewLiabilitieshaveappeared(thecurrentandlongterm
portionsofthemortgageloan).Theloanof$20,000hasbeendividedup
betweentheshorttermportionof$1,000andthelongtermportion(due
inaperiodofgreaterthanoneyear)of$19,000.Also,noticethatthe
OwnersEquityisnotaffected.
WhatarethefactorsthatchangeOwnersEquity?Theitemsbelowgive
usasummaryoftheonlyitemsthathaveanimpactonthebeginningbal
anceofOwnersEquity.
37
ShortTermAssets:
Cash............$37,000
TotalShortTerm
Assets...........$37,000
LongTermAssets:
Truck.............$8,000
Building...........25,000
Land.............10,000
TotalLongTerm
Assets...........$43,000
Liabilities:
CurrentPortionof
MortgagePayable...$1,000
LongTerm:
MortgagePayable...19,000
TotalLiabilities.....$20,000
OwnersEquity:
TotalLiabilitiesand
OwnersEquity....$80,000
Theownerinvestsmoremoneyinthebusiness
Thebusinessmakesaprofitorloss
TheownertakesAssetsoutofthebusiness.
Thus,whenSaminvestedthe$60,000intothebicyclecompany,this
increasedherOwnersEquityinthecompanybythissameamount.When
thecompanymakesaprofit,thisisalsoanincreasetoherOwnersEquity.
Finally,ifSamdecidestotakeanymoneyorotherAssetsoutofthebicycle
companyforherownuse,thiswillreducetheOwnersEquityasitshows
uponthebicyclecompanysBalanceSheet.
SamPurchasesInsurance(ShortTermAsset)
OnJanuary3,thecompanypurchasesathreeyearinsurancepolicyonthe
building.Thecostofthisinsuranceis$1,500.Becausethispurchasecovers
threeyearsandatthetimeofpurchasehasnotbeenusedupatall,the
expenditurerepresentsanAsset.WecallthisAsset,PrepaidInsurance.The
companypaysforthisinsurancewithcash.Afterthistransaction,the
BalanceSheetlookslikeitdoesinFigure3.7:
BalanceSheet
January3,2006
Assets
38
ShortTermAssets:
Cash............$35,500
PrepaidInsurance......500
TotalShortTerm
Assets...........$36,000
Liabilities:
CurrentPortionof
MortgagePayable...$1,000
LongTerm:
MortgagePayable..$19,000
InFigure3.7theonlychangeintheBalanceSheetafterthepurchaseof
theinsuranceisthatoneAsset(cash)hasbeenexchangedforanotherAsset
(PrepaidInsurance,betweenShortandLongTermAssets)fortheexact
amountof$1,500.
SamOrdersandBuysBicycles(ShortTermAssets)
OnJanuary5,Samordersandbuystwodifferentbrandsofbicyclesfrom
twodifferentcompanies.Shebuyseightyofonekindthatcost$100apiece,
andtwentyfiveoftheotherkindthatcosther$200apiece.Thetotalcost
ofthe105bicyclestothecompanyis$13,000.Thispurchaserepresentsa
ShortTermAssetknownasInventory.
InventoryisaShortTermAssetbecausethecompanyanticipatesselling
these105bicyclesinoneyearorless.Asabove,withthepurchaseofthe
LongTermAssets,thecompanydoesnotwanttopayforallofthesebicy
cleswithcash.Itpays$10,000incashandagreestopaytheadditional
$3,000totheselleratalaterdatefromthesale.This$3,000becomesan
AccountsPayableofthebusiness,andisshownintheShortTermLiabilities
section.
AswesawinFigure3.1,thereareseveraldifferenttypesofpayables.The
termAccountsPayableisreservedforthepurchaseofInventoryitemsthat
aregoingtoberesoldbythecompany.
39
LongTermAssets:
Truck............$10,000
Building...........25,000
Land..............8,000
TotalLongTerm
Assets...........$44,000
OwnersEquity:
TotalLiabilitiesand
OwnersEquity....$80,000
QUICKTip
KeepinganEyeonInventory:HavingtoolittleortoomuchInventoryinasmall
businesswillcreateproblemsforthecompany.Drawingupabudgetisacriti
calpartoftheaccountingprocessthatwillaidintheplanningandcontrolof
thecompanysexpendituresandhelpthebusinessownertomaintaincontrolof
allaspectsofthebusiness.Budgetswillbediscussedfurtherinchapter10.
Afterthistransaction,theBalanceSheetlooksliketheoneinFigure3.8:
BalanceSheet
January5,2006
Assets
40
ShortTermAssets:
Cash............$37,000
Inventory..........13,000
PrepaidInsurance.....1,500
TotalShortTerm
Assets...........$37,000
LongTermAssets:
Truck.............$8,000
Building...........25,000
Land.............10,000
TotalLongTerm
Assets...........$43,000
Liabilities:
AccountsPayable....$3,000
CurrentPortionof
MortgagePayable....1,000
Longterm:
MortgagePayable...19,000
OwnersEquity:
TotalLiabilitiesand
OwnersEquity.....$83,000
Onceagain,theBalanceSheetstaysinbalance.Assets($83,000)=
Liabilities($23,000)+OwnersEquity($60,000).
YoullnotethattheBalanceSheetinFigure3.8datedJanuary5,2006,is
quitedifferentfromtheonedatedDecember31,2006inFigure3.4.This
demonstrateshowtheBalanceSheetcanchange,representingthecompa
nysAssets,Liabilities,andOwnersEquityatanygivenpointintime.
Inthischapter,youhavelearnedabouttheBalanceSheetandthedefini
tionsofallofitscomponents.Youhavelearnedhowthesecomponentsrelate
toeachother.Youhavealsolearnedaveryimportantpoint:Retained
Earningsarenotnecessarilycomprisedofonlycash,andtherefore,cashman
agementisahighprioritytoabusinessmakingaprofit.Finally,youlearned
howvarioustransactionsaffecttheBalanceSheetofasmallbusiness.
ANSWERS
1.No.ThiswouldnotappearonthecompanysBalanceSheet,since
thisisanAssetthatbelongstotheownerandnotthebusiness.
2.Yes,becausethisAssetisusedbythebusiness.
3.No.ThiswasonceanAsset,butisnolongeronesinceitisnot
usedintheoperationsofthebusiness.
4.No.Althoughacompanysemployeesareoftenreferredtoas
Assets,theyarenotlistedasAssetsonacompanysBalance
Sheetsincethecompanydoesnotownthem.
5.Yes.ThisiscalledAccountsReceivable.
6.No.ThisisaLiability,notanAsset(somethingowedratherthan
somethingowned).
7.Thisdependsonwhetherthecompanyownstheland.Ifitdoes,the
landisconsideredanAssetbecauseithasvalue.
8.Yes.
9.No.ThisisanAssetoftheowner,notofthecompany,andthese
Assetsarekeptseparate.
10.Yes,thishasfuturebenefittothecompanysincetheinsurancecom
panyowestheminsuranceforthreeyearsintothefuture.
41
GLOSSARY
AccountingEquation:A(ssets)=L(iabilities)+OE(OwnersEquity),
Theformuladepictstherelationshipsofthevariouselementsofthe
BalanceSheettoeachother.
AccountsPayable:AShortTermLiability(debt)incurredfromthepur
chaseofInventory.
Assets:Itemsofvaluethatareownedbythecompanyandarerepresent
edontheBalanceSheet.InorderforanitemtobeshownontheBalance
Sheet,itmustmeetthreetests:1)thecompanymustcontrolitorownit,2)
theitemmusthavesomevaluetothecompany,and3)thisvaluemustbe
measurable.Assetsarecategorizedasshorttermorlongtermitems.
BalanceSheet:ThisfinancialstatementisalistingoftheAssets(items
owned),Liabilities(itemsowed),andOwnersEquity(whatbelongstothe
owner(s)).Therelationshipsbetweenalltheseitemsarerepresentedbythe
accountingequation.
Creditors:ThoseindividualsorcompaniestowhichmoneyorotherAssets
areowed;forexample,thesupplierfromwhomSampurchasedthebicycles
andtowhomsheowesanadditional$3,000isacreditorofthecompany
Equity:SeeOwnersEquity
HistoricalCost:Theamountpaidforanitemownedbythebusiness
(Assets),ortheamountincurredinadebtonthedateoftheagreementto
enterintotheobligation(Liabilities).Eventhoughovertimethevaluesof
theseAssetsand/orLiabilitiesmaychange,theywillalwaysbeshownon
theBalanceSheetattheirhistoricalcost.
IntangibleAssets:ThoseAssetsthatareofvaluetoabusinessand
meetalltestsofbeinganAsset,butdonothavetangiblequalities;for
example,trademarksandpatents.
Inventory:AnAssetheldbyabusinessforthepurposeofresale.Inthe
caseofSolanaBeachBicycleCompany,Inventoryisthebicyclesthatthe
companyintendstosell.
Liabilities:Debtsowedbyabusiness.Theycaneitherbeshorttermor
longtermdependinguponwhentheybecomedue.ShortTermLiabilities
aretobepaidwithinayear.Examplesinthebicyclecompanyarethe
AccountsPayable,andthecurrentportionoftheMortgagePayable.Long
TermLiabilitiesextendbeyondoneyear.Anexampleinthebicyclecom
panyistheportionofthemortgagewhichisduetobepaidbeyondthe
currentyear.
42
LongTermAssets:Thoseitemsthatwillbeconsumedorconvertedto
cashafteraperiodofoneyear.ExamplesoftheseAssetsinthebicycle
companyarethetruck,thebuilding,andtheland.
OwnersEquity:Thedifferencebetweenwhatisownedandwhatis
owed;inacompany,thisamountbelongstotheowners.TheOwners
Equityismadeupoftheoriginalandadditionalinvestmentsbytheowner,
plusanyprofitthatisretainedinthebusiness,minusanycashorother
Assetsthatarewithdrawnordistributedtotheowner(s)
RetainedEarnings:Theamountofprofitearnedbythebusinesssince
itsinception,minusanymoneythatistakenoutordistributedtothe
owner(s).AtSolanaBeach,thisiswhateverthecompanyearnsinselling
bikes,minuswhateverExpensesareincurred;forexample,electricity,gas
forthetruck,mortgagepayments,salaries,etc.
ShortTermAssets:ThoseAssetsthatarecashorwillbeconvertedto
cashorconsumedwithinaperiodofoneyearorless.Examplesofthese
AssetsinthebicyclecompanyareCash,AccountsReceivable,bicycle
Inventory,andPrepaidInsurance.
TransactionsThatEffecttheIncome
Statement
TheIncome
Statement
Chapter
4
Atthispoint,wearefamiliarwiththeBalanceSheetandhowitishelpful
inshowingwhatAssetsSolanaBeachBicycleownsandwhatLiabilitiesthe
companyowes.Wealsolearnedthatthedifferencebetweenthesetwo
itemsiscalledOwnersEquityandrepresentswhatthebicyclecompanyis
worthattheendoftheyear.Thefinalthingthatwelearnedwasthatthe
BalanceSheetrepresentsthesevaluesforoneparticularpointintimeand
forthatpointintimeonly.Itcanbeconsideredasnapshotofthebusiness.
Nowthatherbusinessisupandrunning,Samanthaisveryinterestedin
knowing,Whatisthebottomline?HowmuchmoneydidImake?Forthis
informationSamshouldbecomefamiliarwiththeIncomeStatement.
TheIncomeStatementpresentsasummaryofanentitysRevenues(whatthe
companyearnedfromsalesofproductsandservices)andExpenses(whatwas
expendedtoearnthisrevenue)foraspecificperiodoftime,suchasamonth,
aquarter,orayear.Thisperiodoftimeisknownastheaccountingperiod.
OnekeydifferencebetweentheIncomeStatementandtheBalanceSheetis
thattheIncomeStatementreflectsaperiodoftimeratherthanasingle
momentintimeaswiththeBalanceSheet.TheIncomeStatementisalso
calledaStatementofEarningsoraStatementofOperations.
ThepreparationoftheIncomeStatementservesseveralpurposes.Often,
theonlyreasononeusestheIncomeStatementistoconcentrateonthe
bottomlineorNetIncome(RevenueminusExpenses).TheIncome
StatementcanalsobeusefulforanalyzingchangesintheRevenuedataover
aperiodoftime,ordeterminingratiosofparticularExpensestoRevenue
andhowtheseratioshavebeenchangingovercertainperiodsoftime.These
twotopicswillbediscussedinchapter8.(SeeAppendixBforareallife
exampleofanIncomeStatementfromStationCasinos,Inc.)
InFigure4.1wecanseeallofthebicyclecompanysRevenueandExpenses
foritsfirstyearinbusiness.ByreviewingthesenumbersSamcanalsosee
herbottomline,thatis,hercompanysNetIncomefortheyear.
Ingeneral,IncomeStatementsareorganizedintothreesections.Thefirst
sectionshowstheRevenuesearnedfromthesaleofgoodsand/orservices
fortheperiodbeingreported.InthecaseoftheSolanaBeachBicycle
Company(Figure4.1)thisperiodisoneyear.Thesecondsectionliststhe
ExpensesthebusinesshasincurredtoearntheseRevenuesduringtheperi
odrepresentedbytheIncomeStatement.Thethirdsectionisthedifference
betweentheseRevenuesandExpensesinwhichwehopetheRevenuesout
weightheExpenses,indicatingaprofit.IftheExpensesaregreaterthanthe
Revenues,thiswouldindicatealossnotagreatthinginabusiness.
Intheexamplebelow,thenumberslistedinsideofparenthesesrepresent
subtractions.
IncomeStatement
FortheYearEndedDecember31,2006
Sales
$35,500
CostofGoodsSold
14,200
GrossProfit
$21,300
OperatingExpenses:
SalariesandWages
$5,200
BicycleParts
1,625
InsuranceExpense
500
BadDebtExpense
175
ToolsExpense
50
BankServiceFee
15
TotalOperatingExpenses
$7,565
NetIncomefromOperations
$13,735
OtherRevenueandExpenses:
RepairRevenue
$3,850
RepairExpenses
(1,100)
InterestExpense
(1600)
NetIncomeBeforeTaxes
$15,585
Less:IncomeTaxes
(4,500)
NetIncome
$10,385
TheIncomeStatement
TheAccrualConcept
TheAccrualConceptaddressestheissueofwhenRevenueisrecognizedon
theIncomeStatement.Revenueisrecognizedwhenitisearnedand
Expensesarerecognizedastheyareincurredregardlessofwhenthecash
changeshands;thisisreferredtoasaccrualbasisofaccounting.Thistypeof
accountingisusedbybusinessesthroughouttheUnitedStatesforthepres
entationoftheirfinancialstatements.Somesmallfirmsandmostindividu
alsstillusethecashbasisofaccountingtodeterminetheirincomeand
IncomeTaxes.Underthecashbasisofaccounting,Revenueisnotreported
untilcashisreceived,andExpensesarenotreporteduntilcashisdisbursed.
CashBasisofAccounting:Thereasonasmallbusi
nessmightusethecashbasisofaccountingisthatitis
easierthantheaccrualsystemtokeeptrackofthe
RevenuesandExpenses.Noassumptionshavetobe
made(forinstance,fordepreciation),andnoaccruals
havetobemadeforitemssuchasAccountsReceivable
andAccountsPayable.Accountingentriesareonlymade
whencashisactuallyexchanged.
GenerallyAcceptedAccountingPrinciplesrequiretheaccrualsystemof
accounting,andthusmostfinancialstatementsthatyouwillencounterand
thatareusedbyinvestorsandbankerswillbepreparedundertheaccrual
systemofaccounting.Itisforthisreasonthatthroughouttheremainderof
thisbook,wewilluseonlytheaccrualbasisofaccountingforallofour
examples.
Revenue
Revenue(orsales)iswhatthecompanyearnedduringaparticularperi
odoftimefromthesaleofmerchandiseorfromtherenderingofservic
estoitscustomers.Revenuecancomefromseveralsources;afirmcan
generateRevenuefromsales,interest,dividends,royalties,oranycombi
nationofthese.ThesumofallofthesesourcesisthetotalRevenuesof
abusiness.
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AsshowninFigure4.1,Revenueof$35,500isfromthesaleofbicycles.
IfyoulooktowardsthebottomoftheIncomeStatement,youllseethatthe
bicyclecompanyalsoearnedRevenuefromdoingrepairs($3,850).This
repairRevenuehasbeenseparatedfromthesalesRevenueabove,because
themainbusinessissalesandnotrepairs.
AtthispointtherehasbeennodiscussionofNetIncome.Revenueisone
componentofNetIncome,butitisnotthewholestory.Expensesandother
itemsneedtobeaddedtoorsubtractedfromRevenuetoarriveattheNet
Incomefigure.
Alert!
RevenueVersusCashFlow:ItisimportanttonotethatRevenueisnotequalto
cashflow.Revenuecanbegeneratedpriortoabusinessreceivingcash.Inother
words,asalecanbemadeinwhichonlyapromisetopayisgenerated,but
cashdoesnotchangehands.Eventhoughthecashwillnotbecollecteduntil
somepointinthefuture,theRevenueisrecognizedatthetimethatthemer
chandisehasbeentransferredtothebuyer,ortheserviceshavebeenper
formedbytheseller.Therefore,itispossibleforacompanytohavealarge
amountofsales(orRevenue)andstillhaveacashflowproblem,sincetheyhave
notcollectedthemoneyyet.
InFigure4.1,wecanseethatthe$35,500ofsaleswasgeneratedbycol
lectingcashandpromisestopaycashinthefuture.Youcannottellsimply
byreadingthisonenumbercalledSaleshowmuchwasgeneratedfromeach
ofthesetwosourcesindividually.Butyoucantellthatattheendoftheyear,
thereisstill$9,175owedfromthesales,meaningthat$9,175isexpected
buthasnotbeenreceivedincashyet.YouknowthisfromtheBalanceSheet
inFigure3.2(AccountsReceivableatDecember31,2006).Thereasonthat
youcannottellintotalhowmuchwassoldonaccountduringtheyearis
becausesomeoftheAccountsReceivablecouldhavebeenpaidoffduring
theyearbeforethisBalanceSheetwasgenerated.The$9,175onlyreflects
howmuchisstillowedtothebusinessonDecember31,2006.
TheIncomeStatement
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Expenses
Expensesrepresentthecostofdoingbusiness.ExamplesofExpensesare
rent,utilities,bankservicefees,toolandequipmentExpenses,baddebt
Expense,andsalaries.Inourcurrentexample,theExpensesofSolanaBeach
BicycleCompanyfallunderthetitleofOperatingExpenses.Theseareallof
theExpensesfortheyear2006thatwereincurredbytheshopinorderto
generateRevenueintheoperationofthebusiness.Thetotalis$7,565.
AnotherExpensethatdoesnotappearinthelistingofoperatingExpenses
butisnecessarytogenerateRevenueisCostofGoodsSold($14,200).This
Expenseisthecostofeitherthebicyclespurchasedbythecompanyorthe
componentsusedtobuildthebicyclesthatweresoldduring2006.
Thereisanimportantdistinctiontobemadebetweenanexpenditure
andanExpense.Anexpenditureisthespendingofcash.AllExpensesare
expenditures;however,notallexpendituresareExpenses.Itsoundsconfus
ing,butitsreallyquitesimple.AnExpenseisanexpenditurethatgenerates
Revenue.IftheexpendituredoesnotimmediatelygenerateRevenue,itis
notanExpense.Considerthepurchaseofabuilding.Whenthepurchaseof
abuildingismadeitdoesnotimmediatelyproduceRevenue.Atthatpoint
intimethepurchaseisconsideredanexpenditure.However,overtimethis
buildingwillbeusedintheproductionofRevenue,andthebuilding(and
othersuchLongTermAssets)depreciateorareusedup.Thedepreciation
ofthebuildingthusbecomesanExpenseandismatchedwiththose
Revenuesithelpedtogenerate.
NetIncome
NetincomerepresentsthedifferencebetweenRevenuesgeneratedduring
theperiodandtherelatedExpenses,whichgeneratedthatRevenue.Prior
tocalculatingNetIncome,acompanyfirstcalculatesgrossincome.The
grossincomeissales(ortotalRevenues)minusthecostofthosegoods
thatweresold.GrossincomedoesnottakeoperatingExpensesinto
account;NetIncome,ontheotherhand,isthegrossincomeminusallof
theoperatingExpenses,plusorminusotherRevenuesandExpenses.
Onceagainnotethatthetermcashisnotused.AswithRevenue,partofthe
bottomlineorNetIncomecouldbemadeupofcash,butotherpartscould
bemadeupofpromisestoreceivecashorpromisestopaycashinthefuture.
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QUICKTip
ExpandYourFocus:Whenevaluatingyourbusiness,youshouldnotsolelycon
centrateonNetIncomeinthefinancialstatements.Thisiscertainlyausefulnum
ber(especiallyifitiscomparedtopreviousyearsfigures),buttherearesever
alotherimportantnumbersandratiosthatultimatelymightbeimportanttoyour
decisions.Someofthesenumbersmightincludegrossincome,thetrendof
salaryExpenses(aretheygoinguptoofast?),howmuchcashisonhandatthe
endoftheyear,howsaleshavebeenincreasing,ifatall.Outsideofthecom
panyitisimportanttopayattentiontothecompetitionaswellastheeconomy
asawhole.Thesearejustafewexamplesofwhy,ifyouonlyfocusontheNet
Incomefigure,youwilllosesightofthewholepicture.
InFigure4.1,thetermNetIncomeappearsthreetimes.Thefirsttime
isNetIncomefromOperations.Thisnumber,$13,735representsthe
incomeearnedfromsellingbicycles,themainproductofSolanaBeach
BicycleCompany.Inadditiontosellingbicycles,thecompanyalsodidsome
repairs.TheserepairsgeneratedRevenueof$3,850duringtheyear.This
Revenueisshownseparatelybecauseitisnotthemainbusinessofthisshop.
Thus,aftertheotherRevenuesandExpensesareaddedtoNetIncome
fromOperations,anewtotalisderivedlabeledNetIncomeBeforeTaxes.
Thisnumberis$15,585.Afterthetaxesarepaidonthistotalwearriveat
thebottomlineorNetIncomeaftertaxesof$10,385.
Confusing?Maybealittle,butaccountingconventionrequiresthatwe
separateoutNetIncomefromthemainoperationsofthebusinessandfrom
otherincomeearnedfromothertypesofsalesandservices.Afterthesetwo
numbersareshownseparatelyontheIncomeStatement,wehavetoshow
whatthegovernmentisgoingtotakeintaxesbeforewecanfinallyarrive
atthebottomline.
InterestandIncomeTaxes
OtheritemssubtractedfromRevenuesandExpensesbeforedeterminingthe
totalNetIncomeareInterestandIncomeTaxes.Mostaccountantsclassify
interestandtaxesasanOtherExpenseoftheperiod,notasanoperating
TheIncomeStatement
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Expense.Thereasonforthisisthatinterestandtaxesdonotproducemain
streamRevenuebutarenecessarytopayinordertostayinbusiness.
BadDebtExpense
OneoperatingExpenseshowninFigure4.1isBadDebtExpensefor$175.
ThisExpenserepresentstheamountoftheAccountsReceivablethatthe
companyanticipatesthatitwillbenotbeabletocollect.Mostbusinesses
trytokeepthisnumbertoaminimum,inordertokeeptheirExpenseslow.
Theamountof$175,inthecaseoftheSolanaBeachBicycleCompanyis
anestimationmadebymanagement;inmostbusinessesthisestimateis
madebaseduponprioryearsexperienceoftheircollectionsofAccounts
Receivable.
QUICKTip
KeepBadDebtsinCheck:InordertokeepyourBadDebtExpensetoamini
mum,itisimportantthatyoudoextensivecreditchecksonthosecustomersto
whomyouaregoingtoextendcredit.Thiscanbedonewiththehelpofpro
fessionalservicessuchasDunnandBradstreetandbyreviewingandunder
standingtheirfinancialstatementspriortoextendingthiscredit.
QUIZ
Baseduponyourknowledgeofaccountingsofar,lookingattheIncome
StatementinFigure4.1,wouldyousaythattheSolanaBeachBicycle
Companyhadagoodfirstyearofbusiness?Whatwouldyouliketo
seethemdodifferentlynextyear?Whatadditionalinformationdoyou
needtomakethesedecisions?
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TransactionsThatEffecttheIncomeStatement
LetsexaminethetransactionsthatcreatedtheIncomeStatementinFigure
4.1.
Sales
IntheRevenuesectionabovewelookedatthetotalRevenue(orsales)for
theyear.Nowletslookatanindividualsaleduringtheyear,andseewhat
effectithasontheIncomeStatement.Whatwehavebeenlookingatin
Figure4.1istheIncomeStatementattheendoftheyear.Nowletsgoback
tothebeginningoftheyearandseehowthesefinalfiguresinFigure4.1
werearrivedat.
AssumethatonJanuary6,thecompanymakesitsfirstsalestwobicy
clesforatotalof$500.Thecompanyoriginallyboughtthebikesfor$100
each(atotalof$200).AfterthistransactiontheIncomeStatementwould
lookliketheoneinFigure4.2.(NotethatthisIncomeStatementinFigure
4.2isasofJanuary6,whereastheoneinFigure4.1,isasofDecember31.)
IncomeStatement
FortheWeekEndedJanuary6,2006
Sales..........................................$500
CostofGoodsSold.................................200
GrossProfit......................................$300
Expenses..........................................
NetIncome......................................$300
ThistransactionhascausedtwochangestotheIncomeStatement.First,
ithasincreasedtheRevenueaccountcalledSalesby$500,andsecond,it
hasincreasedanExpenseaccountcalledCostofGoodsSoldbythecost
ofthetwobicyclesor$200.
AtthesametimethistransactionhaschangedtheBalanceSheetinsev
eralways.Assumingthatthesebicyclesweresoldforcash,theAssetaccount
TheIncomeStatement
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(cash)ontheBalanceSheetwouldincreaseby$500.AsecondAsset
accountcalledInventory,wherethesebicycleswerelistedwhentheywere
bought,wouldbedecreasedbythecostofthetwobicycles,$200.
TheotherchangeontheBalanceSheetisthattheRetainedEarningsfig
uregoesupbythedifferencebetweenthesalespriceofthesetwobicycles
andthecost.Thus,RetainedEarningsincreasesby$300($500$200),the
profitmadethroughthesaleofthebicycles.
(Note:RememberthatRevenueminusExpensesequalsNetIncome,and
NetIncomeincreasesRetainedEarningsontheBalanceSheet.Onceagain,
averyimportantpartofthisconceptisthatthereisnomentionofcash.
Whetherthesebikesweresoldforcashorthepromisetopaycashinthe
future,isofnoimportancetothebottomlinealthoughitisaveryimpor
tantconcernfromacashflowmanagementstandpoint.)
NowletslookattheAccountingEquation,A=L+OEthatwelearned
aboutinchapter1.OneAsset,cash,hasincreasedbythesalepriceof$500.
AnotherAsset,Inventory,hasdecreasedbythecostofthebicyclesthat
weresold,$200.RetainedEarnings,partofOwnersEquity,hasincreased
bythedifferencebetweenthesalepriceandthecost,or$300.Thustheleft
sideofthisequationhasincreasedby$300(oneAssetup$500andthe
otherdownby$200),andtherightsideoftheequation,OwnersEquity,
hasincreasedbythesameamount,theNetIncomeof$300.
Usingtheequation,thetransactionwouldlooklikethis:
Cash+$500
Inventory$200=NetIncome+$300
Thisconceptisfurtherdemonstratedinchapter6,DoubleEntry
AccountingSystem.
CostofGoodsSoldandGrossProfit
Duringthecompleteyearof2006,thecostoftheallofthebicyclessold
wasequalto$14,200.Thedifferencebetweenthesalespriceofthebicy
cles($35,500)andthecostofthesebicycles($14,200)iscalledtheGross
Profit.Thewordgrossisusedsinceitrepresentstheprofitofthebicycle
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companybeforetheoperatingExpensesaresubtracted.Inthecaseofthe
bicyclecompany,theGrossProfitisequalto$21,300.
OperatingExpenses
OperatingExpensesarethosecoststhatarenecessarytooperatethebusi
nessonadaytodaybasis.OnJanuary7,SolanaBeachBicycleCompany
paystheownerherfirstweekspayof$100.
Alert!
PayingtheOwner:RememberthattheownerofthiscompanyandtheSolana
BeachBicycleCompanyaretwoseparateentitiesandwhenthebusinesspays
theownerhersalary,thisconstitutesoneentitypayinganother.
Afterthissecondtransaction,theIncomeStatementlooksliketheonein
Figure4.3:
IncomeStatement
Sales..........................................$500
CostofGoodsSold.................................200
GrossProfit......................................$300
Expenses.........................................100
NetIncome......................................$200
The$100paidtotheownerisanExpense(SalaryExpense)andassuch
itisshownintheIncomeStatementunderExpenses.TheNetIncomeis
decreasedbytheentire$100,asistheRetainedEarningsandthecashin
TheIncomeStatement
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theBalanceSheet.Assumingthatthesalaryispaidincash,theimpacton
theaccountingequationwouldlooklikethis:
Cash$100=NetIncome$100
BusinessTransactions
SellingBicyclesbutReceivingOnlyPartialPayment
OnJanuary21,thebicyclecompanysoldtenmorebicyclesforatotalof
$5,000.Thecostofthesetenbicycleswas$2,000.Thebuyersofthesebicy
clespaidatotalof$3,500incashandpromisedtopaytheother$1,500
withinsixtydays.
AfterthistransactiontheIncomeStatementwouldlookliketheone
belowinFigure4.4:
IncomeStatement
Sales.........................................$5,500
CostofGoodsSold................................2,200
GrossProfit.....................................$3,300
Expenses.........................................100
NetIncome.....................................$3,200
NoticethatontheIncomeStatementundertheaccrualsystemof
accounting,incomelikeRevenueisdeterminedwhenitisearnedandhas
nothingtodowithwhenthecashisreceived.Theentire$5,000wasadded
totheexisting$500insaleseventhoughonly$3,500cashwasreceivedfor
thetenbicycles.Thisstepistakenbecauseatransactionhasoccurredin
whichthebuyershaveobligatedthemselvestopaythefull$5,000.
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Thecostofthegoodssold(whichisanExpense)increased$2,000
becausethetenbicyclesthatweresoldhadcostthebusinessthisamount
ofmoney(tenbicyclesat$200each).IfwewerelookingattheBalance
Sheet,theInventoryAssetwouldbedecreasedbythis$2,000,thecostof
theInventorythatwassold.
Also,ontheBalanceSheet,theRetainedEarningsincreased$3,000.
(Revenueof$5,000minusExpensesof$2,000.)Nowyoucanseethat
becauseoftherelationshipbetweenNetIncomeontheIncomeStatement
andRetainedEarningsontheBalanceSheet,anytimeNetIncomeis
changed,RetainedEarningsisalsochangedbythesameamount.
SotheimpactontheaccountingequationofA=L+OEwouldlooklike
this:
Assets
=Liabilities+OwnersEquity
Cash+$3,500
Inventory$2,000
=NetIncome+,$3,000
AccountsReceivable+$1,500
RepairingBicyclesandReceivingCash
OnFebruary14,fivecustomerspickupbicyclestheyhadbroughtintothe
shopforrepair.Thecustomerspaidatotalof$375fortherepairofthese
fivebicycles.Thecostofthepartstorepairthesebicycleswas$105.
AfterthistransactiontheIncomeStatementwouldlookliketheonein
Figure4.5:
TheIncomeStatement
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IncomeStatement
FortheTwoWeeksEndedFebruary14,2006
Sales.........................................$5,500
CostofGoodsSold................................2,200
GrossProfit.....................................$3,300
Expenses.........................................100
NetIncomefromOperations........................$3,200
OtherRevenue:
RepairRevenue...................................$375
RepairExpenses...................................(105)
NetIncome.....................................$3,470
ThistransactionofrepairingthebicyclesincreasedNetIncome,cash,and
RetainedEarningsby$270.Also,thetotalAssetsownedbythecompany
increasedby$270.
Atthispointyoushouldassumethatthebicyclepartswereboughtfor
cashimmediatelypriortobeingusedtorepairthebicycles.Therefore,there
isnoInventoryofbicycleparts.
Onceagain,letslookattheimpactontheAccountingEquation:
Cash+$375(fromcustomers)=NetIncome+$270
Cash$105(tobuyparts)
OtherOperatingExpenses
Duringtheyear,SolanaBeachBicycleCompanyincurredotherExpenses
thatwerenecessarytooperatethebusiness.Thebusinesshadtopayinter
estonthemortgagethatitheld.Sincethemortgageisfor$20,000,andthe
interestrateonthisloanis10percent,thetotalinterestpaidduringtheyear
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is$2,000.Inadditiontotheinterest,thecompanyboughtsomesmalltools
touseontherepairs,whichcostatotalof$1,625.Thecompanywasalso
chargedaservicefeeof$15bythebankwhereithasitsaccount.Thetotal
oftheseoperatingExpensesincreasedtheExpensesontheIncome
StatementandreducedcashandRetainedEarningsontheBalanceSheet.
Attheendoftheyear,theownerconcludedfrompriorexperienceswith
businessreceivablesthatshewasnotgoingtobeabletocollect$175from
oneofthecustomersthathadpromisedtopay.Inordertorecognizethis
onthefinancialstatements,shecreatedanExpensecategorycalledBad
DebtsExpense.ThisExpenseisincreasedbytheamountofthereceivable
thatwillnotbecollected,andanewaccountissetup,calledAllowancefor
DoubtfulAccountsfortheothersideofthetransaction.Thisallowance
accountiscalledacontraAssetaccount,andisusedtoreduceAccounts
ReceivableontheBalanceSheet.
ThelastExpensethatislistedontheIncomeStatement,Insurance
ExpenseisanotherExpensethatreducesNetIncomewithoutusingcashat
thetimetheExpenseisrecognized.Rememberfromchapter3,Prepaid
InsuranceislistedontheBalanceSheetasanAssetof$1,500.(Refertopage
40inchapter3,ifyoudontremember!)Thiscameaboutbecausethebicy
clecompanyboughttheinsuranceinadvanceofusingit.Sincethiswasa
threeyearpolicy,bytheendofyearone,onethirdofithadbeenusedby
thebusiness.TorecognizetheusingupofthisAsset(PrepaidInsurance),
theInsuranceExpenseisincreasedby$500whichcorrespondstothe
Expenseofusingtheinsuranceforoneyear.Eventhoughtheinsurancewas
paidforlastyear,itisbeingusedonethirdatatimeduringeachofthethree
years.Eachtimeweusetheinsurance,itrepresentsanExpensetothecom
panyeventhoughthecashwasexpended(anexpenditure)inaprioryear.
Onceagain,weseethedifferencebetweenanexpenditureandanExpense.
WealsoseethatexpenditureseventuallybecomeExpenses.Inyearone
whentheinsurancewaspurchased,itwasanexpenditureofcashtothecom
pany.ItdoesnotbecomeanExpenseuntiltheinsurancepolicyisactually
usedforoneyear.
TheAssetitselfisnolongerworththefullamountpaid,sinceitnowonly
representstheremainingtwoyears.Therefore,theAssetisreducedbythe
sameonethird(oneyearofthethreeyears),orby$500.
TheIncomeStatement
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Lookingattheimpactthiswouldhaveontheaccountingequation,we
notethefollowing:
PrepaidInsurance$500=NetIncome(InterestExpense)$500
InthischapteryoulearnedthecomponentsofanIncomeStatementand
howtheyrelatetoeachother.YoualsolearnedthatRevenueandNet
Incomearenotthesameascashbecauseaccountantsusuallyusetheaccru
albasisofaccountingandnotthecashbasis.Finally,youlearnedhowindi
vidualtransactionsaffectandchangetheIncomeStatement.
Inchapter5youwillfindouthowtoprepareanduseaStatementof
CashFlows.
ANSWER
Itisnotpossibletomakeacompleteanalysisofacompanyjustbylook
ingatonefinancialstatement.Sam,theowner,andweasoutsiders
wouldalsoneedtolookattheBalanceSheetaswellastheStatementof
CashFlows(tobediscussedinthenextchapter).
ItisimportanttonotethattheSolanaBeachBicycleCompanydidmake
aprofitof$10,385.Manynewsmallbusinessesdonotmakeaprofitfor
thefirstthreeorfouryears,sothatisimpressive.
Inplanningfortheyearahead,Sammightdecidetoputmoremoneyinto
advertisingandexpandtherepairbusiness.Only10percentofthecom
panysRevenuecamefromrepairs,sotherecouldberoomforgrowthin
thatareaofthebusiness.
Otherinformationthatwouldbehelpfultolookatincludestheotherfinancial
statementsaswellasthebudgetsforthenexttwoyears,2007and2008.
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GLOSSARY
AccountsReceivable:Thisisatermusedtodescribemoneythatis
tobereceivedinthefutureforcurrentsalesofgoodsorservices.
Normally,AccountsReceivableappearsontheBalanceSheetasa
ShortTermAssetsincecompaniesgenerallygivecredittocustomersfor
thirtytosixtydays.
AccrualBasisofAccounting:Thisaccountingmethodrecognizes
transactionswhenRevenueisearned,Expensesareincurred,andpur
chasestakeplacewhetherornotcashchangeshandsatthatmoment.
ThisisthemethodofaccountingusedbyvirtueofGenerallyAccepted
AccountingPrinciple,andmostbusinessesusethisratherthanthealter
native,thecashbasisofaccounting.
BadDebtExpense:ThisExpenseappearsontheIncomeStatement
andisincreasedbytheamountofthereceivablesthatwillnotbecollect
ed(thatis,debtsowedtothecompanythatwillnotbepaid).Whenthis
Expenseiscreated,acontraAssettoAccountsreceivableisalsocreated
calledAllowanceforBadDebts.ThiscontraAssetreducestheAccounts
ReceivableaccountontheBalanceSheetandkeepsthetwosidesofthe
BalanceSheetinbalance.
BottomLine:AnothertermusedforNetIncome,itrepresentsall
ExpensessubtractedfromallRevenues.Thisfiguregetsitnamefromthe
factthatitappearsatthebottomoftheIncomeStatement.
CashBasisofAccounting:Thisaccountingmethodonlyrecognizes
RevenueandExpenseswhencashisexchanged.IfthesaleorExpense
takesplaceinoneperiodwithoutcashchanginghands,becauseof
receivablesandpayables,theRevenueandtheExpensesarenotrecog
nizeduntilafutureperiod.Forthisreason,thecashbasisofaccounting
istypicallynotusedforbusinessaccordingtoGAAP,butisthemethod
generallyusedinpersonalaccounting.
CostofGoodsSold:ThecostofalltheInventorythatwassoldduring
theperiodstatedintheIncomeStatement.Costofgoodssoldisan
ExpenseandissubtractedfromRevenuetoarriveatGrossProfit.
Expenditures:Thespendingofcash.AllExpensesareexpenditures;
however,allexpendituresarenotExpenses.Onlyexpendituresthatimme
diatelygenerateRevenueareconsideredExpenses.Whenexpenditures
aremadeforitemsthathavefuturebenefits,theyareclassifiedasAssets
andconvertedtoExpensesastheyareusedup.
TheIncomeStatement
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Expenses:ExpensesareexpendituresmadetogenerateRevenue.
Whetherornotcashchangeshands,acompanyincursanExpenseas
soonasitmakesacommitmenttopayforaproductorservice.
GrossProfit:ThedifferencebetweenRevenueandCostofGoods
SoldbeforeoperatingExpenses,interest,andtaxesaresubtracted.A
goodanalysisfortheownerofacompanyistocompareGrossProfit
fromoneyeartoanotheranddeterminewhetheritisincreasingor
decreasingandwhy.
IncomeStatement:ThisfinancialstatementisalistingofallRevenues
andExpensesofthebusinessearnedorincurredduringaparticularperi
odoftime.TheIncomeStatementisusuallyproducedbyacompany
monthly,quarterly,orannually.Itisoneofthethreemajorstatementspro
ducedbybusinessesintheUnitedStates,theothertwobeingtheBalance
SheetandtheStatementofCashFlows.
NetIncome:ThedifferencebetweenRevenueandExpensesforades
ignatedperiodoftime.InthecaseofSolanaBeachBicycleCompany,
wesawthreeusesofthetermNetIncome.Thefirst,NetIncomefrom
operations,showsallnormalRevenueandExpensesthatdealwiththe
mainoperationsofthisbusinesssellingbicycles.Thesecondusage
wasNetIncomebeforetaxes,whereNetIncomefromoperationsis
increasedandreducedbyotherRevenueandExpensesthatareoutside
thenormaloperationsofthisbusinesslikerepairingbicycles.Thethird
usagewasNetIncome.Thisiswhatisreferredtoasthebottomline
sinceitappearsatthebottomoftheIncomeStatement.Itisderivedby
reducingNetIncomebeforetaxes,bytheamountofIncomeTaxesfor
theyear.
OtherRevenuesandExpenses:Thoseitemsthatarederivedfrom
transactionsthatarenotthemainbusinessofthecompanyandthatare
listedontheIncomeStatementunderOtherRevenuesandExpenses.In
thecaseofSolanaBeach,salesofbicyclesisthemainbusiness;repairs
arenottheshopsmainbusinessandarelistedunderOtherRevenues
andExpenses.
Recognize:ThistermreferstotherecordingoftheRevenuesand
Expensesintherecordsofthecompany.Thisoccursatthepointintime
whenRevenueandExpensesareshownontheIncomeStatement.
Revenuesarerecognizedwhenservicesareperformedorwhentitleis
transferredongoodssold.Expensesarerecognizedwhentheyare
incurredandbecomeanobligationofthecompany.
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Revenue:Theamountearnedbyabusinessbysellinggoodsorper
formingservicesistermedRevenue.InthecaseoftheSolanaBeach
BicycleCompany,Revenuerepresentstheearningsinfromthesellingof
bicyclesaswellastherepairofbicycles.Sincethemainbusinessofthe
companyistosellbicycles,theRevenuethatisearnedfromtherepairsis
shownasotherincome.
TheIncomeStatement
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PreparingandUsing
aStatementofCash
Flows
Chapter
5
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AfteranalyzingtheBalanceSheetandtheIncomeStatementfor
SolanaBeachBicycleCompany,Samanthahadaclearunderstandingof
whatherbusinessownedandwhatsheowed,aswellaswhatitsbottom
lineisfortheyear.Althoughthingsarelookinggoodsofar,Samhasa
naggingconcern,whichsheraisesatameetingwithherbusinessadvisor:
Ihavereadthatmanysmallbusinessesgobankrupt,notbecausethey
donthaveagreatproductoragreatservice,butbecausetheyrunoutof
cash.Isthatright?
Well,Samisright.Aswediscussedinchapter4,makingaprofit,orhav
ingalargeamountinRetainedEarnings,doesnotequalhavingcash.Andif
thereisnocash,thereisnowaytopaythesalaries,paytheIRS,orpayany
otherbillsforthatmatter.InthischapterwewilldiscusstheStatementof
CashFlowsandthefinancialstatement,whichwillhelpSaminherquest
tostayontopofthecashflowinherbusiness.
ForacompanysfinancialstatementtobeinaccordancewithGenerally
AcceptedAccountingPrinciples(GAAP),theStatementofCashFlows
mustbeincludedasoneofthefourrequiredfinancialstatements.Doyou
remembertheotherthree?TheyaretheBalanceSheet,theIncome
Statement,andStatementofRetainedEarnings.
TheStatementofCashFlowsshowstheflowofcashwithinthebusi
nesswherethecashcamefromandhowitwasspentduringtheperiodof
reporting(whichisgenerallyamonth,aquarter,orayear).Italsoshowsthe
cashflowsofthecompany,dividedintocategoriesaccordingtothreemajor
activities:operating,investing,andfinancing.Thisishelpfultostatement
users,businessowners,investors,andcreditorsbecauseitindicatesthetype
oftransactionthatgaverisetoeachoneofthecashflows.
Additionally,theStatementofCashFlowsdiffersfromtheBalance
SheetandIncomeStatementintwokeyways.TheBalanceSheetshows
thefinancialstatusofacompanyattheendofthereportingperiod(a
snapshot),butboththeIncomeStatementandtheStatementofCash
Flowsshowtheflowofactivityduringthereportingperiod(ashortmovie
comparedtothesnapshotthatistheBalanceSheet).Theseconddiffer
enceisthattheIncomeStatementreportsthisactivityontheaccrualbasis,
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andtheStatementofCashFlowsreportsitonthecashbasis.Remember
fromchapter4,thatunderthecashbasisofaccounting,Revenueisnot
reporteduntilcashisreceived,andExpensesarenotreporteduntilcashis
disbursed.
WhatIsthePurposeoftheStatement?
Liketheotherrequiredfinancialstatementsyouhavelearnedaboutthe
BalanceSheetandtheIncomeStatementtheStatementofCashFlows
enablesuserstomakedecisionsaboutthecompany.TheStatementof
CashFlowsismoreliketheIncomeStatementthantheBalanceSheetin
thatitisachangestatement.Itshowsthetransactionsthatcausedcashlev
elstochangefromthebeginningoftheperiodtotheend.Aswasmen
tionedearlier,acompanycanmakeaprofitorearnalargeamountof
Revenuebutnothaveenoughcashtopayitsbills.TheRevenue,thusthe
NetIncome,mayhavebeengenerated(whollyorinpart)bypromisesto
payinthefuture(AccountsReceivable),soitiscriticallyimportantto
reviewboththebottomlineaswellasthecompanyspositionincashto
reallyforecastitsfuture.
ThereareseveralwaysinwhichyoumightuseaStatementofCash
Flowsinyourownlife.Willyouhavesufficientcashattheendofthemonth
topurchaseadditionalInventory?Willyouhavethecashflowinthefuture
tobuythenewequipmentyoullneedtohandleallthegrowthyoureexpe
riencing?Willyouhavethecashnecessarytopurchaseanewbuildingfor
theplannedexpansion?(SeeAppendixBforareallifeexampleofa
FinancialStatementfromStationCasinos,Inc.)
Inbusinessthetermcashhasabroadermeaningthantheamountofcash
inthebankattheendoftheyear.Itisalsodefinedasliquidshortterm
investments;liquidinvestmentsarethosethatcanquicklybeconvertedinto
cashwithinaveryshortperiodoftime,usuallybycashingthemin(inthe
caseofcertificatesofdeposit,forexample)orbysellingthem.Forthisrea
son,theyarealsoreferredtoascashequivalents.(SeeFigure5.1forexam
ples.)Therefore,wheneverthetermcashisusedinthischapteritrefersto
cashandallcashequivalents.
PreparingandUsingaStatementofCashFlows
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Figure5.1:EXAMPLESOFCASHEQUIVALENTS
Cashinthebank
Commercialpaper(aformofshorttermloan)
Anyinvestmentthathasamaturitydateoflessthanthreemonths
Certificatesofdeposit
Moneymarketaccounts
U.S.Governmenttreasurybills
BylookingattheBalanceSheetinchapter3,Figure3.2,youcanseehow
muchcashtheSolanaBeachBicycleCompanyhasattheendofthe2006
$17,385.ByreviewingtheStatementofCashFlowsinFigure5.2,wecan
seewherethecashcamefromandwhereitwentduring2006.
StatementofCashFlows
YearEndedDecember31,2006
Note:Parenthesesindicatedecreasesincash
CashFlowfromOperatingActivities:
NetIncome.........................$10,385
IncreaseinAccountsReceivable...............(9)
IncreaseinInventory...................(23,000)
IncreaseinPrepaidInsurance..............(1,000)
IncreaseinAccountsPayable...............3,000
TotalCashFlowfromOperations...................($19,615)
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CashFlowfromInvestingActivities:
PurchaseofTruck.....................($8,000)
PurchaseofBuilding...................(25,000)
PurchaseofLand......................(10,000)
TotalCashFlowfromInvestingActivities..............($43,000)
CashFlowfromFinancingActivities:
BorrowingfortheMortgage..............$20,000
OwnersInvestment.....................60,000
TotalCashFlowfromFinancingActivities...............$80,000
NetIncreaseinCashandCashEquivalents.............$17,385
(NoticethatthisisthesamenumberforendingcashontheBalance
SheetinFigure3.2,sincetherewasnobeginningbalanceincash,$0
+thischange=$17,385)
Nowletsexamineeachofthestatementssectionsclosely.
OperatingActivities
Aswasmentionedearlier,theStatementofCashFlowsreportscashflow
relatedtothreeareasoperatingactivities,financialactivities,andinvest
mentactivities.Thisisbecausealistofcashflowsmeansmoretobusiness
owners,investors,andcreditorsastheyanalyzethebusinessiftheycandeter
minethetypeoftransactionthatgaverisetoeachoneofthecashflows.
Theoperationssectionofthecashflowstatementshowshowmuchcash
wasgeneratedfromoperations;thatis,thedaytodayrunningofthebusi
ness.InthecaseofSolanaBeachBicycleCompany,thecashgenerated
fromoperationswouldincludethemoneybroughtinduetobicyclesales
andrepairs.ThisstatementalwaysbeginswithNetIncome,thefigurecal
culatedontheIncomeStatement(RevenueminusExpenses).Thenthe
itemsfromoperationsthatcausecashtoincreaseordecreaseareadded
andsubtracted.
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Sincenotallofthebicyclecompanyssales(Revenue)werecashcus
tomers,youmustsubtractthesalesoncredit(AccountsReceivable)from
NetIncometodeterminetheamountofcashgeneratedfromthesesales.We
knowfromtheIncomeStatementinFigure4.1that$35,500inRevenue
fromsaleswasgeneratedin2006.InFigure5.2wecanseethatAccounts
Receivablehasincreasedfromabeginningbalance(theamountofmoney
thebikeshophadatthebeginningoftheyear)of$0toanendingbalance
of$9,000.ThisisthenetincreaseinAccountsReceivable,thereceivable
minustheallowancefordoubtfulaccounts.Thismeansthatofallthesales
fortheyear($35,500),cashhasnotbeenreceivedfor$9,000ofthattotal.
Inventoryalsohasincreasedfromabeginningbalanceof$0to$23,000
attheendoftheyear.ThischangeindicatesanincreaseinoneAsset,
Inventory,andadecreaseincashbecausecashwasusedtopurchasethat
Inventory.BecausetheInventorypurchaseusedcash(lateryouwilladjust
fortheportionthatwaspurchasedonaccount),youmustsubtractthe
increaseinInventoryinordertodeterminethecashgeneratedfromopera
tions.ThereductiontoNetIncomeinourexampleis$23,000.
PrepaidInsurancerepresentsthecashpurchaseofinsurancethatisgoing
tobeusedinthefuture.Inthisexample,SolanaBeachBicycleCompany
haspaid$1,500incashforthisAsset.Sincethispolicyisforthreeyears,at
theendof2006,onethirdoftheAssethasbeenusedup.Theremaining
AssetofPrepaidInsurancecoversthenexttwoyears.The$500thatrepre
sentstheinsurancecoveragefor2006,isshownontheIncomeStatement
asanoperatingExpense,andcorrespondinglyhasreducedtheAssetPrepaid
Insurance.TheremainingbalanceinthePrepaidInsuranceaccountof
$1,000representsanoutflowofcashthatisnotincludedontheIncome
Statement.ForthisreasonitneedstobesubtractedfromNetIncomeinthe
operatingactivitiessection.
(YoumaybeconfusedastowhyinthecaseofInventory,theentire
amountoftheAssetwasdeductedinthecashflowstatement,butinthe
caseofinsurance,onlyaportionwassubtracted.Thedifferencebetween
InventoryandthisinsuranceisthefactthattheInventorywasallsoldand
neededtobeadjustedforthefullamount.Withtheinsuranceonlyone
thirdhasbeenusedup,andthusonlyonethirdneedstobeadjustedinthe
statement.)
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ThebalanceintheAccountsPayableaccounthasincreasedfromthe
beginningoftheyearwhenitwas$0toanendingbalanceof$3,000.This
accountrepresentsthepurchaseofInventory(bicycles)onaccount.
Towardsthetopofthestatement,wesubtracted$23,000fromNetIncome
forthepurchaseofInventory,butsinceonly$20,000ofthatwaspaidwith
cashandtheremaining$3,000isstillowedtothecreditor(whatwecall
AccountsPayable),weaddthat$3,000backin.Inourexamplethisisthe
reasonforthe$3,000adjustment.
WhenalloftheseadjustmentsaremadetoNetIncome,thetotalrepre
sentsthecashflowfromoperations.Inthisexample,thereisanegativecash
flowfromoperationsof$19,615.Whatitmeansinthecaseofthebicycle
company(ascanbeenseeninFigure5.2)isthatinsteadofreceivingallcash
foritssales,theSolanaBeachBicycleCompanyallowedsomepeopletopay
later($9,000inAccountsReceivable).Inaddition,Samtooksomeofthe
money($23,000)thatcameintobuymoreInventoryandalsopurchased
insurance,whichfurtherreducedthecashbalancebutdidnotreduceNet
Income.Finally,$3,000wasborrowedintheformofanAccountsPayable
thatallowedthecompanytobuypartoftheInventorywithoutreducing
thecashbalance.ThistransactiondoesnotaffectNetIncome.Itisimpor
tanttonotethathavinganegativecashflowisnotnecessarilyabadthing;
inthiscaseitisacceptablebecausethecompanyisexpectingtoreceivecash
withinarelativelyshortperiodfromAccountsReceivable.If,however,the
companyweretooperateatanegativecashflowforanextendedperiod,it
couldputitslevelsofavailablecashanditsabilitytosettleitsowndebtsin
jeopardy.
InvestingActivities
Anytimeacompanymakesapurchaseofproperty,plant,orequipment,this
additionistreatedasaninvestmentintheorganization.Thisinvestmentrep
resentsacashflowfromthecompany.Eventhoughtheentirepurchasemay
nothavebeenwithcash,butwithsomeborrowedmoney,theentirepurchase
isshownasacashflowintheinvestingsectionofthecashflowstatement,
andanyborrowingofmoneyisshownseparatelyinthefinancingsection.
InFigure5.2wecanseethattheSolanaBeachBicycleCompanypur
chasedthreeLongTermAssetsduringtheyear2006.Thelandfor$10,000,
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thebuildingfor$25,000,andthetruckfor$8,000areallshownasnegative
cashflowsintheinvestingactivitiessectionofthecashflowstatement.The
totalofthesethreepurchasesrepresentsanegativecashflowfrominvest
ingactivitiesof$43,000.
FinancingActivities
Thesectioncalledfinancingactivitiesrepresentsthecashthathascome
intooroutofthecompanyforthepurposeoffinancingalloftheother
activitiesofthebusiness.ThiscouldincludeRetainedEarningsandmoney
broughtinbystockissuedbythecompany,oraswecanseeinFigure5.2
the$60,000thatSamanthainvestedintothebusinessonthefirstday.
(RememberthatSamspersonalmoneyisaccountedforseparatelyfromthe
companysmoney.Ifsheinvestspersonalfundsinthebusiness,whilethisis
adecreaseinherpersonalcashfunds,itisanincreaseinfundsforthebusi
ness.)Becausethisinvestmentwasincashitisshownasanincreaseinthe
cashflowfromfinancingactivities.InadditiontothisinvestmentbySam,a
fifteenyearloanwasnegotiatedinordertopurchasethelandandthebuild
ing.Thisloanfor$20,000isalsoshownasaninflowofcashtothebusiness
andthusanincreaseincashflowfromfinancingactivities.
Thetotalofthesetwoitems,$80,000,representsthetotalcashflowinto
thecompanyfromfinancingactivitiesduringtheyear2006.
Thetotalofthethreecashflowsfromoperations,frominvesting,and
fromfinancingrepresentsthetotalincreaseordecreaseincashandcash
equivalentsforthebusinessduringtheyearbeingreported(inthisexam
ple,anincreaseof$17,385).Noticethatthistotalrepresentsthechangein
cashfromthebeginningoftheyeartotheendoftheyear.Inourexample,
cashatthebeginningoftheyearwas$0,andattheendwas$17,385,anet
increase.
InthischapteryouhavelearnedhowtopreparetheStatementofCash
Flows.Inchapter6youwilllearnaboutthedoubleentrysystemof
accountingandhowtransactionsarerecordedintheaccountingbooks.
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GLOSSARY
StatementofCashFlows:Oneofthefourrequiredfinancialstate
ments.Thisstatementshowswherethecashcamefromandhowitwas
spentduringtheperiodofreporting.
Cash:Includescurrencyandcoins,balancesincheckingaccountsas
wellasanyitemthatisacceptableintothesecheckingaccounts,suchas
checksandmoneyorders.
CashEquivalents:Thecashheldbyabusinessaswellastheliquid
shortterminvestmentsthatcanquicklybeconvertedintocashwithina
veryshortperiodoftime.
OperatingActivities:Oneofthethreecategoriesofbusinessactivity
representedontheCashFlowStatement.Thissectionofthestatement
showshowmuchcashwasgeneratedfromoperations;thatis,theday
todayrunningofthebusiness.InthecaseofSolanaBeachBicycle,this
wouldincludecashgeneratedfrombicyclesalesandrepairs.
InvestingActivities:Oneofthethreecategoriesofbusinessactivity
showsthosepurchasesofproperty,plant,orequipment.Theseitemsare
treatedasaninvestmentintheorganizationandrepresentacashflow
outofthecompany.
FinancingActivities:Oneofthethreecategoriesofbusinessactivity
representsthecashthathascomeintooroutofthecompanyforthepur
poseoffinancingalloftheotheractivities.InthecaseofSolanaBeach
BicycleCompanythisincludesthemoneyborrowedonthemortgage
andthemoneyinvestedinthebusinessbySam.
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TheGeneralJournal
TheGeneralLedger
DoubleEntry
Accounting
Chapter
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Thetermsdebitandcreditareenoughtoinducefearineventhemost
intrepidnonaccountant.Buteventhoughyoumayneverbecomean
accountant,youwillneedtounderstandtheseconceptsinordertohavea
solidgraspofaccountingandbusiness.Inthischapteryoulllearnwhat
thesetermsmeanandhowtheyareusedintheworldofaccounting.
Alert!
WhatIsaDebit?:Theworddebitsimplyreferstotheleftsideoftheamount
columnsandthewordcreditidentifiestherightsideoftheamountcolumns.
Nothingmore,nothingless.Debitdoesnotmeansomethingunfavorableand
creditdoesnotmeansomethingfavorable,assomenonaccountantsoftenbelieve.
TheGeneralJournal
Sometimeafterabusinesstransactionoccursitisrecordedinabookcalled
thegeneraljournal.Whiletherearemanydifferentkindsofjournals,itis
mostimportanttofocusonthegeneraljournal.Ageneraljournalisoften
referredtoasthebookoforiginalentrybecausethisjournalisthebookin
whichatransactionisfirstrecorded.
Ifacompanyweretobuylandforcash,thepagesofageneraljournalwill
lookliketheoneshownbelowinFigure6.1(theentriesinthisfiguredo
notcomefromSolanaBeachBicycleCompanybutaresimplyexamples):
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Figure6.1:
JOURNAL
Amounts
Date
Entries
Reference
Debits
Credits
01/05/06
Land
$10,000
Cash
$10,000
(BoughtLandforcashfornewwarehouse)
01/31/06
SalaryExpense
$400
Cash
$400
(PaidSalaryforthemonthofJanuarywithcash)
JournalEntries
Toillustratehowtransactionsarerecordedinthegeneraljournalyoucan
usethetransactionsdescribedinchapters3and4.Butfirstletsgobackto
theAccountingEquationwetalkedaboutinchapter1.
A=L+OE
ThestandardaccountingruleisthatAssets,ortheleftsideoftheequa
tion,areincreasedwithdebits,anddecreasedwithcredits,whiletheright
sideoftheequation,theLiabilitiesandtheOwnersEquityitemsarejust
theopposite;thatis,theyareincreasedwithcredits,anddecreasedwith
debits.Whenyouincreaseordecreasethedebits,bythesameamountas
youincreaseordecreasethecreditsoneachtransaction,youmakesurethat
thedebitsalwaysequalthecredits,akeygoalofbookkeeping.Ifthedebits
donotequalthecreditsattheendoftheperiod,(month,quarter,oryear),
itindicatesthatamistakewasmadesomewherealongthelineandoneof
thetransactionswasenteredimproperly.Byusingthissystem,the
AccountingEquationalwaysstaysinbalanceaftereachtransactionis
recordedsinceyouareincreasingordecreasingbothsidesoftheequation
DoubleEntryAccounting
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byequalamounts.Thereisastandardwayofdealingwithdebitsandcred
itsassignedtoAssets,Liabilities,OwnersEquity,Revenues,andExpenses.
Figure6.2belowsummarizesthisconcept:
Figure6.2:
INCREASES/DECREASESINACCOUNTS
Transaction
JournalEntry
AssetsIncrease
Debit
AssetsDecrease
Credit
LiabilitiesIncrease
Credit
LiabilitiesDecrease
Debit
Revenue(OEIncreases)
Credit
Expense(OEDecreases)
Debit
Nowletsrecordinthegeneraljournalsomeofthetransactionsofthe
previouschapters.Itisimportanttorememberthateverysingletransaction
inthejournalmustberecordedasbothadebitandacredit.First,Sam
invested$60,000inherbicyclecompany.Thistransactionwouldberecord
edasshowninFigure6.3:
Figure6.3:
JOURNAL
Amounts
Date
Entries
Reference
Debits
Credits
2006
Jan1
Cash
$60,000
OwnersInvestment
$60,000
(OwnerInvests$60,000inCash)
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Youalreadyknowthatwhenevertheownerofabusinessinvestscash
intohisorherbusiness,cashisincreasedandsoistheOwnersInvestment
(partofOwnersEquity).Ifcash(anAsset)increases,thisisshownasa
debitinthejournal;theincreaseinOwnersEquityislistedasacredit.(See
Figure6.2above.)
Inthenexttransaction,thecompanybuysabuilding,land,andatruck
for$43,000.Sincethebicycleshopdoesnothavesufficientcashtopayfor
alloftheseAssets,theownerneedstoborrow$20,000andpaystheremain
derincash($23,000).Thistransactionwouldberecordedinthegeneral
journalasshowninFigure6.4:
Figure6.4:
JOURNAL
Amounts
Date
Entries
Reference
Debits
Credits
2006
Jan3
Truck
$8,000
Building
$25,000
Land
$10,000
Cash
$23,000
MortgagePayable
$20,000
(PurchaseofAssetsfor
CashandMortgage)
Noticeintheabovejournalentry,DEBITSwereusedtoincreasethe
Assets(land,building,andtruck),whileCREDITSwereusedtodecrease
Asset(cash),buttoincreasetheLiabilityMortgagePayable.Thus,depend
inguponwhichsideoftheaccountingequationtheaccountappears,this
willdetermineifitisrecordedasadebitoracredit(seeFigure6.2).
Nowwellmoveontothetransactionsfromchapter4,whichwere
recordedontheIncomeStatement.
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OnJanuary5,thebicyclecompanysoldtwobicyclesforatotalof$500.
Asyouremember,thisonetransactioncausedtwochangestotheIncome
Statement.First,itincreasedtheRevenueaccountcalledSalesby$500,
andsecond,itincreasedanExpenseaccountcalledCostofGoodsSold
bythecostofthesetwobicyclesor$200.Rememberalsothatatthesame
timethatthistransactioniscausingachangetotheIncomeStatement,it
isalsocausingtheBalanceSheettochangeinseveralways.Thesebicycles
weresoldforcash;thus,theAssetcashwouldincreaseby$500.TheAsset
Inventorywoulddecreasebytheircostof$200(sincethebicycles
(Inventory)donotbelongtothecompanyanylonger).The$300differ
encebetweenthesalepriceandthecost($500$200)wouldbean
increasetoRetainedEarnings,whichispartofOwnersEquity.
NoticeinthetransactionbelowinFigure6.5,thereisnoentryfor
RetainedEarningsorOwnersEquity.Theprofitfromthistransactionof
$300,simplyappearsintheBalanceSheet(asRetainedEarnings)whenthe
Revenue($500)andtheExpense($200)arerecorded.
Thesetwotransactionswouldberecordedinthegeneraljournalasseen
belowinFigure6.5:
Figure6.5:
JOURNAL
Amounts
Date
Entries
Reference
Debits
Credits
2006
5Jan
Cash
$500
Sales
$500
Also:
5Jan
CostofGoodsSold
$200
Inventory
$200
(SoldBicycles)
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ReferringbacktotheAccountingEquation,A=L+OE,thesalestrans
actionhasincreasedtheleftside(theAssetCash)by$500,andincreased
therightside,OwnersEquitybythesameamount.Thesecondpartofthis
transactionthatreducestheInventoryalsokeepstheaccountingequation
inbalance,theExpenseofthebikes(thedebit),andthedecreasein
Inventory(thecredit).Inbothofthesetransactions,thedebitstorecord
thesetransactionsareequaltothecredits.
Lookingatanothertransactioninchapter4,OperatingExpenses,youcan
seetheimpactontheGeneralJournal.OnJanuary7,SolanaBeachBicycle
CompanypaysSamherfirstweekspayof$100.Thistransactionwouldbe
recordedintheGeneralJournalasshowninFigure6.6:
Figure6.6:
JOURNAL
Amounts
Date
Entries
Reference
Debits
Credits
2006
7Jan
SalaryExpense
$100
Cash
$100
(PaidSalaries)
Thistransactionhasdecreasedtheleftsideoftheaccountingequation,
AssetsorCashby$100,andhasalsodecreasedtherightsideOwners
EquitywithanExpensebythesameamount.Onceagain,thedebitsequal
thecredits.
Finallylookatonemoretransactionfromchapter4,whereSolanaBeach
BicycleCompanyrepairssomebicyclesfor$375.Thepartsfortheserepairs
costthecompany$105,paidforincash.Thistransactionisrecordedinthe
GeneralJournalasfollowsinFigure6.7:
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Figure6.7:
JOURNAL
Amounts
Date
Entries
Reference
Debits
Credits
2006
14Feb
Cash
$375
RepairsRevenue
$375
Also:
14Feb
RepairsExpense
$105
Cash
$105
(PerformedRepairs)
Onceagain,noticethatinthefirstpartofthistransaction,theleftsideof
theaccountingequationisincreasedby$375,andtherightside,Owners
Equity(viaaRevenueitem),isincreasedbythesameamount.
Inthesecondpartofthetransaction,therightsideisdecreasedwitha
credittoanAsset(cash)by$105,andtheleftsideisdecreasedwithadebit
toanOwnersEquityaccount(RepairsExpense).Thustheequation(A=
L+OE)staysinbalance,andthedebitsequalthecredits.
TheGeneralLedger
Duringthemonth,thejournalentriesmadetorecordtheJanuarytransac
tionswouldbepostedfromthegeneraljournaltothegeneralledger.The
generalledgerisabookcontainingarecordofeachaccount.(Seeboxed
sectionbelowFigure6.8.)Postingissimplytheprocessoftransferringthe
informationfromthegeneraljournaltotheindividualaccountpagesinthe
generalledger.Thecashaccount,whichprobablyisthefirstpage(orpages)
inthegeneralledger,wouldlookliketheexampleinFigure6.8:
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Figure6.8
CASH
Account#101
Debit
Credit
Date
CommentsRef.Amount
DateCommentsRef.Amount
Noticethattheaccounthastwosides.Asbefore,theleftsideisusedto
recordthedebitsandtherightsideisusedtorecordthecredits.
NoticethatthesampleledgeraccountinFigure6.8listsanaccountnum
ber,101intheupperrighthandcorner.EveryAsset,Liability,Owners
Equity,Revenue,andExpenseitemhasanumberassignedtoit.Usually,the
Assetsarethe100s,theLiabilitiesthe200s,theOwnersEquitythe300s,
theRevenuesthe400s,andtheExpensesthe500s.Intheledger,eachitem
(oraccount)hasaseparatepagewithaseparatenumber.Inthiscase,cash
hasbeenassignedthenumber101,andallcashtransactionsarerecordedon
thispage.
Theaccountsareusuallynumberedforavarietyofreasons;forexample,
tofacilitatereferencingorforuseinsteadoftheaccountname.Thislisting
ofaccountsisnormallycalledthechartofaccounts.
Afterpostingthefirstjournalentry(January1),thecashaccountwould
looklikeFigure6.9:
Figure6.9
CASH
Account#101
Debit
Credit
Date
CommentsRef.Amount
Jan1
J1
$60,000
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Thedateofthetransactionisenteredinthedatecolumnonthelefthand
sidesincetheentrywasadebit.J1isenteredinthereferencecolumnand
thattellsyouthatthejournalentrythatrecordedthetransactioncanbe
foundonpageoneofthegeneraljournal.Sixtythousanddollarsisentered
inthelefthandamountcolumn.
Theotherhalftothisfirstjournalentry(thecredit)wouldbepostedto
theOwnersInvestmentaccountandwouldberecordedasshowninFigure
6.10:
Figure6.10
OWNERSINVESTMENT
Account#301
Debit
Credit
Date
CommentsRef.Amount
Jan1
J1
$60,000
Ofcourse,inthisinstancethedataispostedtotherighthandcolumn
sincetheentryisacredittotheaccount.
Nowafterpostingthefirstentry,thegeneraljournalwouldappearas
showninFigure6.11:
Figure6.11:TORECORD$60,000INVESTMENTBYOWNER
JOURNAL
Page1
Date
Entries
Ref.
Amounts
Debits
Credits
2006
Jan1
Cash
101
$60,000
OwnersEquity
301
$60,000
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YouseethattheaccountnumbersforthecashandOwnersInvestment
accountshavenowbeenenteredinthereferencecolumnofthejournal.
Thisstepcompletesthepostingprocessforthefirstjournalentry.Thesame
procedureisrepeateduntilallthejournalentrieshavebeenpostedtothe
generalledger.
AfterpostingallthejournalentriesrecordedinJanuary,thecashaccount
wouldlooklikeFigure6.12:
Figure6.12
Cash
Account#101
Debit
Credit
Date
CommentsRef.Amount
Jan1InvestmentJ1
$60,000Jan1Assets
J1
$23,000
Jan3InsuranceJ1
$1,500
Jan5InventoryJ1
$10,000
Jan6SalesJ1
$500
Jan7Salary
J1
$100
Jan21Sales
J1
$3,500
Total
$54,000
Total
$34,600
Ifyouaddthedebitandcreditsidesofthecashaccount,youwillfind
thatthedebitstotal$54,000andthecreditstotal$34,600.Thedifference
betweenthesetwofiguresis$19,400.Youcouldsaythatthecashaccount
hasadebitbalanceattheendofJanuary.Remember,inordertoincreasean
Asset,werecordadebit.Ifattheendoftheperiodthereisadebitbalance
inanAssetaccount,thatmeansthatthereisapositivebalance,orinthis
casewithcash,moneyinthebank.Debitsandcreditswillgenerallynot
beequalforeachindividualaccount;butoncealltheaccountsareconsid
eredtogether,thedebitsandcreditsshouldbeequal.Thisisreflectedonthe
trialbalanceforthecashaccountbeforeadjustments.Adiscussionofthe
trialbalancefollowsbelow.
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TrialBalance
Typically,accountantsandbookkeeperswillprepareatrialbalancefromthe
generalledgerafteralltransactionshavebeenrecordedandposted.Atrial
balanceismerelyalistofallaccountsinthegeneralledgerthathaveabal
anceotherthanzero,withthebalanceineachaccountshownandthedeb
itsandcreditstotaled.AtrialbalanceofSolanaBeachBicycleCompanyat
January31,2006,wouldlookliketheonebelowinFigure6.13:
TrialBalance
(BeforeAdjusting&ClosingEntries)
January31,2006
Debits
Credits
Cash
$19,400
Accountsreceivable
1,500
Inventory
20,800
PrepaidInsurance
1,500
Truck
8,000
Building
25,000
Land
10,000
AccountsPayable
$3,000
MortgagePayable(LongTerm)
20,000
OwnersInvestment
60,000
RetainedEarnings
0
Sales
5,500
RepairRevenue
CostofGoodsSold
2,200
Expenses(Salary)
100
$88,500
$88,500
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Atrialbalanceispreparedbyfirstturningthroughthepagesofthegen
eralledgerandlocatingeachaccountwithabalanceotherthanzero,asin
Figure6.12wherethecashaccounthadadebitbalanceof$19,400.Once
itisdeterminedwhatthebalanceineachaccountis,thisisnotedonthe
trialBalanceSheet.Generallyspeaking,thetrialbalanceispreparedfortwo
reasons:thefirstreasonistodeterminewhetherthetotaldebitsequalthe
totalcredits.Iftheydonotequal,somekindoferrorhasbeenmadeeither
intherecordingofthejournalentriesorinthepostingofthegeneralledger.
Ineithercase,theerrormustbelocatedandcorrected.Thesecondreason
istofacilitatethepreparationofadjustingentries(discussedinthenextsec
tion),whicharenecessarybeforethefinancialstatementscanbeprepared.
YoushouldnotethatifSolanaBeachBicycleCompanyhadbeeninoper
ationpriortothisyear,aRetainedEarningsfigurewouldappearonthe
presenttrialbalance.TheRetainedEarningsaccountwillshowthebegin
ningRetainedEarningsuntiltheaccountantclosestheaccountsthataffect
theRetainedEarningsbytheamountoftheprofitorlossfortheperiod
(month,quarter,oryear).Formoreinformationonclosingaccounts,see
ClosingJournalEntries,page93.
Accountingrecordsarenotkeptuptodateatalltimes.Todosowouldbe
awasteoftime,effort,andmoneybecausemuchoftheinformationisnot
neededfordaytodaydecisions.Adjustingentriesisasteptakentorecog
nizefinancialeventsthathaveoccurredpriortothefinancialstatements
issuancedatebutwhichhavenotbeenrecordedinthejournal.Theseare
nottransactionswithaparticulardateattached,buttheyarefinancialreal
itieswhichrequiredocumentationinordertomaintainaccuraterecords.In
thecaseoftheSolanaBeachBicycleCompanytherearefiveitemsthat
needtobeadjustedattheendofeachmonth:AccumulatedDepreciation
onthebuildingandonthetruck,PrepaidInsurance,Interestonthemort
gage,andtheportionofaccountreceivablesthatthecompanydoesnot
believeitwilleverbeabletocollect(baddebts).Aftertheadjustedjournal
entriesarerecordedinthejournal,theymustbepostedtotheaccountsin
thegeneralledger,justliketheearlierjournalentries.
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PrepaidInsurance
Rememberinchapter3,PrepaidInsuranceislistedontheBalanceSheetas
anAsset.ThiscameaboutbecauseSolanaBeachBicycleCompanybought
insuranceinadvanceofusingit.BytheendofJanuary,onethirtysixthof
thethreeyearpolicyhadbeenusedupandbecameanExpense.Torecog
nizetheusingupofthisAsset(calledPrepaidInsurance),anExpense
calledInsuranceExpenseisincreasedby$41.67($1,500/36months).The
Assetitselfisnolongerworththefullamountpaid,sinceitnowonlyrep
resentstheremainingthirtyfivemonths.Ifyouthinkbacktotheaccount
ingequationagainA=L+OEthelefthandsideoftheequationis
reducedby$41.67(becausetheAssetcalledPrepaidInsurancehas
decreased),andtherightsideisalsoreducedbythesameamountbecause
ofinsuranceExpense(whichcausesareductioninOwnersEquity).An
adjustmentforthisamountwillbemadeinthejournal.
DepreciationExpense
LongTermAssetslikethebuildingandtruckhaveafinitelife.Theirorigi
nal(historical)costisthereforespreadovertheirusefullives.Thisprocess
iscalleddepreciation.InordertodepreciatethesetwoAssets,youneedto
knowwhatthelifeexpectancyofeachis,thatishowlongtheseAssetswill
produceincomeforthebusiness.Inourexample,youcanassumethatthe
buildinghasalifeexpectancyoftwentyfiveyears,andthetruckoffive
years.TodepreciatethesetwoAssets,youcandividethehistoricalcostby
thelifeexpectancy.
Truck:
$8,000(historicalcost)/5years(lifeexpectancy)=$1,600Depreciation
peryear
Building:
$25,000(historicalcost)/25years(lifeexpectancy)=$1,000Depreciation
peryear
Sinceyouareonlylookingforthedepreciationadjustmentforthesetwo
AssetsforthemonthofJanuary,eachnumberwouldbedividedbytwelve
(months)toarriveatdepreciationadjustmentforthemonthofJanuary.
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Truck=$1,600(depreciationperyear)/12(monthsperyear)=$133.33
permonth
Building=$1,000(depreciationperyear)/12(monthsperyear)=$33.33
permonth
QUICKTip
TheLifeExpectancyofanAsset:Oneoftheassumptionsyouastheownerofa
businessneedtomakeiswhatthelifeexpectanciesofLongTermAssetsare.
Howshouldyoudothis?Theeasiestwayistoestimatebasedonyourexperi
enceofsimilarAssetsusedinthebusinessinthepast.Youcanalsogetinfor
mationfromthelibraryonwhataveragesareusedforsimilarAssetsinyour
industry.Finally,theIRShasascheduleofLongTermAssets,withlifeexpectan
cyfiguresthattheywillaccept.Thefinaldecisionisyours,andifreasonable,it
isacceptable.
InterestExpense
Asyouremember,SolanaBeachBicycleCompanyhastopayintereston
themortgagethatittookoutonthelandandbuilding.Themortgagewas
for$20,000fortenyearsat8percentperyear.Thetotalinterestperyearis
$1,600($20,000x8percent).Therefore,eachmonththebusinessowesthe
mortgagecompanyonetwelfthoftheyearstotalinterestor$133.33
($1,600/12months).Sincethecashisnotoweduntiltheendoftheyear,
SolanaBeachBicycleCompanyhascreatedanotherLiabilitycalledInterest
Payablethatisdueattheendoftheyear.TheamountofthisLiabilityisthe
sameastheInterestExpenseof$133.33forthemonthofJanuary.
AccountsReceivableWriteOffs
AttheendofJanuary,thecompanyassumedthatitwasnotgoingtobeable
tocollect$50fromsomeofthecustomersthathadpromisedtopay.(This
wasaguesstimateorassumption,sincethecompanywillnotknowuntil
nextmonthwhoisgoingtopayandwhoisnot.)Inordertorecognizethis
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assumptiononthefinancialstatements,SamcreatedanExpensecategory
calledBadDebtsExpense.Theotherhalfofthisentryistoincreasean
accountcalledAllowanceforDoubtfulAccounts.Thisaccountiscalleda
contraAsset;itisareductiontoAccountsReceivablethatfactorsinthe
expectationthatcertainAccountsReceivablewillnotbepaidandkeepsthe
BalanceSheetinbalance.YoushouldnotethateventhoughtheBadDebt
Expensedoesnotusecash,itreducestheNetIncomeinthesamewayas
otherExpensesthatdousecash.InthecaseofBadDebtExpense,theAsset
reducedisAccountsReceivable(ratherthancash).
QUICKTip
EstimatingBadDebts:Likedepreciation,themanagementofthecompanymust
estimatebaddebtsfortheperiod.Thisestimationcanbedonebasedonpast
experiencethatacertainpercentofreceivablescannotbecollected.Itisalso
possiblethatmanagementhasspecificinformationonparticularaccountsthat
willnotbecollectedandcanincorporatethisdataintotheadjustments.
TrialBalanceAfterAdjustments
Aftertheadjustingentriesarepostedtothejournal,theaccountantmay
prepareanothertrialbalancetohelpinthepreparationoftheactualfinan
cialstatements,ortheaccountantmaybeabletopreparethestatementsby
usingthegeneralledgeronly.AtrialbalancepreparedattheendofJanuary
2006wouldlooklikeFigure6.14:
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TrialBalance
(AfterAdjustments,BeforeClosing)
January31,2006
Debits
Credits
Cash
$29,400.00
AccountsReceivable
1,500.00
AllowanceforDoubtfulAccounts
(50)
Inventory
10,800.00
PrepaidInsurance
1,458.33
Land
10,000.00
Building
25,000.00
AccumulatedDepreciationBuilding
(33.33)
Truck
8,000.00
AccumulatedDepreciationTruck
(133.33)
AccountsPayable
$3,000.00
InterestPayable
133.33
20,000.00
OwnersInvestment
60,000.00
RetainedEarnings
Sales
5,500.00
RepairRevenue
CostofGoodsSold
2,200.00
SalariesExpenses
100.00
InsuranceExpense
41.67
DepreciationExpense
166.66
InterestExpense
133.33
BadDebtExpense
50.00
$88,633.33
$88,633.33
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Therearesomedifferencesbetweenthistrialbalanceandtheoneon
page86,whichshowsthetrialbalancebeforetheadjustingjournalentries.
First,fournewaccountshavebeencreated:InsuranceExpense,
DepreciationExpense,AccumulatedDepreciation,andInterestExpense.
TheaccountcalledInsuranceExpenserepresentstheamountofthe
usedupPrepaidInsuranceforonemonth.Itwasincreasedby$41.67at
thesametimethatPrepaidInsurance(theAsset)wasdecreasedbythe
sameamount.
TheDepreciationExpenseaccountwascreatedtorepresentthe
depreciationonthetwoLongTermAssets,truck,andbuilding.Instead
ofreducingtheLongTermAssetsdirectlyastheygetolder,accountants
setupanotherseparatecontraAssetaccount.This,liketheonediscussed
aboveforAllowanceforDoubtfulAccounts,wasareductiontoAccounts
Receivable.ForLongTermAssetsthecontraaccountiscalled
AccumulatedDepreciation.EachLongTermAssethasaseparatecontra
Assetaccount.(AccumulatedDepreciationTruckandAccumulated
DepreciationBuilding.)OntheBalanceSheet,thecontraAssetswould
appearlikethoseshowninFigure6.15below:
Figure6.15:PARTIALBALANCESHEET
CurrentAssets:
AccountsReceivable...............................$1,500
Less:AllowanceforDoubtfulAccounts.....................(50)
NetAccountsReceivable...........................$1,450
LongTermAssets:
Truck.........................................$4,000
Less:AccumulatedDepreciationTruck..................(400)
NetTruck......................................$3,600
Land,eventhoughitisaLongTermAsset,doesnotdepreciateanddoes
nothaveanaccumulateddepreciationcontraAssetaccount.
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ThelastnewaccountisInterestExpense.Thisaccountrepresentsthe
amountofinterestthathasbeenpaid.Inourexample,thisis$133.33per
monthontheMortgage.
Ingeneral,accountingrecordsareclosedattheendoftheyear.Afterthe
closingjournalentrieshavebeenmadeandposted,alltheIncome
Statementaccounts(alsocalledtemporaryaccounts)beginthenewyear
withazerobalance.Forexample,nextyearwewanttoaccumulateand
showinthesalesaccountthetotalsalesmadeduringthatyearandthatyear
only;todothis,thesalesaccountmusthaveazerobalanceatthebeginning
oftheyearsothefiguresfromthepreviousyeardontcarryover.
WhenSolanaBeachBicycleCompanydecidestomakethefinancial
statementsfortheendofthemonth,theaccountantwouldmakethefol
lowingentriesinthegeneraljournalasshowninFigure6.16toclosethe
recordsforJanuary,2006:
Figure6.16
JOURNAL
Page5
Date
Entries
Ref.
Amounts
Debits
Credits
2006
Jan31
Sales
$5,500.00
CostofGoodsSold
$2,200.00
SalariesExpense
100.00
InsuranceExpense
41.67
DepreciationExpense
166.66
InterestExpense
133.33
BadDebtExpense
50.00
RetainedEarnings
2,808.34
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EachRevenueandExpenseaccountisclosed(broughttoazerobalance)
by(1)determiningthebalanceoftheaccountand(2)placingthisamount
(theaccountbalance)ontheoppositesideoftheaccount;thatis,adebit
balanceforanaccountisbalancedoutonthecreditsideofthejournal,and
acreditbalanceisbalancedoutonthedebitside.Forexample,priortoclos
ing,thesalesaccounthadacreditbalanceof$5,500.Toclosethesales
accountitwasdebitedfor$5,500toachievethedesiredzerobalance.The
CostofGoodsSoldaccounthadadebitbalanceof$2,200;thus,toclose
thisaccountitwascreditedfor$2,200.
AfteralloftheRevenuesandExpenseshavebeenclosed(madetohave
azerobalance),andthedebitsandcreditsareaddedinthejournal,there
willbeadollardifference.Intheexample,thisdifferenceisthedifference
betweenthesalesdebitandthecreditsforthevariousExpenses:$2,808.34.
ThisrepresentsNetIncomeforthemonthofJanuary.Inordertomakethe
closingentrybalanceanadditionalcreditisneeded;thiscreditisto
RetainedEarnings.Asyoulearnedinpreviouslessons,RetainedEarningsis
theaccountwhereprofitsareaccumulatedfromyeartoyear.
QUICKTip
HandlingRevenueandExpenseAccounts:RevenueandExpenseaccountsare
temporaryaccounts.Youcanclosethemanytimeyouwantsummarizedinfor
mationabouttheirfinancialposition.Attheendoftheaccountingperiodall
RevenueandExpenseaccountsareclosedintotheRetainedEarningsaccount.
ThisleavesalloftheRevenueandExpenseaccountswithazerobalanceafter
theclosingprocessandletsthestatementreaderknowhowmuchprofitorloss
hasbeencreatedbythebusiness.
Beforepostingtheclosingentries,thesalesandCostofGoodsSold
accounts(forexample)lookedlikeFigure6.17:
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Figure6.17
Sales
Account#401
Date
CommentsRef.Debit
DateCommentsRef.Credit
Amount
Amount
2006
Jan6
J1
500.00
Jan21
J1
5,000.00
CostofGoodsSold
Account#501
Date
CommentsRef.Debit
Amount
Amount
2006
Jan6
J1
200.00
Jan21
J3
2,000.00
Afterpostingtheclosingentries,thesalesandCostofGoodsSold
accountswouldlooklikeFigure6.18:
Figure6.18
Sales
Account#401
Date
CommentsRef.Debit
Amount
Amount
2006
Jan6
J1500.00
Jan31Closing
J5
5,500.00Jan21
J15,000.00
CostofGoodsSold
Account#501
Date
CommentsRef.Debit
Amount
Amount
2006
Jan6
J1
200.00
Jan21
J3
2,000.00Jan31Closing
J52,200.00
95
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NoticethatinthetrialbalanceinFigure6.19,therearenoRevenueor
Expenseaccountslisted.However,thedifferencebetweentheRevenueand
Expensespriortotheirclosinghasnowbeenclosedandappearsinthe
RetainedEarningsaccount.
ThedoublelinesdrawnacrosstheaccountsinFigure6.18aremeanttoindi
catethattheaccountsareclosed.Entriesforthefollowingperiod(inthis
example,February2006)wouldbepostedtotheseaccountsinthespaces
underthedoublelines.Alloftheaccountsthatwereclosedwouldlooklike
thesalesandCostofGoodsSoldaccountsillustratedaboveinthatthedebits
andcreditswouldbalance,except,ofcourse,thedatesanddollarsfigures
wouldbedifferent.
Oftenaccountantswillprepareanafterclosingtrialbalancetoseethat
thedebitsandcreditsarestillinbalanceandtoseethatallthetemporary
accountshavebeenclosed.SolanaBeachBicycleCompanysafterclosing
trialbalancewouldlooklikeFigure6.19.Noticethataccumulateddepreci
ationislistedasasubtractiononthedebitside.
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TrialBalance
(AfterClosing)
January31,2006
Debits
Credits
Cash
$29,400.00
AccountsReceivable
1,500
AllowanceforDoubtfulAccounts
(50)
Inventory
10,800.00
PrepaidInsurance
1,458.33
Land
10,000.00
Building
25,000.00
AccumulatedDepreciationBuilding
(33.33)
Truck
8,000.00
AccumulatedDepreciationTruck
(133.33)
AccountsPayable
$3,000.00
InterestPayable
133.33
20,000.00
OwnersInvestment
60,000.00
RetainedEarnings
2,808.34
$85,941.67
$85,941.67
Theclosingprocessisafairlyroutineone.Itmerelyreversesthebal
ancesintheIncomeStatementaccounts,bringingtheendingbalancesto
zero.Thus,sincesaleshasacreditbalanceattheendoftheaccounting
period,toclosethisaccountyoumustdebitittobringitsbalanceto
zero.JusttheoppositehappenswithCostofGoodsSoldandallofthe
otherExpenses;thatis,theynormallyhaveadebitbalanceandtoclose
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them,theyarecreditedforthesameamount.Onceallthesedebitsand
creditsfromtheclosedaccountsaretotaledonthetrialbalance,thedif
ferenceshouldbeacreditthatisappliedtoRetainedEarnings.Thiscred
itbalancerepresentsNetIncome.Ifforsomereasonthedebitsare
greaterthanthecreditsfromtheclosedaccountsthisamountwillrep
resentaNetLoss.
Inthischapteryouhavelearnedhowtorecordbusinesstransactionsinto
theoriginalbookofentrytheGeneralJournal.Youhavealsolearnedhow
toposttotheaccountingledgersandhowtomakeadjustingentries.Finally,
youhavelearnedhowtoclosetheaccountingrecordsofacompany.In
chapter7youwilllearnhowtheaccountingforcorporationsdiffersfrom
thatofanindividualproprietorship.
GLOSSARY
AccountsReceivableWriteOffs:Theprocessofidentifyingan
accountreceivablethatisnevergoingtobepaidandtakingitoffthe
books.TheseaccountsarewrittenofftoanExpenseaccountwiththe
amountbeingestimatedbymanagementbasedonpastexperiencesof
collectionrates.Whentheentryismade,twoaccountsarecreated,an
ExpenseaccountcalledBadDebtsExpenseandacontraAssetaccount
(contratoAccountsReceivable).
AdjustingJournalEntries:Journalentriesmadeattheendofthe
accountingperiod(month,quarter,and/oryear)torecognizetransactions
thathaveoccurredpriortothestatementsissuedate,butwhichhavenot
yetbeenrecordedinthejournal.Examplesoftheseentriesinclude:depre
ciation;salariesearned,butnotyetpaid;adjustmentstoprepaiditems,like
insuranceandinterestonthemortgagewhichhasnotyetbeenpaid.
ChartofAccounts:Alistingofaccountnumbersforeachofthe
accounts.Thesenumbersareusuallydividedintofivegroups;100sfor
Assets,200sforLiabilities,300sforOwnersEquity,400sforRevenues,
and500sforExpenses.Everytimeanyaccountingentryismade,the
accountantwillusethesameaccountnumberforthatparticularAsset,
Liability,OwnersEquity,Revenue,orExpense.
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ClosingJournalEntries:Theprocessrequiredtobringallaccountsto
azerobalance.Thisprocessisdoneattheendoftheperiod(month,
quarter,oryear)priortothepreparationofthefinancialstatements.Only
RevenuesandExpenses(alsocalledtemporaryaccounts)areclosedand
thedifferencebetweenRevenuesandExpensesisrecordedasNetIncome
ornetloss.
Credit:Therightsideoftheamountcolumninajournalorledger.Credits
arerecordedwhenAssetsandExpensesarereducedandwhen
Liabilities,OwnersEquity,andRevenueaccountsareincreased.
Debit:Theleftsideoftheamountcolumninajournalorledger.Debits
arerecordedwhenAssetsandExpensesareincreasedandwhen
Liabilities,OwnersEquity,andRevenueaccountsaredecreased.
Depreciation:TheprocessofspreadingthehistoricalcostofaLong
TermAssetoveritsusefullife.Inordertodeterminethisamount,manage
mentmustmakeanassumptionastothelifeofalloftheLongTermAssets.
Thehistoricalcostisthenspreadevenlyoverthislifeexpectancy.When
thismethodofdepreciationisused(evenlyspreadoverthelife)itiscalled
thestraightlinemethodofdepreciation.
GeneralJournal:Thebookinwhichtransactionsarefirstrecorded,
oftenreferredtoasthebookoforiginalentry.Assoonasabusiness
transactiontakesplace,itisrecordedinthegeneraljournal.Theaccounts
impactedbythetransaction:thedate,thedebits,credits,andanexpla
nationofthetransactionarealsorecorded.
GeneralLedger:Abookcontainingapage(orpages)forevery
accountinthebusiness.Afteratransactionisrecordedinthegeneraljour
nal,thecomponentsarethentransferred(orposted)totheindividual
accountsinthegeneralledger.Thus,atanyonetime,onecanreviewthe
individualaccountsinthegeneralledgertodeterminetheircurrentbal
ances.
JournalEntries:Assoonasabusinesstransactionoccurs,anentryis
madeinthegeneraljournaltorecognizethistransaction.Adebit(ordeb
its)andacredit(orcredits)willbemadetotheaccountsthatareimpact
edbythistransaction.Thedebitsandcreditsforeachtransactionwill
alwaysbeequal.
Posting:Theprocessoftransferringtheinformationinthegeneraljour
naltotheindividualaccountsinthegeneralledger.Atanytime,onecan
reviewtheindividualaccountsinthegeneralledgertodeterminetheirbal
ances.
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TrialBalance:Alistofallaccountsinthegeneralledgerthathavea
balanceotherthanzero.Thisispreparedrightbeforethefinancialstate
mentstomakesurethattheaccountsareinbalanceandthatalljournal
entrieshavebeenpreparedcorrectlyandaccurately.Ifthetrialbalance
doesnotbalance(thatis,debitsdonotequalcredits),itindicatesthat
therehasbeenanerrormadeineithertherecordingofthetransactions,
inthegeneraljournal,orinthepostingofthosetransactionstothegen
eralledger.(Thisdoesnotincludeatrialbalance,whichhasbeencom
pletedaftertheclosingofaccounts.)
100AccountingforNonAccountants
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WhatIsCapitalStock?
DividendsandSplits
IncorporatingSolanaBeachBicycle
Company
TheCorporation
Chapter
7
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UptothispointwehavebeenstudyingtheSolanaBeachBicycle
Company,whichisanindividualproprietorship.Inotherwords,thebusi
nesshasoneownerSamantha.Shehasinvestedsomeofherownmoney
intothecompanyaswellasborrowingsomeadditionalmoney.
NowSamisthinkingofgrowingherbusiness.Shehasheardthatbyusing
otherpeoplesmoney,shewillhavemoreworkingcapitalandhavetheabil
itytoexpandthebusiness.Shehasdecidedtoinvestigatethepossibilityof
incorporatingherbusinessandsellingstockinherbusiness.
Butwhatisacorporation,really?
Acorporationhasbeendefinedasanartificialbeingindependentfromits
owners,legallyaseparateentity.Corporationscanbesetupasforprofitor
notforprofit.Forprofitcorporationsdependonmakingmoneyinorderto
continueintothefuture.Notforprofitcorporationsdonotdependupon
thisprofittocontinue.Thesetypesofbusiness,ratherthandependingon
theirprofit,dependongiftsandgrantsfromthepublicandprivatesectors
fortheircontinuation.Examplesofnotforprofitcorporationsincludechar
ities,governmental,educational,andrecreationalorganizations.
QUICKTip
TheOtherSideofIncorporation:Althoughincorporationhasmanybenefits,it
shouldalsobenotedthattheproprietorlosespartialormajoritycontroltotheother
stockholders.Also,theamountofpaperworkandoversightincreases.Beforemak
ingthedecisiontoincorporateyoushouldseekprofessionaladvicefromyour
accountant,lawyer,andfinancialadvisorregardingtheprosandcons.
Acorporationisgiventherighttooperate(acharter)fromthestatein
whichitincorporates,butthefactthatabusinessisincorporatedinone
state,doesnotmeanthatitcannotoperateintheothers.Duetodiffering
taxlawsandtheincorporationfees,somestateshavebecomemoreadvan
tageoustoincorporateinthanothers.
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CharacteristicsofaCorporation
Thereareseveralcharacteristicsthatdifferentiateacorporationfromother
formsofbusiness.Oneofthecharacteristicsofacorporationthatdistin
guishesitfromapartnershiporaproprietorshipisthatithashavelimited
liability.Thismeansthatthecreditorsofacorporationcanlayclaimonlyto
theAssetsofthecorporation.Creditorsofpartnershipsorproprietorships,
ontheotherhand,canturntothepersonalAssetsofeachownerwhenev
ertheAssetsoftheunincorporatedfirmarenotsufficienttomeetthecred
itorsclaims.Becauseofthiscorporatecharacteristic,thestateshavelaws
thatrestrictthestockholdersrighttowithdrawAssetsfromthecorpora
tion.Eachstatehasalawthatpreventsacorporationfrompayingdividends
(thatis,ownerswithdrawingAssets)wheneverthenetAssets(Assetsminus
Liabilities)areatorbelowacertainlevel.ThisminimumnetAssetfigureis
oftencalledthelegalcapitalofacorporation.
Figure7.1:CHARACTERISTICSOFACORPORATION
Ischarteredasalegalandseparateentitybyanindividualstate
ProtectsthepersonalAssetsoftheowners(stockholders)againstcredi
torsclaims(limitedliability)
Canissuecapitalstocktoraisemoney
Canissuedividendstostockholders
Maynotissuedividendsthatwouldreducethelegalcapitalbelowa
designatedlevel
Thereareanumberofreasonswhyacompanywouldconsiderincor
poration.Someofthesereasonsmightinclude:1)gainingtheuseof
additionalcashwithouttheownerputtinginhis/herownpersonalfunds;
2)removinglegalliabilityfromtheindividualandprotectinghis/herper
sonalAssets;3)securingvarioustaxadvantages.Incorporationmayeven
providethecompanywithmorecredibilityintheeyesofthebusiness
communityandthegeneralpublic.
TheCorporation103
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WhatIsCapitalStock?
Whenacorporationreceivesitscharterfromthestate,italsoreceivesthe
righttosellaparticularnumberofsharesofstocktothepublic.Eachshare
representspartownershipinthecompany.Thisnumberofsharesthecharter
allowsthecorporationtoselliscalledtheauthorizedshares.Thecorporation
cansellasmanysharesasitchoosesuptothisauthorizedamountbutno
more.Whenthestockisinitiallysoldtothepublic,thecorporationwill
receivethemoney.Aftertheinitialsale,whenthestockissoldfromoneindi
vidualtoanother(onastockmarketsuchastheNewYorkStockExchange
ortheNASDAQ),thismoneydoesnotaffecttheAssetsofthecorporation.
Theshareholdersarejointlytheownersofacorporationandcanlegally
receiveadistributionoftheAssetsofthecorporationintwoways.First,the
corporationcanbeliquidatedthatis,alltheLiabilitiesarepaidoffandthe
remainingAssetsdistributedtotheshareholders,whichmeansthatthecor
porationceasestooperate;orsecond,thecorporationcanpaydividends.
TypesofCapitalStock
Usually,twotypesofcapitalstockcanbeauthorizedbythestatecommon
stockandpreferredstock.
Figure7.2:SOMECHARACTERISTICSOF
COMMONSTOCKANDPREFERREDSTOCK
Commonstockholdershavetherighttovoteforthedirectorsofthecor
poration;preferredshareholdersusuallydonot.
Preferredshareholdershavefirstclaimtodividends;thatis,inanyyear
whendividendsaredeclaredbytheboardofdirectors,preferredshare
holdersmustbeallocatedtheirshareofthedividendsbeforethecom
monstockholdersareentitledtoany.
Thepreferredshareholdershaveafixedclaimtodividendsduringany
oneyear,whereas,thecommonshareholdersclaimsarenotfixed.
Intheeventthecorporationisliquidated(thatis,itsAssetssold,
Liabilitiespaidoff,andtheremainingcashdistributedtotheshare
holders),thepreferredshareholdersclaimtothecorporateAssetstakes
precedenceoverthoseofthecommonshareholders.
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Mostpreferredstockiscumulative.Thismeansthatifthepreferred
shareholdersarenotpaidtheirfulldividendinanyyear,insubsequent
yearsdividendpaymentstothepreferredshareholdersmustbesuffi
cienttocoverthepreviouslyinadequatedividendpaymentsbeforeany
dividendscanbepaidtothecommonstockholders.
Thecommonandpreferredstockmayormaynothaveaparvalue;par
valueisthevalueassignedtoeachsharebyacorporationinitscorporate
charter.Ifastockhasaparvalue,thatvalueappearsonthestockcertificate
(forexample,$1paror$5paror$100par,andsoon).Stockrarely,ifever,
isinitiallysoldbyacorporationforlessthanparvalue,eitherbecausestate
lawspreventsuchasaleorbecausethelawsallowthecreditorsofthecor
porationtoholdstockholderspersonallyliabletotheextentofanysuchdis
count.
Inmanystatesthetotalparvalueofallstocksoldwillbethecorpora
tionslegalcapital.Insomestates,however,acorporationslegalcapitalis
equaltothetotalamountreceivedwhenthestockisinitiallysold.Thiscan
varysinceparvaluestockisoftensoldformorethantheparvaluefigure.
Thislegalcapitalamountisanimportantfigurebecauseacorporationmay
notissuedividendsthatwouldcausethenetAssets(AssetsLiabilities)to
gobelowtheamountofthislegalcapital.
Alert!
UnderstandingDividendCalculations:A10percentCommonStockwithapar
valueof$100,shouldreceivea$10dividendeachyear.A10percentPreferred
Stockwithaparvalueof$100,shouldalsoreceivea$10dividendeachyear.
Butifonly$6ispaidindividendsinyearone,thenthenextyear,theremaining
$4plusthe$10foryeartwomustbepaidtocumulativepreferredstockholders
beforethecommonstockholdersreceiveanyfurtherdividend.
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Whendividendsoncumulativepreferredstockarenotpaid,thosedivi
dendsaresaidtobeinarrears,andafootnotemustbeaddedtothefinan
cialstatementsindicatingtheamountofthedividendsinarrears.The
BalanceSheetwillnotshowdividendsinarrearsasaLiability.Somepre
ferredstockisnoncumulative,whichmeansthatifayearpassesandthe
preferredstockholdersdonotreceiveadividend,thoseshareholdersnever
receivethatdividendpayment.
Somepreferredstockisparticipatingpreferred,whichmeanthatthepre
ferredshareholdersclaimtodividendsinanyoneyearisnotrigidlyfixed.
Thoseshareholders,incertaingoodyears,willsharewiththecommon
shareholdersintheexcessdividendpayments.Theamountorpercentage
ofdividendsthatthepreferredshareholderscanreceiveinexcessofthe
amounttowhichtheyhaveapriorclaimvariesconsiderablyfromcompa
nytocompanyandisdeterminedbytheboardofdirectors.
QUIZ
AssumethattheBlancaCorporationhas10,000sharesofcumulative,
participating,preferredstockoutstanding.Thereare20,000sharesof10
percentCommonStock,andtheywilleachreceive$10pershareindiv
idends.Thispreferredstockisalso10percent,witha$100parvalue.The
PreferredStockparticipatesatthe30percentlevel,meaningthatthese
stockholderswillreceive30percentofwhateverexcessdividendsareleft
overaftertheinitialdividendshavebeenpaid.Thedividenddeclaredby
theboardofdirectorsthisyearis$500,000.Howmuchintotaldothe
preferredandcommonstockholdersreceiveindividendsthisyear?
TheStockholdersEquitySectionoftheBalanceSheet
Asyourecallfromchapter3,theOwnersEquitySectionoftheBalance
Sheetcontainstwoitems,OwnersInvestmentandRetainedEarnings.The
onlydifferenceonthebooksofacorporationisthattheOwners
InvestmentisreplacedwithCommonStockandPreferredStockandthis
sectioniscalledtheStockholdersEquitysectioninaprivatelyowned
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company.Thereasonforthisisthatthestockholdersaretheownersofthe
corporation.
DividendsandSplits
Ingeneral,acorporationcannotpayadividendwhensuchactionwould
reducethecorporationscapitalbelowitslegalcapitalfigure.Usually,divi
dendscanbepaid,butonlytotheextentofthetotalRetainedEarnings,i.e.,
theprofitthathasbeenretainedinthebusiness.
Inaddition,acorporationobviouslycannotpayacashdividendunlessit
hasthecashtodoso,andthecashisnotneededforotherpurposes.Often,a
corporationhassizableRetainedEarningsasaresultofsuccessfuloperations
inthepast,butverylittlecash,whichreducesitsabilitytopaydividends.
Therearetwogoalsofacorporation,1)tomaximizeNet
Incomeand2)tosatisfythestockholderswiththeincrease
intheirstockpriceorwiththefutureexpectationofastock
priceincrease.Theactofissuingacashdividendislike
adoubleedgedsword.Ontheonehand,itwillsatisfythe
immediateneedsofthestockholderstoreceivecash,but
ontheotherhanditwilldepletecashinthecompanyfor
futureinvestmentandgrowth.Therefore,management
needstocarefullyadjustthisbalancetosatisfyboththe
shortandlongtermgoalsofthestockholders.
DividendswithoutCash
StockDividends
Dividendscanbedividedintotwocategories,cashandstock.Companies
oftendeclareandissuestockdividendsinsteadofcashdividends.Only
whentheboardofdirectorsdeclaresdividendsdotheybecomelegalliabil
itiesofthecorporation.Oncethedividendsaredeclared,thecorporationis
legallyrequiredtopaythesedividendsorissuetheadditionalshareswithin
TheCorporation107
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aspecifiedperiodoftime.Whenstockdividendsareissued,thecorporation
willissueadditionalsharesofstockinthecorporationtoeachshareholder
insteadofcash.
Thereareseveralreasonswhyacorporationmayissuestockdividends
insteadofcash.Theremaynotbesufficientcashtopayacashdividend,so
ratherthannotissuinganydividendsthatyearatall,theboardmaydecide
toissuethestockdividendinstead.Anotherreasonforissuingthestock
dividendmightbethatthecompanyneedsthecashforotherpurposes.If,
forinstance,theyareplanninganexpansionofoperationstoBraziland
needtoaccumulatecashinordertobeginthenewoperation,theycan
issuestockdividendsinordertokeepsufficientlevelsofcashnecessaryfor
theexpansion.
Alert!
RestrictionsonIssuingStockDividends:Inorderforacorporationtoissuestock
dividendsitmusthaveenoughauthorizedstockthathasnotbeenissued.Ifit
doesnot,thecorporationwillhavetoapplyfortheissuingofmorestockfrom
theSecretaryofStateinthestateinwhichthecorporationisincorporated.
StockSplits
Acompanycanalsodeclareastocksplitinsteadofissuingcashdividends.
Thestocksplitincreasesthenumberofsharesoutstandinganddecreases
thestocksparvalue.Stockmaybesplitinavarietyofwaysforexample,
twoforone;threeforone;threefortwo;andsoon.(Inatwoforonestock
split,eachsharebecomestwoshares.Inathreefortwostocksplit,every
twosharesbecomesthreeshares.So,forexample,astockholderwhoheld
tenshareswouldhavefifteensharesafterthesplit.)Whetherthecompany
issuesastockdividendorastocksplit,itmusthavetheadditionalshares
authorizedbythestatepriortotheissue.Ifthecompanyalreadyhasan
amountofauthorizedsharesthathavenotyetbeenissued,thenthisis
unnecessary.Ifacompanyhadtenthousandsharesauthorizedwhenthey
werechartered,andhaveonlyissuedthreethousandsharestodatebutnot
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enoughstockremainsfromtheinitialauthorization,thecompanymust
requestalargerauthorizationfromthestate.
Acompanymaysplititsstockforseveralreasons.Onereasonisthata
stocksplitincreasesthenumberofsharesonthemarket,whichmaymean
that,intime,morepeoplewillownapartofthecompany.Itisdesirableto
havemoreinvestorsbecauseitcreatesmoreinterestinthecompanysstock,
aswellasinthecompany,whichhasthepotentialofdrivingupthestock
priceandgettingmorecapitalinvestedintothecompanyaswell.Another
reasonforastocksplitisthatincreasingthenumberofsharesreducesthe
pricepershare;thus,again,morepeopleareabletobuytheshares.Yet
anotherreasonisthatmanypeoplewouldratherbuyonehundredsharesof
$50stockthanfiftysharesof$100stockeventhoughtheamountthey
wouldspendandtheproportionofthecompanytheywouldownwouldbe
thesame.Onereasonforthisdecisionisthatthebrokeragefeeonround
lots(onehundredsharesormultiplesthereof)islessthanonoddlots(less
thanonehundredshares).
IncorporatingSolanaBeachBicycleCompany
SaleofStock
Well,now,Samanthahasheardallofthesedefinitions,andtheprospectof
gettingmorecapitalintoherbusinessisveryinterestingtoher.Byincorpo
rating,sheisabletoexpandherbusinesswithoutputtinganymoreofher
ownmoneyintoit.Sheincorporatesherbusinessusingclosetothesame
nameasbefore,soasnottoconfusehercurrentcustomers,andcallsthe
businessTheSolanaBeachBicycleCorporation.
Whenthenewcorporationsellsstock,cashisincreased(ifthestockwas
soldforcash),andthecommonstockaccountisincreasedbythesame
amount.Forexample,when120,000sharesofCommonStockwithPar
Valueof$50issoldfor$60persharecash,cashisincreased$7,200,000,
thecommonstockaccountincreases$6,000,000(120,000sharesx$50par
value),andanotheraccountcalledPaidinCapitalCommon(orCapitalin
ExcessofPar)isincreasedby$1,200,000.ThisCapitalinExcessofPar
amountrepresentsanyamountpaidintothecorporationoverandabove
theparvalueofthestock.ThisaccountisalsopartofStockholdersEquity.
TheCorporation109
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Youmaybewonderingwhytheamountpaidforthestockintheexam
pleaboveishigherthantheparvalue.Rememberthattheparvaluewas
simplyavalueassignedtoeachshareofstockwhenthebusinesswasincor
porated.Bylawinmoststates,thestockcannotbesoldforbelowpar,but
canbesoldformorethanparvalue.Thestock,whenitisfinallyissuedon
themarket,willalmostalwayssellatabovepar,causingtheaccountPaid
inCapitalinExcessofPartobecreated.
TheimpactontheBalanceSheetisshowninFigure7.3:
Figure7.3
Whenstockdoesnothaveaparvalue,buttheBoardofDirectorshas
assignedastatedvaluetothenoparstock,thestocksaletransactionis
accountedforinamannersimilartothatshownintheFigure7.3.The
amountaddedtothecommonstockaccountequalsthetotalstatedvalue
ofthestocksoldandanyexcessisaddedtothepaidincapitalaccount,now
calledPaidinCapitalinExcessofStatedValue,Common.Thesaleofpre
ferredstockwouldcausethesamechangesasshownintheexample,with
theexceptionthatthetitleoftheaccountswouldbePreferredStockand
PaidinCapitalinExcessofPar,Preferredinstead.
Whenstockhasneitheraparvaluenorastatedvalue,thecommonstock
accountisincreasedbywhateveramountisrealizeduponthesaleofthe
stock.Forexample,iftensharesofnoparcommonstocksellsfor$100,the
commonstockandcashaccountsarebothincreasedby$100;iftenmore
sharesaresoldfor$115afewdayslater,thecommonstockaccountincreas
esanother$115,andsoon.
CurrentAssets:
Cash.........+$7,200,000
StockholdersEquity:
CommonStock,
$20Par.......+$6,000,000
PaidinCapitalinExcess
ofPar,Common..+$1,200,000
$7,200,000
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PaymentofCashDividends
Whentheboardofdirectorsdeclarescashdividends,theRetainedEarnings
figureisdecreasedanddividendspayable,aCurrentLiability,isincreased.
Forexampleifacorporationhas150,000sharesofcommonstockout
standingandtheboardofdirectorsdeclaresa$.20dividend,theRetained
Earningswoulddecreaseby$30,000andthedividendspayablewould
increaseby$30,000(150,000sharesx$.20).TheBalanceSheetchanges
areshowninFigure7.4.TheIncomeStatementisnotaffectedatallbythis
declaration.
Figure7.4:BALANCESHEETCHANGES
CurrentLiabilities:
DividendsPayable..............................+$30,000
StockholdersEquity:
CommonStock......................................XXX
RetainedEarnings...............................$30,000
TotalLiabilitiesandStockholdersEquity..............NoChange
Whenthedividendisactuallypaid,cashisdecreasedanddividends
payableisdecreased.Continuingtheprecedingexample,whenthedividend
ispaid,cashwoulddecrease$30,000andtheLiabilitycalleddividends
payablewouldbeeliminatedfromtheBalanceSheet.
Financialstatementsareaffectedinthesamemannerwhencashdivi
dendsaredeclaredandpaidtopreferredshareholders.
StockDividendsDeclaredandIssued
AssumetheSolanaBeachBicycleCorporationsStockholdersEquitysec
tionlookedliketheoneinFigure7.5afterthecorporationhasbeenin
operationforawhile:
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Figure7.5
StockholdersEquity:
CommonStock,$50Par.......................$10,000,000
PaidinCapitalinExcessofPar,Common.............3,500,000
$13,500,000
RetainedEarnings.............................10,000,000
TotalStockholdersEquity.......................$23,500,000
Thecorporationdeclaredandissueda10percentstockdividendwhenits
stockwassellingonthemarketfor$200pershare.Wecantellfromthe
StockholdersEquitysectionthatthecorporationhadtwohundredthousand
sharesofcommonstockoutstandingpriortothestockdividend
($10,000,000commonstock/$50par=200,000shares).A10percentstock
dividendwillincreasethenumberofsharesby20,000(10percentof200,000
=20,000).Sincethemarketpriceofeachshareis$200,theRetained
Earningsaccountisdecreasedby$4,000,000(20,000sharesx$200=
$4,000,000),thecommonstockaccountisincreasedby$1,000,000,(20,000
sharesx$50Par=$500,000),andthepaidincapitalaccountisincreasedby
thedifferencewhichis$3,000,000.Thejournalentrywouldlooklikethis:
Dr.:RetainedEarnings
$4,000,000
Cr.:CommonStock
$1,000,000
Cr.:PaidinCapitalinExcessofPar,Common$3,000,000
Alert!
StockDividendsandRetainedEarnings:Issuingstockdividendsaffectsthecorpo
rationsRetainedEarningsinexactlythesamewayasifitwereacashdividend.
Theonlydifferenceisthatadditionalstockisbeingdistributedtothestockholders
insteadofcash.SinceithasthesameimpactonRetainedEarnings,however,the
corporationmuststillhavesufficientRetainedEarningstomakethisdeclaration.
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TheequitysectionoftheBalanceSheetappearsasshowninFigure7.6
afterthestockdividend:
Figure7.6
StockholdersEquity:
CommonStock,$50Par.......................$11,000,000
PaidinCapitalinExcessofPar,Common..............6,500,000
$17,500,000
RetainedEarnings..............................6,000,000
NoticethatthetotalStockholdersEquity($23,500,000)doesnot
change.Furthermore,neithertheAssetsnortheLiabilitiesofthecorpora
tionareaffectedbyastockdividendnoraretheincomeorExpenseitems.
Theaccountingforastockdividendissomewhatdifferentwheneverthe
dividendisgreaterthan20percentto25percentofthesharespreviously
outstanding.
Wheneversuchlargestockdividendsareissued,themarketvalueofthe
stockisnotrelevantindeterminingthechangeintheBalanceSheetfigures.
Instead,theRetainedEarningsarereducedbytheparvalueofthenew
shares.
HadSolanaBeachBicycleCorporationintheexampleshowninFigure
7.6declaredandissueda50percentinsteadofa10percentstockdividend,
forexample,theBalanceSheetwouldhavebeenchangedtolooklikethe
exampleinFigure7.7.Sincethereare200,000sharesoutstandinginFigure
7.5,a50percentstockdividendwouldentailtheissuingofanadditional
100,000shares.(TherewouldbenochangetothePaidinCapitalinExcess
ofPar,CommonamountfromFigure7.5.)
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Figure7.7
StockholdersEquity:
CommonStock,$50Par.......................$15,000,000
$18,500,000
RetainedEarnings..............................5,000,000
NoticethatTotalStockholdersEquitydoesnotchangefromFigure7.5
becauseallwehavedoneisshiftdollarsoutofRetainedEarningsinto
CommonStock.
NowassumethattheboardofdirectorsoftheSolanaBeachBicycle
Corporationabovedeclaredatwoforonestocksplitinsteadofa50percent
stockdividend.Fourhundredthousandshares(remember,thereweretwo
hundredthousandsharesoutstanding)ofnew$25parstockwouldhavebeen
senttotheshareholdersandtheold$50parstockwouldhavebeencalledin
sothatonlythe$25stocksareheldbyshareholders.TheStockholdersEquity
sectionoftheBalanceSheetwouldnowlooklikeFigure7.8:
Figure7.8
StockholdersEquity:
CommonStock,$25Par.......................$10,000,000
$13,500,000
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NoticethattherearenodifferencesinthispartialBalanceSheetandthe
oneshowninFigure7.5(beforethestocksplit)exceptthattheparvalue
haschangedfrom$50to$25andthenumberofsharesoutstandinghas
changedfrom200,000to400,000.
Whenacorporationbuysbackitsownstockanddoesnotcancelitorresell
it,itisknownastreasurystock.Acorporationmaybuyitsownstockfora
varietyofreasons.Forexample,itmayneedthestocktodistributeforstock
dividendsortosatisfyastockoptioncontractwithitsemployees.
PurchaseofTreasuryStock
Tobegin,operationSolanaBeachBicycleCorporationsoldonehundred
thousandsharesof$50parstockfor$60eachonJuly1,2007,theday
SolanaBeachBicyclebegandoingbusinessasacorporation.Twoyearslater,
itbuysbacktenthousandsharesofitsownstockfor$700,000(noticethat
thepriceofthestockhasincreasedfromtheoriginalsalepriceof$60to
$70).Untilthisstockislegallycanceledorresold,itisknownastreasury
stock.
BeforetheSolanaBeachBicycleCorporationacquireditsownstock,its
StockholdersEquitysectionoftheBalanceSheetlookedlikeFigure7.9:
Figure7.9
StockholdersEquity:
CommonStock,$50Par(120,000shares)...........$6,000,000
$7,200,000
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AftertheSolanaBeachBicycleCorporationacquiredtenthousandshares
ofitsownstock,itsStockholdersEquitysectionoftheBalanceSheet
lookedlikeFigure7.10:
Figure7.10
StockholdersEquity:
CommonStock,$50Par
(10,000SharesofwhichareTreasuryStock)..........$6,000,000
PaidinCapital,Common.........................1,200,000
$7,200,000
RetainedEarnings(SeeFootnote1).................10,000,000
$17,200,000
Less:CostofTreasuryStock........................(700,000)
ThefollowingfootnotewouldbeincludedbelowtheBalanceSheetofthe
currentyear:
Footnote1:AlthoughtheRetainedEarningstotals$10,000,000,the
acquisitionoftreasurystockhasreducedtheRetainedEarningsavailable
fordividendsby$700,000,thecostofthetreasurystock;thus,theSolana
BeachBicycleCorporationmaylegallydeclareandpaydividendsofnot
morethan$9,300,000($10,000,000RetainedEarnings$700,000
TreasuryStock).
Youshouldbeawareofseveralchangescausedbythepurchaseofthe
treasurystock:
ThetotalStockholdersEquityhasdecreasedfrom$17,200,000to
$16,500,000.TheBalanceSheetisstillinbalancebecausecashhas
decreasedbythesameamount$700,000(theamountofcashpaidfor
thepurchaseofthetreasurystock).
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AtreasurystockpurchasereducestheRetainedEarningsofacompany
andasaresultreducestheamountofdividendsthecorporationcan
pay.AcorporationusuallycannotbuytreasurystockunlessitsRetained
Earningsisequaltoorexceedsthecostofthetreasurystock.This
restrictionisnecessarytopreventacorporationfromreducingitscap
italbelowitsrequiredlegalcapitalfigure.
TheBalanceSheetwouldnotbecompletewithoutsomenotationin
theStockholdersEquitysectionofthestatementregardingthereduc
tionofRetainedEarningsduetotreasurystock,asisaccomplishedby
thefootnoteinFigure7.10above.
Thenumberofsharesofcommonstocknowoutstandingis110,000
shares(thenumberofsharesissuedhasnotchangedfromtheoriginal
120,000).
Alert!
TreasuryStockIsNOTanAsset:Thepurchaseofthestockbythecorporation
merelyreducestheamountthattheownershaveinvestedinthebusiness.
Ifcashdividendsweredeclaredtoday,theywouldbepaidonlytothe
ownersofthe110,000shares;thecompanywouldnotpaydividendsto
itselfonthetenthousandsharesoftreasurystock.Dividendsarepaidonly
onoutstandingstock,andtreasurystockisnotconsideredtobeoutstand
ing.Eachcorporationisauthorizedtoissueamaximumnumberofshares
asspecifiedinthecorporatecharter.Thenumberofsharesauthorizedcan
begreaterthanorequaltothenumberofsharesissued,butacorporation
canissuenomoresharesthanauthorized.Mostfirmsshowthenumberof
sharesauthorized,issued,andoutstanding,intheStockholdersEquitysec
tionoftheBalanceSheet.Forexample,beforethepurchaseofthetreasury
stocktheSolanaBeachBicycleCorporationsStockholdersEquitysection
wouldlooklikeFigure7.11:
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Figure7.11
StockholdersEquity:
CommonStock,$50Par
Authorized500,000Shares
Issued&Outstanding120,000Shares..............$6,000,000
$7,200,000
TotalStockholdersEquity......................$17,200,000
Afterthepurchaseofthetenthousandsharesoftreasurystock,the
SolanaBeachBicycleCorporationsStockholdersEquitysectionwould
looklikeFigure7.12:
Figure7.12
StockholdersEquity:
CommonStock,$50Par(10,000sharesofwhichareTreasuryStock)
Issued120,000Shares
Outstanding110,000Shares....................$6,000,000
$7,200,000
RetainedEarnings(SeeFootnote1)................10,000,000
$17,200,000
Less:CostofTreasuryStock.......................(700,000)
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Footnote1:AlthoughtheRetainedEarningstotal$10,000,000,the
SolanaBeachBicycleCorporationmaylegallydeclareandpaydividends
ofnotmorethan$9,300,000.Theacquisitionoftreasurystockhas
reducedtheRetainedEarningsavailablefordividendsby$700,000,the
costofthetreasurystock.
Noticeabovethatthenumberofsharesissuedandauthorizedhasnot
changedsincethepurchaseofthetreasurystock.Theonlychangeistothe
numberofsharesoutstanding.Eventhoughthetreasurystockisnolonger
outstanding,thosesharesareconsideredtostillbepartoftheissuedshares
ofthecorporation.
SellingtheTreasuryStock
Thecompanycaneitherhold,sell,orcancelitstreasurystock.IftheSolana
BeachBicycleCorporationsoldfourthousandsharesofitstreasurystock
for$80persharethejournalentrytorecordthissalestransactionwouldbe:
Debit:Cash....................................$320,000
Credit:TreasuryStock............................$280,000
(4,000sharesxtheoriginalcostof$70pershare)
Credit:PaidinCapitalinExcessofCost,Treasury........$40,000
Afterthesaleofthefourthousandsharesoftreasurystockthe
StockholdersEquitysectionwouldlooklikeFigure7.13:
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Figure7.13
StockholdersEquity:
CommonStock,$50Par(6,000sharesofwhichareTreasuryStock)
Issued120,000Shares
Outstanding114,000Shares....................$6,000,000
PaidinCapitalinExcessofCost,Treasury...............40,000
$7,240,000
RetainedEarnings(SeeFootnote1)................10,000,000
$17,240,000
Less:CostofTreasuryStock.......................(420,000)
Youshouldbeawareofseveralchangescausedbythesaleofthetreas
urystock:
ThetotalStockholdersEquityincreased(fromFigure7.12)by
$320,000theamountofcashreceivedforthesaleofthetreasurystock.
TheTreasuryStockaccountdecreasedbyonly$280,000,theamount
thefourthousandshareshadcostthecompanywhentheywerepur
chased:4,000sharesx$70pershare.(Remember,thecompanybought
thesesharesatthemarketrateof$70pershare.)
ThesaleofTreasuryStockformorethanitcost(boughtat$70pershare
andsoldfor$80pershare,sotheoriginalcosttothecorporationwas
$280,000whilethesalespricewas$320,000)didnotresultinaprofit
of$40,000.Therulesofaccountingdonotallowacorporationtomake
aprofitonthesaleofitsownstock.TheIncomeStatementisnotaffect
edbythetransaction;theRetainedEarningsdonotchange;andthe
$40,000simplycreatesanewBalanceSheetaccountthatiscalledPaid
InCapitalinexcessofCost,Treasury.Thisaccountissomewhatlikethe
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PaidinCapital,Commonaccountthatresultswhenstockisinitially
soldformorethanitsparvalue.
Alert!
SellingTreasuryStock:Whentreasurystockissoldforlessthanitcost,thePaid
InCapital,Treasuryaccountisreduced.Ifthisaccountdoesnotexistorifthe
accountisnotlargeenoughtoabsorbthedifferencebetweenthesalesprices
andthecostofthetreasurystock,thePaidInCapitalinExcessofPar,Common
isreduced.IfthisaccountisnotsufficientthenRetainedEarningsisreduced.
Inthischapter,youhavelearnedabouthowthefinancialstatementsina
corporationdifferfromthoseofaproprietorship.Youhavealsolearned
aboutthecorporatestructureandhowindividualtransactionsaffectthe
financialstatementsofacorporation.Inchapter8youwillbeintroducedto
howtousefinancialstatementsforshorttermdecisionmaking.
ANSWER
PreferredStock
CommonStock
10,000Sharesx$10=$100,000
20,000Sharesx$10=$200,000
Remaindertobedivided=
$500,000$100,000$200,000=$200,000
30percentofRemainder=$60,000
70percentofRemainder=$140,000
TotalforP.S.=$160,000
TotalforC.S.=$340,000
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GLOSSARY
Arrears:Theamountofmoneythathasnotbeenpaidoncumulativepre
ferredstock.Sincethestockiscumulative,inmostcases,thedividendsfor
commonstockandothernoncumulativepreferredstockmaynotbepaid
untilthedividendsinarrearshavebeenpaid.
AuthorizedShares:Thenumberofsharesastateallowsacorporation
toissuetothepublicwhenthecompanyisincorporated.Ifacorporation
needsorwantstoissuemorestockthanauthorizedinordertoraisemore
capital,itmustrequesttheauthorizationofadditionalshares.
CapitalStock:AtermusedtorefertoboththeCommonandPreferred
Stockofacorporation,whichthecompanyisinitiallyauthorizedtoissue
whenitreceivesitsincorporationcharter.
CashDividends:Dividendsdeclaredbytheboardofdirectorsand
paidincashtostockholders.ThesebecomeaLiabilityonthecorporations
BalanceSheetwhentheyaredeclaredbytheBoardofDirectors.Thecor
porationmusthavesufficientRetainedEarningsandcashtomakethisdec
laration.Afterthedeclaration,oncedividendsarepaid,cashand
RetainedEarningsarereduced.
CommonStock:Oneofthetwotypesofstockthatacorporationcan
issuetothepublicwhenitischarteredbythestate.Commonstockusual
lydoesnothaveadefineddividendamountperyear,butonlyreceives
dividendswhentheyaredeclaredbytheboardofdirectors.Common
stockholdersusuallyhavevotingrightstoelecttheboardofdirectors.
Corporation:Anincorporatedbusinessisanartificialbeingindepend
entfromitsowners.Itisalegalseparateentity.Acompanywillrequestper
missiontoexistfromthesecretaryofstateofanystate.Onceithasbeen
grantedthechartertooperate,itmaysellstockinordertoraisecapital.
CumulativePreferredStock:Whenholdersofthistypeofstockare
notpaidafulldividendinanyyear(usuallythisdividendamountwillbe
statedontheshareofstock),thensubsequentyearsdividendpayments
tothemmustbesufficienttocoverthecurrentyearaswellastheamount
thatwasnotpaidinanypreviousyears,beforeanydividendscanbe
paidtothecommonstockholders.(SeealsoPreferredStock.)
LegalCapital:Inmanystates,thisisthetotalparvalueofallstocksold.
Insomestates,however,acorporationslegalcapitalisequaltothetotal
amountofmoneyreceivedwhenthestockisinitiallysold.Thus,inthissec
ondcase,thelegalcapitalwouldbeequaltotheparvalueandthepaid
incapitalinexcessofpar.
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PaidinCapitalinExcessofPar:Theamountofmoneyreceivedby
acorporationfromthesaleofstockabovetheparvalue.Insomestates,
itisboththeparvalueandthepaidincapitalinexcessofparthatrep
resentsthelegalcapitalofthecorporation.
ParValue:Thevalueassignedbyacorporationtoeachshareofstock,
commonorpreferred,whenitisincorporated.Inmoststates,thecommon
stockcannotbesoldatbelowpar.Generally,stocksellsformorethanthe
parvalueratherthanattheparvalueitself.
ParticipatingPreferredStock:Preferredstockholders,incertain
goodyears,willsharewiththecommonshareholdersintheexcess
dividendpayments.Forexample,afterthepreferredstockholdersreceive
their10percentdividend,andthecommonstockholdersreceivetheir
declaredamountofdividend,ifthereismoneyleftintotaldeclarationfor
theyear,thecommonandthepreferredwillshareinthatamount.Ifpre
ferredstockisnotparticipating,thetotalremainingamountwillgotothe
commonstockholders.(SeealsoPreferredStock.)
PreferredStock:Oneofthetwotypesofstockthatacorporationcan
issueuponreceivingitscharterfromthestate.Thistypeofstockhaspref
erenceovertheCommonStockholdersforwhendividendsareissuedand
alsowillreceiveitsmoneybackfromthecorporationfirstifthereisaliq
uidation.(SeealsoCumulativePreferredStockandParticipatingPreferred
Stock.)
StockDividends:Dividendsdeclaredbytheboardofdirectorsand
issuedtothestockholdersintheformofadditionalsharesofstockrather
thancash.ThecorporationmusthavesufficientRetainedEarningsand
authorizedstocktomakethisdeclaration.
StockSplit:Astocksplitisdeclaredbytheboardofdirectorstosplitthe
numberofsharesthatastockholdercurrentlyholds.Thesesplitscanbe
fortwoforone,threeforone,etc.Thecorporationmusthaveasufficient
numberofauthorizedsharestomakethesplit.Often,stocksplitsare
declaredbytheboardofdirectorswhenthepriceofthestockisveryhigh
andthecorporationwantstoencouragemorestockholdersinthecorpo
rationbyloweringthepriceofeachshare.
TreasuryStock:Thecorporationsownstockthatitholdswhenitbuys
sharesbackfromexistingstockholders.Thisstockremainsonthebooksof
theissuingcorporationuntilitcancelsthestockorresellsthesharesback
tothepublic.TreasurystockappearsontheBalanceSheetasareduction
ofRetainedEarnings.
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WorkingCapital
CompositionofAssets
UsingFinancial
Statementsfor
ShortTermAnalysis
Chapter
8
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Financialstatementscanbeextremelyusefulforevaluatingacompanys
futureinthenearterm(usuallydefinedasonetotwelvemonths)aswellas
beyondthenearterm.Thischapterwillfocusonneartermevaluation;eval
uationbeyondtheneartermwillbethefocusofchapter9.
Themostimportantquestiontobeansweredwhenevaluatingacompanys
neartermfutureiswhetherornotthecompanywillbeabletopayitsdebts
whentheycomedue.Ifthefirmcannot,itmaybeforcedintobankruptcyor
perhapsevenforcedtoceaseoperations.Asyoulearnedearlier,evenaprof
itablecompanycanbecomeshortoncashandplaceitsfutureinjeopardy.
Certainfinancialstatementuserswillbeparticularlyinterestedinthe
shorttermprospectsofacompany.Bankers,forexample,whohavemadeor
arecontemplatingmakingshorttermloans(thirtyday,sixtyday,orevensix
monthloans)aremainlyconcernedwithdeterminingwhethertheborrowing
companywillbeabletorepaytheirloanswhentheycomedue.Thesestate
mentuserswillattempttoforecastthecompanyscashflowfortheperiodof
timeduringwhichtheirloansareexpectedtobeoutstanding.Forthisreason,
thecashflowstatementdiscussedinchapter5becomesveryimportant.
Eventhoseuserswhoaremostlyinterestedintheshortterm,willalso
haveaninterestinthelongterm.Againtakingbanksasanexample,bankers
mustbeawareofwhatishappeningnowandwhatthefuturelookslikefor
alloftheircustomersinordertodecidetowhomtheycanloanmoneyand
inordertoestimatetheirownfuturecashflows.
Figure8.1givessomeexamplesofhowcertainfinancialstatementusers
mightuseshorttermratios.
Figure8.1:HOWSHORTTERMRATIOSAREUSED
Users
Ratios
UsedFor
Bankers
CurrentRatio
Tomakeshorttermloans
WorkingCapital
Vendors
QuickRatio
Toextendcredit
forpurchases
InventoryTurnover
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Users
Ratios
UsedFor
CreditCardCompany
CurrentRatio
Toissuecreditcards
WorkingCapital
BusinessOwners
All
Ongoingshortterm
analysisoftheirbusinesses
Thereareanumberofkeyfiguresthatareusefulintheseassessments.
TheyarehighlightedinFigure8.1andlistedbelowinFigure8.2.
Figure8.2:KEYSHORTTERMRATIOS
Ratio
Calculation
CurrentRatio
CurrentAssets/CurrentLiabilities
QuickRatio
QuickAsset/CurrentLiabilities
[QuickAssets=CurrentAssetsInventoryPrepaidItems]
WorkingCapital
CurrentAssetsCurrentLiabilities
InventoryTurnoverRatio
CostofGoodsSold/AverageInventory
[AverageInventory=(BeginningInventory+EndingInventory)/2]
AverageCollectionPeriodAccountsReceivable/AverageSalesperday
(AverageSales/Day=AnnualSales/365)
UsingFinancialStatementsforShortTermAnalysis127
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Tofigureoutwhetheracompanyisgoingtosurviveintheshortterm,you
shouldlookfirstattheBalanceSheet.ComparethecompanysCurrent
AssetswiththeirCurrentLiabilities(debtsthatmustbepaidwithintwelve
months)usingthecurrentratio.
CurrentRatio=CurrentorShortTermAssets/CurrentorShortTerm
Liabilities
AlsowidelyusedisthecomparisonofthefirmsquickAssetsthose
CurrentAssetsthatcanbequicklyturnedintocashtotheCurrent
Liabilities.UsuallyquickAssetsincludecash,currentreceivables,andmar
ketablesecurities,orinotherwords,CurrentsAssetsminusInventoryand
prepaiditems.ThisratioofquickAssetstoCurrentLiabilitiesisreferredto
asthequick(oracidtest)ratio.
QuickAssetRatio=QuickAssets/CurrentorShortTermLiabilities
ReferringtoFigure3.4inchapter3,thecurrentratiofortheSolanaBeach
BicycleCompanywouldbe12.6.ThisiscalculatedbydividingtheShort
TermAssetsonDecember31,2006,of$50,385bytheShortTermLiabilities
onthesamedayof$4,000.AgainusingthevaluesfromFigure3.4,thequick
ratioforthebicyclecompanywouldbe6.6.Thisiscalculatedbytakingthe
quickAssetsonDecember31,2006,of$26,385anddividingthembythe
CurrentLiabilitiesof$4,000.Butwhatdothesenumbersmean?
BeforeyoucandecidewhetherafirmhassufficientCurrentAssetsor
quickAssetstocovertheirCurrentLiabilities,youneedtoknowwhatthe
currentandquickratioswereintheprecedingperiods.Theruleofthumb
isthatthecurrentratioshouldbegreaterthan2.0.Whatthismeansis
thattheCurrentAssetsavailabletothecompanytopaytheirdebtsareat
leastdoubletheirCurrentLiabilities.ThequickAssetratioruleofthumb
isthatthisratioshouldbe1.5orlarger.Theseratiosvaryfromindustryto
industry,andthereforeyourcompanyscurrentratioshouldnotonlybe
comparedtoprioryearsandtotheruleofthumbfigure,butshouldalso
becomparedtosimilarcompaniesinthesameindustry.
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Ingeneral,thelargerthecurrentandquickratiosarethegreaterthe
probabilitythatacompanywillbeabletopayitsdebtsinthenearterm.In
thecaseoftheSolanaBeachBicycleCompany,thecurrentandquickratios
arewellabovetheruleofthumb,whichmeansthebusinessisinaverygood
positiontobeabletopayitsCurrentLiabilities.
Alert!
BiggerIsntAlwaysBetter:Theseratioscanalsobetoolarge.Acompanysprof
itabilityisreducedwheneverithastoolargeaproportionofanyparticulartype
ofAssetincludingcash.Acurrentorquickratiothatiswayovertheindustry
averagemaybeanindicationthatthisisthecase.
Knowingtheenvironmentalconditionsthatexistedinpriorperiodsas
comparedtonowandhavingdataaboutsimilarcompaniesinthesame
industryarealsouseful.Youcangettheaverageratiosforvariousindustries
frompublicationssuchasMoodys,Standard&Poor,Dun&Bradstreet,or
RobertMorrisAssociates.
QUICKTip
StayInformed:Unfortunately,thereisnoeasyorshortcutmethodforobtaining
theinformationonpresentandpastenvironmentalconditions.Youmustread
widelyandbesensitivetochangesinthemarketplace.
WorkingCapital
Anotherimportantfactortoconsiderintheshortterminadditiontothese
tworatiosisthefirmsworkingcapital.Thisiscalculatedbysubtractingthe
CurrentLiabilitiesfromtheCurrentAssets.
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WorkingCapital=CurrentorShortTermAssetsCurrentorShort
TermLiabilities
Workingcapitalisacushion.Itallowsmanagementtomakeerrorsinits
estimateoffuturecashreceiptsanddisbursementsandstillbeabletopay
itsdebtswhentheyfalldue.Forexample,ifmanagementestimatesboth
cashreceiptsanddisbursementsforthenextthirtydaystobe$30,000,and
forsomereasonreceiptsonlytotal$25,000anddisbursementstotal
$35,000,thefirmmusthaveeithersufficientworkingcapitalatthebegin
ningofthemonthtocovertheshortfallorgoodcreditwithitsbankers.If
thisisnotthecaseitwillfinditselfunabletosettleitsdebtsandpossibly
beoutofbusinessorwiththecreditorstakingcontrol.
Alert!
ItsAllRelative:Howdoweknowwhatisagoodenoughcushion?Thecalcu
lationofworkingcapitalwillnothelpagreatdealunlessitisrelatedtothefirms
cashflowandtoprioryearsfigures.Forexample,calculatingaworkingcapi
talof$20,000doesnotmeananythingbyitself.However,toknowthatwork
ingcapitalthreeyearsagowas$10,000,twoyearsagowas$14,000,and
lastyearwas$17,000indicatesapositivetrendthatgivesmoremeaningto
thisyearsfigureof$20,000.Alsoimportantistheeconomy,thebudgetfor
futureCurrentLiabilities,andtheneedtohaveexcesscashinthebusiness.
Inaddition,itisnecessarytocomparetheworkingcapitaltothecashflow
ofthefirm,asyoucalculatedinchapter5.Howmuchworkingcapitalafirm
shouldhavedependsuponitscashflow.Itmakessensethatabusinessthat
receivesand/ordisbursesanaverageof$7,000,000perweek,shouldhavea
largerworkingcapitalbalancethanafirmthatreceivesand/ordisburses
$7,000perweekbecausethefirstbusinessneedsforcasharehigher.
Inthecaseofourbicyclecompany,theworkingcapitalcushionisvery
good.Itis$46,385(CurrentAssetsof$50,385minustheCurrent
Liabilitiesof$4,000).
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QUICKTip
WorkingCapitalCushion:Isyourworkingcapitalcushionlargeenough?What
isyourcashflowpermonth?Isitevernegative?Whatisyourcashflowbudg
etforthefuture?Ifyouhadanormalnegativeflowofcashinthepast,andyou
haveprojectedanegativeflowofcashforthenexttwelvemonths,youwillneed
alargerworkingcapitalcushionthanifyourprojectionsaretheopposite.Also,
whatareyourpredictionsfortheeconomyoverthenexttwelvemonths?Ifyou
expectaslowdownthatmightaffectyourindustryandcompany,youwillwant
tohavealargercushionforworkingcapitalsinceyouwilllikelyhaveless
Revenuecomingintohelpyoucoveryourdebts.
CompositionofAssets
Indecidingwhetheracompanyisgoingtosurvivethenearterm,youalso
wanttolookatthecompositionoftheirCurrentAssets;thatis,youwant
toseethateachofthevariousCurrentAssetitemsisadesirablesize.Your
maininterestherecentersonreceivablesandInventoryitems.
Inventoriesandreceivablessometimesmaybecometoolarge.
Receivablesmaybecometoolargebecausecustomersdelaytheirpay
mentsorbecausethecompanychangeditscreditpolicysothatsalesare
madetopeopleorfirmswhoaregreatercreditrisksorwhoareslowerin
payingofftheirdebts.Inventoriesgettoolargewhen,forexample,man
agementoverestimatesthedemandforthecompanysproductsand
eitherbuysormakestoomanyitems.Thesesituationshavenegative
implicationsfortheneartermbusinessprospects.Todeterminewhether
inventoriesareareasonablesize,youcancalculatetheInventory
turnoverratio.
InventoryTurnoverRatio
InventoryturnoverratioiscalculatedbydividingCostofGoodsSoldbythe
averageInventory.
InventoryTurnoverRatio=CostofGoodsSold/AverageInventory
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AverageInventoryisdefinedas(beginningInventorybalance+ending
Inventorybalance)/2.ThisrepresentsthenumberoftimesthattheInventory
turnedover(wassoldduringaparticularperiodoftime).Ifabusinesssells
andreplacesitsstockofInventoryatarapidrate,turnoverishigh;ifitemssit
withoutbeingsoldforlongperiods,Inventoryturnoverislow.Thereisno
widelyusedruleofthumbavailable.TodecidewhethertheInventoryturnover
figureforafirmisdesirable,youmustlookatpreviousturnoverfiguresofthe
firm,turnoverfiguresofothersimilarfirms,andindustrywideaverages.Arel
ativelyhighturnoverfigurewouldsuggestthatsalesarebeinglostduetoshort
ageofInventory;alowturnoverfiguremaysuggestthatdemandforthegoods
isfalling,thatsomeoftheInventorycannotbesold,orthatpricesmustbe
reduced.AlowturnoverfiguremayalsoindicatethatasoftheBalanceSheet
datetoomuchcashhasbeeninvestedinInventoryitems.
Inagrocerystore,youwouldexpecttoseeanInventoryturnoverofone
totwodaysbecausetheInventoryisperishable.Inafurcoatboutique,on
theotherhand,youwouldexpectthisratiotobeoneortwomonthssince
furcoatsareboughtmuchlessfrequentlyandinmuchsmallerquantities
thanfoodstuffs.Itiscriticaltoknowandunderstandtheindustryyouare
analyzinginordertobeabletoevaluatetheratios.
WhatwouldyouwanttheInventoryturnoverratiobefortheSolana
BeachBicycleCompany?TheirInventorycertainlywillnotmoveasfastas
theperishablecommoditiesinagrocerystore;however,iftheyaregoingto
stayinbusinessandnotendupwithalotofInventorythattheycantsell,
itshouldmovefasterthanthefurcoatsdiscussedabove.Sowhatdoyou
think?Oneweek?Onemonth?TwoMonths?Letssee.
TofindtheCostofGoodsSold,weneedtomovetoFigure4.1inchap
ter4.OnDecember31,2006,theCostofGoodsSoldwas$14,200.
ThentocalculatetheaverageInventory,wegobacktoFigure3.4in
chapter3,andseethatInventoryonDecember31,2006,is$23,000.What
wasInventoryonDecember31,2005?Well,thebicyclecompanywasnot
inbusinessthen,soitwaszero.NowtocalculatetheaverageInventoryof
beginning($0)andending($23,000),weaddthesetwonumberstogether
anddividebytwo.Thus,averageInventoryis$11,500.
ToarriveatInventoryturnover,wedivideCostofGoodsSold($14,200)
byaverageInventory($11,500)andarriveat1.24.Whatdoesthismean?
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Well,itmeansthatInventoryisturningoverontheaverageof1.24times
peryear.Thatisabouteverytwelvemonths.Notgood!Thebicyclesare
beingbuiltand/orbought,andthennotsoldfortwelvemonths.Ifthisratio
isnotimproved,thecompanyisgoingtohavealotofmoneytiedupin
Inventory,sinceitsnotgettingitbackforalongtimenearlyoneyear.She
mayneedabettermarketingplan.Oritmaybethatthereisjusttoomuch
Inventoryintheshopforwhatcanbesoldatthislocation.Whatotherpos
sibilitiesdoyousee?
AverageCollectionPeriod
TodeterminewhetherthebalanceinAccountsReceivableistoolarge(or
toosmall),youcancalculatetheaveragecollectionperiod.
Averagecollectionperiod=Accountsreceivable/averagesalesperday
(AveragesalesperdayisequaltoAnnualSales/365days.)
Youmustrelymoreonthefirmspreviousaveragecollectionperiodfig
uresinevaluatingtheresultandlessonthefiguresofotherfirmsandindus
trywidefiguresinthiscasebecausefirmscreditpoliciesandtheirmixof
cashsalesandsalesonaccountdifferwidely.Iftheaveragecollectionperi
odhasbeenincreasing,itmayindicatethefirmsincreasingdifficultyincol
lectingitsreceivablesastheycomedue.
Onceagain,letslookattheSolanaBeachBicycleCompanyandseehow
theyaredoingincollectingtheirreceivables.TofindAccountsReceivable
wegotoFigure3.4andseethatattheendof2006,AccountsReceivableis
$9,000(Thisisnetreceivables:AccountsReceivableminusallowancefor
doubtfulaccounts.)ThenwelookatFigure4.1andseethatsalesforthe
year2006are$35,500.Toarriveataveragesalesperday,wedivide$35,500
by365daysandget$97.26.Toarriveattheaveragecollectionperiodwe
dividetheAccountsReceivable$9,000bytheaveragesalesperdayof
$97.26andgetanumberof92.5.Thismeansthatitistakingthecompany
ninetytwoandonehalfdaystocollecttheirreceivables.SolanaBeach
BicycleCompanyhasapolicythatgenerallygivescustomersthirtytosixty
daystopay.ThefactthattheaveragecollectionperiodforSolanaBeach
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Bicycleislongerthanthismeansthatitistakingthecompanytoolongto
collecttheirmoneyandbeabletouseitagainintheactivitiesofthebusi
ness.Thisisnotagoodsign.Thecompanymustfigureouthowtogetthe
customerstopaythemsoonerorstopgivingthemcreditatall.
Onceyoudecidethatthecompanyisgoingtosurviveinthenearfuture,
youcanturntoestimatingitslongtermfutureprospects.Asyoubeginto
lookbeyondtheshorttermsuccessofacompany,themainfocusofyour
attentionshiftsfrominformationpresentedontheBalanceSheettoinfor
mationpresentedontheIncomeStatementinordertolookatpastper
formanceandprojectanytrendsintothefuture.
Thelongtermfutureofacompanydepends,toaverylargeextent,upon
thecapabilityofthecompanysemployees.Oneofyourmaingoalsisto
determinehowwelltheemployeeshavedoneinthepastandhowwellthey
aredoingnow.Theinformationthatyouhavealreadygatheredatthebegin
ningofthischapterwithregardtotheshorttermfutureprospectgivesyou
valuablecluesastocurrentperformance.However,thisisnotsufficientto
drawareliableconclusionaboutthelongtermprospectsofthecompany.
chapter9willdetailhowtoapproachmakingthissortofevaluation.
GLOSSARY
AverageCollectionPeriod:Ashorttermfinancialanalyticaltoolcal
culatedbydividingAccountsReceivablebyaveragesalesperday.This
figureisusedbymanagementtodeterminehowlongitistakingthemto
collecttheirAccountsReceivable.Ifacompanyofferspaymenttermsof
thirtydaystoitscustomers,andtheaveragecollectionperiodislonger
thanthirtydays,managementneedstodeterminehowtostartcollecting
thesereceivablesfaster.
CurrentRatio:Ashorttermfinancialanalyticaltoolcalculatedbydivid
ingCurrentAssetsbyCurrentLiabilities.Theruleofthumbisthatthisratio
shouldbegreaterthan2.0;however,thiswillvarysomewhatfromcom
panytocompanyandindustrytoindustry.Thus,itisnecessarytoknow
prioryearfiguresasabasisofcomparison.
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InventoryTurnoverRatio:Ashorttermfinancialanalyticaltoolthat
iscalculatedbydividingCostofGoodsSoldbyAverageInventory.
(AverageInventory=BeginningInventory+EndingInventory/2).Whatis
goodorbadforthisratiodependsontheindustry.Ifthecompanyisina
businesswherethereareperishablegoods,thenthisnumberneedstobe
verylow.Inabusinesssellingnonperishablegoodssuchasclothes,it
wouldhigher.Inabusinesswhereproducingthegoodstakesalong
timebuildingairplanes,forinstancetheratiowouldbeevenhigher.
QuickRatio(orAcidTestRatio):Ashorttermfinancialanalytical
toolcalculatedbydividingQuickAssetsbyCurrentLiabilities.Theruleof
thumbforthisratioisthatitshouldbeabove1.5.However,aswiththe
currentratio,thehistoryofthecompanysratioandtheaveragesinthe
industryshouldbeconsidered.
WorkingCapital:Ashorttermfinancialanalyticaltoolcalculatedby
subtractingCurrentLiabilitiesfromCurrentAssets.Todeterminewhatisa
safeandcomfortablecushion(sufficienttocoverwhateverdebtsmayfall
due),thisfigureneedstobecomparedtothecashflowofthecompany
aswellastoprioryearsdata.
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QualityofEarnings
EarningsData
DividendData
Footnotes
UsingFinancial
Statementsfor
LongTermAnalysis
Chapter
9
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QualityofEarnings
Inanalyzingfinancialstatements,itisimportanttokeepinmindthequality
ofearningsofthecompanybeinganalyzed.Butwhatisqualityofearnings?
Ingeneral,companieswithahighqualityofearningshaveastronghistoryof
earningsandstrongratiosforboththeshortandlongterms,andthusare
consideredtobeinagoodpositiontomaintainhigherearningsinthefuture.
Thequalityofearningsconceptisusedbybothcreditorsandinvestorswho
understandthatthebottomlineofallorganizationsisnotequal.Companies
withhigherqualityofearningsreceivehighercreditlimits,lowerinterest
costs,andhigherstockprices.YoucanseeinFigure9.1whatproducesahigh
erqualityofearningsforabusiness.
Figure9.1:WHATPRODUCESA
HIGHERQUALITYOFEARNINGS?
AmajorityofNetIncomecomingfromcontinuingoperationsas
opposedtoonetimetransactions.
Thequickconversionofsalesintocash,i.e.,relativelylowaverage
collectionperiod
Anappropriatedebtequityratio
AfullyfundedpensionLiability
Stableearningtrends
Highlydevelopedbrandloyaltyamongconsumers
Stableorincreasingmarketshare
Anunqualifiedauditopinion
Goodlaborrelations
Inchapter8wereviewedseveralratiosthatarebeneficialinanalyzing
theshorttermviabilityofacompany.InFigure9.2below,weseethatthere
arealsoseveralratiosthatneedtobereviewedandevaluatedtounderstand
thelongtermstrengthofacompany.Eachoftheseratioswillbediscussed
inthischapter.
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Figure9.2:LONGTERMINFORMATION
USEDTOEVALUATEACOMPANY
1.Rateofreturnoninvestment
2.Netprofitasapercentageofsales
3.PercentageofvariousExpensestosales
4.Rateofgrowthofsales
5.Earningspershare
6.Extraordinarygainsandlosses
7.Price/earningsratio
8.Numberoftimesinterestandpreferredstockdividendswereearned
9.TotalLiabilitiestototalAssets
10.Dividendpayoutratio
Therateofreturnoninvestmentisprobablythesinglemostimportant
financialstatistic.Itcomesascloseasanyfigurecantoreflectinghowwell
acompanyhasdone.
ReturnonInvestment(ROI)isusuallycalculatedasfollows:
Rateofreturn(asaratio)=NetIncome/AverageStockholdersor
OwnersEquity
Rateofreturn(asapercentage)=NetIncome/AverageStockholdersor
OwnersEquity(x100)
Note:StockholdersEquityisthetermusedinacorporation,whereas,
OwnersEquityisthetermusedinaproprietorshipandpartnership.They
aresimilarinthattheybothshowhowmuchtheowner(s)investedinthe
businessplustheiraccumulatedearnings(RetainedEarnings).
UsingFinancialStatementsforLongTermAnalysis139
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Thisratiodepictshowmuchmoneywasearnedascomparedtothe
amounttheownersinvestedinthebusiness.Intheexampleinchapter3,
Samhadinvested$60,000intothebusinessonJanuary1.Sincethebegin
ningOwnersEquitywas$0onJanuary1,andtheendingOwnersEquity
was$70,385onDecember31,theaveragefortheyearwas$35,193.Since
NetIncomefor2006was$10,385,theownerearned29.5percentonher
investment.($10,385/$35,193)
Is29.5percentagoodreturnontheOwnersInvestment?Theonlyway
toanswerthisquestionistoknowwhatalternativeinvestmentsaninvestor
mightconsider.Cantheownerinvesthismoneyelsewhereandmakemore
money?Iftheanswerisno,thenthereturnisagoodone.Thisanalysis
shouldbemadeonanongoingbasisinordertocontinuallydetermine
wheretoinvestonesmoney.
Havingsaidthis,thereareexceptions.Intheearlyyearsofanewcom
pany,theownermaynotmakeagreatreturnoranyreturn.Butheorshe
maybebettingonthefuture,inthebeliefthatthereturnswilloutpace
otheralternatives.Inaddition,acompanyshouldconsiderhowwellitdoes
inthecurrentyearascomparedtothepreviousyearbycomparingtherate
ofreturnfigureforeachofthetwoyears.Comparingonecompanys
resultstothoseofanothercompanyinthesameindustryisalsoauseful
indicatorofhowthecompanyisdoingincomparisontothecompetition.
Alert!
KnowYourEstimates:Inmakingthesecomparisonsbetweentwoyearswithin
thesamecompanyorbetweenonecompanyandanother,youmustbealertas
towhatestimatesweremadeandwhichgenerallyacceptedaccountingprinci
pleswereused.SinceNetIncomeiscomprisedofseveralestimates,iftheseesti
matesandaccountingstandardsarenotthesamebetweenyears,orbetween
companies,thisratiocannotbecompared.
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Inordertobeabletopredictfutureprofitability,youneedtoexamineyour
companysandothercompaniespastsalesandExpenses.
NetProfitasaPercentageofSales
OnesuchratiothataidsintheanalysisoffutureprofitabilityistheNet
ProfitasapercentageofSales.
NetProfitasaPercentageofSales=(NetIncome/Sales)x100
Anincreaseinthispercentageascomparedtopreviousyearsmayindi
catethatthecompanyisoperatingmoreefficiently.Moresalesweremade
withfewerExpenses.Also,whenthenetprofitasapercentageofsalesis
higherforonecompanythananother,itmayindicatethatonecompanyhas
beenoperatingmoreefficientlythantheother.
InthecaseoftheSolanaBeachBicycleCompany,NetIncomefor2006
was$10,385.Salesfortheyearwere$35,500.Thus,thenetprofitasaper
centageofsaleswouldbe29.25percent.Isthisgood?Bad?Helpful?Since
thisisthefirstyearofoperationsforthecompany,wedonothaveanyprior
yearstocomparethisnumberto.However,itdoestellusthatthecompa
nyismakingover29percentontheirsales.Notbad.Why?Whereelsecan
youinvestyourmoneyandearn29percent?Notverymanyplaces,andnot
onaregularbasis.Ifwehadthedatawecouldcomparethistoothersimi
larsmallbusinessesandinthefuturewewillbeabletocompareittoprior
yearsforthebicyclecompany.(Onceagain,keepinmindthatthedifferent
companiesbeingcomparedmusthaveusedthesameGAAPtoarriveat
theirNetIncomecalculationsinorderforcomparisonstobemeaningful.)
SalesRatios
Tohelpverifythesehunchesandtogainbetterinsightintooperational
changes,itisalsohelpfultocompareavarietyofdifferentExpensestothe
totalsalesfigure.ByunderstandingtheseratiosofvariousExpensesto
sales,onecandetermineifalargerorasmallerpercentageduringtheyear
isbeingspentontheseExpenses.Ifacompanyisgoingtobecompetitive
andsuccessful,itmustcontrolitsExpenses.Theseratiosshowtheareasof
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thebusinesswherethecompanyhasbeenabletocontroltheseExpenses.
SeeFigure9.3forseveralexamples.
Figure9.3:IMPORTANTSALESRATIOS
1.Costofgoodssold/Sales
2.SellinganddeliveryExpenses/Sales
3.GeneralandadministrativeExpenses/Sales
4.DepreciationExpenses/Sales
5.LeaseandrentalExpenses/Sales
6.RepairsandmaintenanceExpense/Sales
7.Advertising/Sales
8.Researchanddevelopment/Sales
Anothersalesbasedratiothatishelpfulistherateofgrowthofsalesfrom
oneperiodtothenext,calculatedbycomparingtheincrease(ordecease)
insalesbetweentwoperiodstothesalesinthefirstperiod.Youwouldfind
itveryinformativetolearnthatSolanaBeachBicycleCompanysales
increased10percentfromoneyeartothenext,and20percentfromyear
twotothree,and30percentfromyearthreetofour,etc.Thepatternof
salesoverthemostrecentyearsofcompanyslifecanhelpyouformanesti
mateofexpectedfuturesales.
EarningsData
Theearningspersharefigure(EPS)andtheprice/earningsratio(P/E)are,
alongwiththerateofreturnoninvestmentratio,themostwidelyused
informationaboutcorporations.Theprice/earningsratioiscalculatedby
dividingthemarketpricepershareofthatcompanysstockbytheearnings
pershareofthecompany.
Price/EarningsRatio=MarketPricePerShare/EarningsPerShare
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Alert!
CorporationsOnly:BoththeP/EratioandEarningPerSharecanonlybecal
culatedforbusinessesthathavebeenincorporated.Why?Becauseiftheyhave
notbeenincorporated,theydonotsellcapitalstock,andtherefore,donothave
commonorpreferredsharestoperformthiscalculation.Anadditionalnote,if
youownasmallbusinessthathasbeenincorporated,theremaynotbeamar
ketpriceforshares.Thus,theP/Eratiocannotbecalculated,butEPScanbe
determined.
Theprice/earningsratiocangiveyousomeveryusefulideasaboutwhat
otherpeopleexpectforthefutureofacompany.Forexample,whenacom
panysstockissellingforfiftytimesearnings(P/Eratiooffiftytoone)and
theaverageP/Eratioformoststocksinthatindustryisfifteentoone,you
mayconcludethat(1)thecompanysearningsaregoingtoincreaseconsid
erablyinthefutureorthat(2)thepriceofthestockisgoingdownbetween
nowandthetimethepresentbuyerswillwanttosellthestock.
Ingeneral,whentheP/Eratioofacompanysstockissignificantlyhigh
erthanaverage,thebuyersofthestockexpectthatthecompanywillpros
per;whentheratioislowerthanaverage,buyersarenotoptimisticabout
thecompanysfuture.
AftercalculatingEPS,youwillwanttocomparetheearningspershare
figuresofacompanyforaperiodoffivetotenyearsandshouldcompare
theEPSfigureswiththoseofothercompanies.
WhenlookingatNetIncomeforacompany,youmustalsoconsiderthe
makeupofthatnumber.Often,thereareextraordinarygainsorlosses
included.Thesearegains/lossesfromthesaleofitemsthatarenotconsid
eredtoberecurring.Sinceyouwanttoprojectthepastintothefuture,you
wanttoeliminatefromthepastdatathosegainsandlossesthatarenot
expectedtooccuragaininthefuture.Therefore,thefigurethatyouwill
findmostusefulistheEPSbeforeextraordinarygainsandlosseswhenthe
earningsfigureusedinthecalculationdoesnotincludegainsorlossesthat
areconsideredananomalyorhighlyunusualinsomeway.However,you
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shouldbesuretolookcarefullyattheextraordinaryitemsanddetermine
thelikelihoodthattheymayoccuragaininthefuture.
Somepeoplebelievethatacompanythatborrowsmoneyisnotasgoodor
aswellmanagedasacompanythatoperateswithoutborrowing.Thisisnot
necessarilytrue.Often,byborrowingmoney,acompanycanincreasethe
NetIncomeforthestockholderswithoutincreasingthestockholders
investment.
Forexample,saythatCompanyA,whoseAssetstotal$100,000,
Liabilitiestotal$10,000,andStockholdersEquitytotals$90,000,expects
aNetIncomenextyearof$9,000.Thisrepresentsareturnoninvestment
of10percent.
Nowassumethatmanagementisconsideringthepurchaseof$40,000
worthofAssets.TheseAssetswillproduceadditionalannualNetIncome
(beforeinterestExpense)of$4,000.Thecompanyhastwochoices.Firstit
canborrowthe$40,000at6percentinterestoritcanhavetheinvestors
puttheadditional$40,000intothebusiness.
Inscenarioone,CompanyAborrowstheneeded$40,000.CompanyAs
NetIncomenextyearwouldbe$10,600($9,000+$4,000$2,400)
beforeIncomeTaxes.The$2,400reductiontoNetIncomeistheintereston
theloan($40,000x6percent).Thus,thereturnoninvestmentwouldbe
11.7percent($10,600/$90,000=11.7percent).
Inscenariotwo,insteadofborrowingthe$40,000,theownersinvest
theirownmoney.Netincomewouldstillincreaseby$4,000to$13,000
($9,000+$4,000).TherewouldbenointerestExpense,andtheReturn
onStockholdersEquitywouldbe$13,000/$130,000(theoriginal
$90,000+theadditional$40,000).Thus,itsReturnoninvestmentremains
at10percent.
Asyoucansee,scenarioone,whereCompanyAborrowedtheaddition
al$40,000,andendedupwithareturnoninvestmentof11.7percentwas
amorefavorableoutcome.
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Alert!
DangerousDebt:Toomuchdebtcanmakeacompanytoorisky.Duringeco
nomicdownturns,thesecompaniesmaynotbeabletorepaytheirdebts.
However,ontheotherhand,littleornodebtmaynotbeagoodthingeither.If
acompanycanborrowmoneyat7percentinterestandearn10percenton
theirinvestment,borrowingwillincreasetheiroverallrateofreturn.
Onewaytohelpyoudetermineifacompanyhasputitselfintoarisky
positionistocalculatetworatios:thenumberoftimesinterestwasearned
andtheratiooftotalLiabilitiestototalAssets.
Tocalculatethenumberoftimesthatinterestwasearned,dividethe
interestExpenseintotheNetIncomebeforeinterestExpenseandbefore
IncomeTaxes.YouusetheincomefigurebeforeIncomeTaxesbecause
interestExpenseisdeductibleforIncomeTaxpurposes.
NumberofTimesInterestWasEarned=NetIncomebeforeInterest
andTaxes/InterestExpense
Thelargerthisratio,theeasieritisforthecompanytomeetitsinterest
payments,andthelesslikelyitisthatthecompanywilldefaultonitsloans.
TocalculatetheratioofLiabilitiestoAssets,youdividetotalLiabilities
bytotalAssets.
RatioofLiabilitiestoAssets=TotalLiabilities/TotalAssets
Theideahereisthatthelargertheratio,themoreriskythecompany.Of
course,acompanywithalargeLiabilitytoAssetratiomayprosperwhilea
companywithoutanydebtatallmayfail.TheLiabilitytoAssetratio,as
wellasanyratio,onlygivesyouapartofthetotalpictureandmustbeana
lyzedalongwithotherratiosandoutsideinformationaboutthecompany,
theindustry,andtheeconomy.
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DividendData
Additionalinformationaboutacompanycanbeobtainedbylookingatthe
cashdividendsthatithaspaidoverthepastseveralyearsandcalculatingthe
dividendpayoutratio,thetotalcashdividendsdeclaredduringtheyear
dividedbytheNetIncomefortheyear.
DividendPayoutRatio=DividendsDeclared/NetIncome
Iftheratioislarge,thecompanyispayingouttothestockholdersalarge
portionofthefundsearnedandnotreinvestingtheminthecompany.Ifthis
ratioissmallorifthecompanypaysnodividendswhatsoever,thecompa
nymaybegrowingrapidlyandusingthefundstofinancethisgrowth.
Whichisbetter?Thisiscompletelydeterminedbyyourpersonalinvest
mentneedsifyouareastockholderorthegoalsofthebusinessifyouare
partofmanagement.
Figure9.4illustratesexamplesofwhichlongtermratiosareusefulfor
varioususers.
Figure9.4:HOWLONGTERMRATIOSAREUSED
Users
Ratios
UsedFor
Lenders
NumberofTimes
EvaluatingtheSafety
InterestWasEarned
ofYourLoan
TotalLiabilities/
TotalAssets
MakingLongTerm
Loans
Stockholders
EPS,P/ERatio
Purchasing/Holding
Stock
DividendPayoutRatio
Owners/Managers
SalesBasedRatios
OnGoingLongTerm
Analysis
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Footnotes
Almostallfinancialstatementsofcompanieslargerthanaveragesmallbusi
nesshavefootnotesattachedtothem.Thefootnotesareasimportantasthe
fineprintinacontract.Whenyouexamineacompanysannualreport,con
siderreadingthefootnotesfirst.Examinethefinancialstatementsnextand
readthepresidentsmessageandtherestoftheadvertisinglast.
Informationcontainedinthefootnotesisquitevaried.Itcaninclude
termsofpensionplans,termsofstockoptionsoutstanding,thenatureand
expectedoutcomeofanypendinglawsuits,termsofalongtermlease
agreement,andprobableeffectsofforcedsaleofpropertiesinaforeign
country.Youmayfindanabundanceofcluesaboutacompanysfuture
fromthefootnotes.
Analyzingfinancialstatementscanbeextremelyhelpful,butwithoutthe
useofhistoricaldata,nopredictionscouldbemadeaboutthefutureofa
company.Themoreyoureadfinancialstatements,usethem,andworkwith
them,thebetteryourdecisionsaboutthefutureofyourcompanyandthose
youwishtoinvestinwillbecome.
Inthischapteryouhavelearnedhowfinancialstatementsandvarious
ratioscanbeusedtoevaluatethelongtermsuccessofabusinessInchap
ter10youwilllearnhowtoprepareanduseabudget.
GLOSSARY
DividendPayoutRatio:Alongtermfinancialanalyticaltoolcalculat
edbydividingDividendsDeclaredbyNetIncome.Thisratioisuseful
whenanalyzinghowmuchoftheearningsfortheyearhavebeendis
tributedtothestockholders.Aswithallotherratios,itmustbecompared
toprioryearsandtoothercompanies.
EarningsPerShare:Alongtermfinancialanalyticaltoolcalculatedby
dividingNetincomebytheaveragenumberofcommonsharesoutstand
ingfortheyear.Thisratiocanonlybecalculatedforcorporations.
Sometimesthisratiogetstoomuchattentionwhenpotentialinvestorsare
makingtheirdecisions.Thisnumberisonlyasaccurateandusefulasis
NetIncomeitselfandmustbeusedinconjunctionwithmanyoftheother
ratiosinthischapter.
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ExtraordinaryGainsandLosses:Gainsandlossesfromthesaleof
itemsthatareneitherconsideredtoberecurringnoranormalpartofthe
businessoperations.Forthisreason,itisrequiredbyGAAPthatthese
gainsandlossesbeseparatedontheIncomeStatementfromincomefrom
operations.
NetProfitasaPercentageofSales:Alongtermfinancialanalyti
caltoolcalculatedbydividingNetIncomebysalesandmultiplyingthe
resultsbyonehundred.Thisratioshouldbecomparedwithprioryears
figuresaswellaswithindustryaveragestodetermineitsvaluetoman
agement.
NumberofTimesInterestWasEarned:Alongtermfinancialana
lyticaltoolcalculatedbydividingNetIncomebeforeTaxesbyinterest
Expense.Thelargerthisnumber,themoresatisfiedthelenderswillbe
sincetheywillhaveahighercoverageoftheinterestduetothembythe
NetIncomeofthecompany.
Price/EarningsRatio:Alongtermfinancialanalyticaltoolcalculated
bydividingmarketpricepersharebyearningspershare.Thisratiocan
onlybecalculatedforcorporationssincepartnershipsandproprietorships
donothavestockandthushavenomarketpriceorearningspershare.
Ingeneralforcorporations,thehigherthisratiothebetter,andapositive
upwardtrendinthisratiofromyeartoyearislookedonfavorablyby
investors.
RateofSalesGrowth:Alongtermfinancialanalyticaltool;theper
centagechangeinsalesbetweentwoormoreyears.Generally,busi
nesseslookforthisfiguretogrowfromyeartoyear.
RateofReturnonInvestment:Alongtermfinancialanalyticaltool
calculatedbydividingNetIncomebytheaverageStockholdersEquity.
TheaverageStockholdersEquityisdeterminedbyaddingthebeginning
oftheyearequitywiththeendoftheyearanddividingbytwo.Agood
rateofreturnisonethatwouldbegreaterthanwhatcouldbeearned
investingthatmoneyinotherplaces,likewiththebankorinbondsor
securities.
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WhatIsaBudget?
PlanningandControl
TheMasterBudget
SalesBudget
CapitalBudget
TheCashBudget
Budgetingfor
YourBusiness
Chapter
10
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WhatIsaBudget?
Thebudgetisadetailedplanthatoutlinesfutureexpectationsinquantita
tiveterms.Budgetsinaccountingcanbeusedforavarietyofreasons.You
canuseabudgettoplanandcontrolyourfutureIncomeandExpenses,
whichwouldlookliketheIncomeStatementswehavebeenreviewing
throughoutthebook.Oryoucanusebudgetstoplanforfuturecapital
expenditures,whichwouldshowwhenthecompanymayplantobuy
LongTermAssetsandwherethismoneyistocomefrom.Governmental
agenciescanusebudgetsofRevenuesandExpensesinordertodetermine
theirfuturetaxneeds.
PlanningandControl
SowhywouldSamwanttodoabudgetforherbusiness?Theanswertothis
questionisthatSamisgoingtoproduceabudgeteachyearforthepurpose
ofplanningforhercompanyintothefutureandtocontroltheamountshe
isspending.
Thetermsplanningandcontrolareoftenusedinterchangeablyinan
accountingsense,buttheyareactuallytwodistinctconcepts.Planningisthe
developmentoffutureobjectivesandthepreparationofbudgetstomeet
theseobjectives.Control,ontheotherhand,involvesensuringthatthe
objectivesestablishedduringtheplanningphaseareattained.Agoodbudg
etingsystemtakesintoconsiderationboththeplanandthecontrol.
Whetherthebudgetisforpersonaluseorforyourbusiness,themajor
advantageofusingabudgetisthatitgivesformalitytotheplanningprocess.
Ifthebudgetinvolvesotherpeople,italsoservesasawayofcommunicat
ingtheplantotheseotherpeople.Oneofthemajorprocesseswithinan
organizationistocoordinateandintegratetheplansandgoalsofthevari
ousdepartments.Oncethebudgethasbeenestablisheditservesasabench
markforevaluatingtheactualresults.
Withoutpreparingabudget,Samwouldnotknowhowmuchmoneythe
bicyclecompanyisgoingtohaveattheendofthemonth,howmuchitmust
borrowtobuythecapitalAssetsneededforthebusiness,norwillsheknowif
theRevenuesaregoingtoexceedtheExpensesorviceversa.Theprocessof
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preparingthebudgetwillbecriticaltoSamassheplansforthefuture.Most
smallbusinessesthatgooutofbusinessdoso,notbecausetheydonthavea
goodproductorservice,butbecausetheyhavenotplannedwellandhaverun
outofcash.Preparingabudgetcanhelpavoidthisundesirableend.
QUICKTip
UsingBudgetsinYourBusiness:Withtheuseofpersonalcomputersandspread
sheetprograms,thebudgetingprocesshasbeensimplified.Budgetscanbe
implementedandmaintainedatlittlecost.Inaddition,itiseasytomake
changesonaregularbasistoviewpotentialsituationsthatmaycomeup.This
allowstheindividualorthemanagertomoreeasilymakedecisionsbasedon
theseanticipatedresults,thusimplementingthecontrolfeatureofabudget.
TheMasterBudget
Themasterbudgetisacompilationofmanyseparatebudgetsthatareinter
dependent.AnexampleofthisnetworkisexhibitedbelowinFigure10.1.
ThemajorbudgetswhichtogethercomprisetheMasterBudgetwillbethe
focusofthischapter.
Figure10.1:THEMASTERBUDGET
BudgetingforYourBusiness151
Sales
Budget
Operating
Expense
Budget
Capital
Budget
Budgeted
Statementof
CashFlows
Budgeted
Balance
Sheet
Cash
Budget
Purchasing
Budget
Ending
Inventory
Budget
Budgeted
Income
Statement
LongRange
SalesForecast
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SalesBudget
LetsassumethatSamwantstoprepareamasterbudgetforthebicycle
companyfortheyear2007.Inordertopreparethisbudget,Samisgoingto
havetoguesstimatehowmuchsalesthebusinesswillgeneratefortheyear.
AsindicatedinFigure10.1,withoutthisfirststepofcreatingasalesbudg
et,noneoftheotherbudgetscanbeprepared.
Tocalculatethetotalsalesfigure,itisnecessarytomultiplytheexpect
edunitsalesforeachproductbyitsanticipatedunitsellingprice.Samcal
culatesthattotalwillbe$85,000foranticipatedsalesofnewbicycles.(She
expectstosell170bicyclesatanaveragepriceof$500perbicycle;170
bicyclesx$500perbicycle=$85,000.)
Inadditiontothenormalsalesofbicycles,thebicyclecompanyhasbeen
increasingitsRevenuefromrepairs.During2007,theRevenuefromrepairs
willbebudgetedat$9,500.TheExpensesassociatedwiththeserepairsare
budgetedtobe$3,600.
CostofGoodsSoldandEndingInventory
EndingInventoryattheendofDecember2006is$13,000.(SeeFigure3.2.)
Assumeonaverage,thecompanyhashada60percentprofitmargin.
Sincesalesarebudgetedtobe$85,000,theGrossProfitwouldbe$51,000
($85,000x60percent).Furtherassumethatsincethecompanyisgrowing,
thebicyclecompanydeterminesthatitwantsendingInventorytogrow
fromthepreviousyearinanticipationofgrowingsalesinthefuture,soSam
hasbudgetedendingInventoryfor2007tobe$32,000.
QUICKTip
InventoryandBudgeting:DeterminingInventoryneedsisnotaneasyprocess
butisanextremelyimportantoneforasmallbusiness.ExcessInventorythatcan
notbesoldmaybecomespoiledoroutofdate.AshortageofInventorywill
causealossofsalesbecausetheproductisnotavailableandcustomerswill
taketheirbusinesselsewhere.Asasmallbusinessowner,carefulplanningand
controliscriticaltomaintainingproperlevelsofInventory.Thisnumbershould
bebaseduponpastexperiencesaswellascarefulbudgetingofsales.
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InorderforthecompanytoachievetheendingInventoryof$32,000for
2007,additionalInventorymustbepurchased.Theamountthatthecom
panyneedstopurchaseiscalculatedbythefollowingformula:
BeginningInventory
+Purchases
EndingInventory
=CostofGoodsSold
Inthecaseofthebicyclecompanyweknowthreeoutofthefour
numbers:
BeginningInventory
(2006EndingInventory:
SeeFigure3.3,chapter3)$13,000
+Purchases
???
EndingInventory
$32,000
=CostofGoodSold
$34,000
Butwait,howdoweknowCostofGoodsSold?Well,weknowbudget
edsalesis$85,000,right?WealsoknowthatGrossProfit=$51,000.And
lastly,weknowthatsalescostofgoodsold=Grossprofit.Sovoila,
$85,000X=$51,000.X=$34,000.Whew!
Byworkingbackwards,wecancalculatethatpurchasesfor2007mustbe
$53,000.
OperatingExpenses
BylookingbackattheMasterBudgetinFigure10.1wecanseethatthe
salesbudgetflowsdirectlyintothebudgetforoperatingExpenses.Asindi
catedinFigure4.1,theseExpenseswere$7,565,or21percentofsalesfor
2006.Again,assumingthatthispercentageremainsfairlyconstantandthat
duringtheyear2007salesarebudgetedtobe$85,000,operatingExpenses
wouldbebudgetedat$17,850(21percentof$85,000).
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CapitalBudget
Thecapitalbudgetisconcernedwiththoseitemsthatwilllastlongerthanone
yearthecompanysLongTermAssets.Todetermineifanyadditionalspace
wouldneedtoberentedorbuilt,thebusinessmustdoalongrangesalesfore
cast.Assumingthatthebusinessisgrowingatafairlyconstantrate,Samhas
predictedthatwithintwoyearsanotherbuildingmustbepurchasedinorder
tomeetthebusinesssproductionandsalesdemands.Samsresearchoflocal
realestateindicatesthatthecostofabuildingwithsufficientspaceforthenext
fiveyearswouldbe$48,000.Therefore,thecapitalbudgetpermonthforthe
nexttwoyears(whenthepurchasewillactuallyhavetobemadesinceSam
doesnotwanttoincuranyadditionaldebtbytakingoutamortgageonthis
building)wouldbe$2,000.($48,000/24months)Inordertopurchasethe
buildingtwoyearsfromnow,$2,000mustbesetasideeverymonthforthe
nexttwoyears.(Thisassumesnoinflationduringthenexttwoyears.)
Withtheinformationthathasbeengatheredtothispoint,itisnowpos
sibletocreateacashbudgetandabudgetedIncomeStatement,Balance
Sheet,andcashflow.Letsexaminethisinformation.
Usingthefigurescalculatedabove,SamcancreateabudgetedIncome
StatementliketheoneshowninFigure10.2:
Sales........................................$85,000
CostofGoodsSold...............................34,000
GrossProfit....................................$51,000
OperatingExpenses..............................17,850
NetIncomefromOperations.......................$33,150
OtherRevenue:
RepairRevenue..................................$9,500
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OtherExpenses:
RepairExpenses..................................3,600
NetIncome...................................$39,050
WhydoesthebicyclecompanyneedthisIncomeStatement?Theymight
useittoshowtothebanktogetaloan.Theymightwanttoshowitto
potentialpartnerslookingforinformationaboutthefutureofthebusiness.
Andofcourse,theywillalsoneeditforplanninghowtheyaregoingto
expandinthefuture!
TheCashBudget
Next,thecompanyneedstocalculatehowmuchcashtheyaregoingto
haveattheendoftheyear.Samneedstoknowthisfigureinordertopre
parethebudgetedBalanceSheet,butmoreimportantly,tomakesurethe
companyhasenoughcashtopayitsbillsinthefollowingperiods,andkeep
thecashbalanceatasafelevel.
Inordertocalculatethebudgetedendingcashbalancefor2007weneed
toknowthebeginningcashbalance.Thisfigureisthesameastheending
cashbalanceonDecember31,2006,becausethebusinessstartsthenew
yearwiththeamountofcashitendedthelastyearwith.Thisfigureis
$17,385(seeFigure3.2).Anumberofassumptionsneedtobemadeas
well.Salesfor2007werepredictedtobe$85,000plus$9,500forrepairs
(foratotalof$94,500),butitmustalsobedeterminedhowmuchofthese
saleswillbeincashandhowmuchwillbeonAccountsReceivable.Inthe
past,75percentofboththebicyclesalesandrepairworkhavebeenpaid
forwithcash,soitissafetoassumethatthiswillbethecasefor2007as
well.Thus,thecashreceiptsfor2007fromsalesandrepairswillbe$70,875
($94,500x75percent).
Assumingthesameratioappliestotheprecedingyear(thatis,75per
centofthesaleswereforcash,andtheother25percentwereonaccount)
thenthe25percentthatwasstillowedtothebicyclecompanyon
December31,2006,willbecollectedin2007.Thisismakingtheassump
tionthattherewerenobaddebts.(Iftherewerebaddebts,thentheamount
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estimatedforbaddebtswouldbedeductedfromtheamounttobecollect
ed.)Again,sincethesalesandtherepairworkfor2006totaled$39,350,the
cashtobecollectedin2007onthese2006saleswouldbe$9,837($39,350
x25percent).
Nowweneedtocalculatethecashexpendituresfor2007.Thefirst
expenditureisthatofpurchasingInventory.ThegeneralruleatSolana
BeachBicycleCompanyisthat80percentofthepurchaseispaidincash
intheyearofpurchase,and20percentispaidinthefollowingyear.In
2006,thebicyclecompanypurchased$23,000ofbicycles(Inventory)and
in2007,theypurchasedbicyclescosting$53,000.Thus,thecashexpendi
turefor2007is$47,000.(20percentof$23,000for2006and80percent
of$53,000for2007).
Socontinuingwiththisassumption,80percentoftheotherexpenditures
atSolanaBeachBicycleCompanyarepaidwithcashintheyearofuse,and
20percentarechargedonaccount.(Everycompanywillhaveitsownpast
datatoguidetheirassumptionsforthepurposesofpreparingbudgetsand
willcalculatethisratio(80/20,65/35,etc.)baseduponitsownexperi
ences.)OperatingExpensesfor2007havebeenbudgetedat$17,850,and
operatingExpensesin2006totaled$7,565(SeeFigure4.1).Basedonthe
80/20breakdownofcashversusaccountpaymentatSolanaBeachBicycle
Company,weknowthatthetotalcashoutlayforoperatingExpensesin
2007wouldbe$15,793:thesumofthecashoutlayfor2007expenditures
($17,850x80percent=$14,280)plusthecashspenttosettleAccounts
Payablefor2006operatingExpenses($7,565x20percent=$1,513).
Eachyear,anothercashexpenditureismadeforrepairExpenses.Allof
theseexpendituresaremadeintheyearinwhichtheyoccur.Thus,the
$3,600forrepairsin2007areallpaidintheyear2007.
Thelastcashexpenditurethatthebicyclecompanymadeduring2007is
the$2,000permonththatthebusinessputasideforthefuturepurchaseof
abuilding.Thiscashtransactionisneitheranexpenditurenorareductionin
cash.Itissimplygoingfromonebankaccounttoanother.Theonlyreasonfor
thetransactionatallistomakesurethatthecashleftintheoperatingcash
accountisnotaccidentallyspentpriortothepurchaseofthebuilding.
LetstakealookbelowatFigure10.3toseehowwecanactuallycalcu
latetheendingcashbalance.
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BudgetedEndingCashBalance
BeginningCash................................$17,385
Add:
CashReceiptsfrom2007Sales......................70,875
CashReceiptsfrom2006Sales.......................9,837
Subtract:
CashPaymentsforInventoryPurchases2007.............42,400
CashPaymentsforInventoryPurchases2006..............4,600
CashPaymentsforOperatingExpensesin2007..........14,280
CashPaymentsforOperatingExpensesin2006...........1,513
CashPaymentsforRepairsExpensesin2007.............3,600
EndingCashBalance............................$31,704
(NotetotheCashBudget:Ofthe$31,704endingcashbalance,
$24,000hasbeensetasideinaseparatebankaccountforthefuturepur
chaseofanewbuilding.)
TheexamplepresentedhereisforasmallbusinesssuchasSolanaBeach
BicycleCompany.However,thesameconceptscanbeappliedtopreparing
apersonalbudgetandthesamebenefitswillbederived.
QUICKTip
ParticipationIsKey:Thesuccessorfailureofbudgetswithinanorganizationis
usuallyenhancedbytheparticipationofthemanagers,whoaregenerallymore
apttofulfillthegoalsthattheyhavehadadirectroleindeveloping.Thisisnt
tosaythatthesebudgetsshouldnotbesubjecttoreviewbyhighermanage
ment;however,anychangesthataremadeshouldbedonewiththeinvolve
mentoftheindividualswhoplayedapartincreatingthebudget.
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Inthischapteryoulearnedthemeaningofabudget,thevalueofprepar
ingone,andthewaysinwhichthecomponentsinterrelate.Inchapter11
youwillfindoutwhoauditorsare,whattypeofreportstheyissue,andwhy
thosereportsareusefultoyou.
GLOSSARY
Budget:Adetailedplanthatoutlinesfutureexpectationsinquantitative
terms.Themajorpurposesofabudgetaretoplanforthefutureandto
controltheoperationsofthecompany.Thebudgetispreparedonan
ongoingbasisandadjustedcontinuallywiththeacquisitionofadditional
information.
CapitalBudget:ThebudgetforLongTermAssets.Notonlydoesthis
budgethelpdeterminewhatfuturecapital(longterm)Assetsareneeded
forthebusiness,butalsohowmuchmoneyneedstobesetasideeach
monthorquartertoacquiretheseAssetsinthefuture.
Control:Involvesensuringthattheobjectivesestablishedduringtheplan
ningphaseofthebudgetpreparationareattained.Forexample,onceit
isdeterminedthattheamountofcashneededattheendoftheyearis
$40,000,allduringtheyearthecashaccountneedstobemonitoredby
carefulreviewofthebudgetanddecisionsmadetoensurethedesired
endingbalanceisattained.
MasterBudget:Anetworkofmanyseparatebudgetsthatareinterde
pendent.ThemasterbudgetstartswiththeSalesBudget.Onceitisesti
matedhowmuchinsalesisgoingtooccurduringtheyear,alloftheother
budgetsforInventory,purchases,cash,andExpenses,etal,canbedeter
mined.
Planning:Thedevelopmentoffutureobjectivesandthepreparationof
budgetstomeetthoseobjectives.Withoutabudget,thereisnoplanning,
andcompaniesthatattempttooperatetheirbusinesseswithoutthistype
ofplanningbasetheirsuccessonluck.
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WhatIsanAudit?
TypesofAuditors
ThePartsoftheReport
AuditsandAuditors
Chapter
11
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WhatIsanAudit?
OneoftherulesthattheSecuritiesExchangeCommission(SEC)has
issuedisthatthefinancialstatementsofpubliccompanies(thosecompa
niessellingstocktothepublic)mustbeexaminedbyanindependentpub
licaccountantthroughtheprocessofanaudit.Thisrulemeansthatan
accountant,whoisnotanemployeeofthecompanyandwhoislicensedto
practiceasapublicaccountantbythestatewherethefinancialstatements
arebeingprepared,mustaudit(orexamine)therecordsofthecompany
andmustdeterminewhetherornotthefinancialstatementsareinaccor
dancewiththerulesofGenerallyAcceptedAccountingPrinciples(GAAP).
Inaddition,theauditorhastheresponsibilitytogivereasonableassurance
thatthefinancialstatementsarefreeofanymaterialmisstatement.
TheAmericanAccountingAssociationdefinesauditingasasystematic
processofobjectivelyobtainingandevaluatingevidenceregardingassertions
abouteconomicactionsandeventstoascertainthedegreeofcorrespondence
betweenthoseassertionsandestablishedcriteriaandcommunicatingthe
resultstointerestedusers.(FromAmericanAccountingAssociation
CommitteeonBasicAuditingConcepts,AStatementofBasicAuditing
Concepts;Sarasota,FL,AmericanAccountingAssociation,1973.)
Whenauditorsissuetheirreportstheymustfollowasetofrulesknown
asGenerallyAcceptedAuditingStandards(GAAS).Thesestandardsare
madeupof1)thetenGenerallyAcceptedAuditingStandards,2)the
StatementsonAuditingStandards(SASs),and3)theInterpretationsof
theseStandards.
ThesestandardshavebeenthejurisdictionoftheAmericanInstituteof
CertifiedPublicAccountantsandtheirAuditingStandardsBoard.Withthe
passageoftheSarbanesOxleyActof2002,Congresshasnowtakenthe
responsibilityforcreatingstandardsforpubliccompaniesandcreatedthe
PublicCompanyAccountingOversightBoard(PCAOB)forthispurpose.
Theboardhastheadditionalresponsibilitytomakesurethatauditqualityis
notcompromisedandthatauditorperformancemeetspublicexpectations.
Inadditiontotheauditingstandards,CPAsareexpectedtofollowthe
CodeofEthicsestablishedbytheprofession.Byestablishingandadhering
tosuchacode,thisensurestheauditorsindependencethemajorattrib
utetheauditorhastoselltothepublic.
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Atypicalauditorsreport(knownastheunqualifiedreport)isissued
whenthefinancialstatementsareinaccordancewithGAAP.Thisreportis
writtenandissuedbytheauditorsandissubmittedtothepublicwiththe
financialstatements.
Rememberthatthefinancialstatementsarepreparedby
andaretheresponsibilityofthemanagementofthecom
panyandnottheauditors.Sincethemajorcorporatefail
uresofthe1990sandearly2000s,theSarbanesOxley
Actof2002requirescompanymanagementtosignalet
terstatingthatthefinancialstatementsarepresentedfair
lyinaccordancewithGenerallyAcceptedAccounting
Principles,justastheauditorsmust.
AccountingVersusAuditing
Aswehavediscussedinpreviouschapters,accountingistheprocessof
recording,classifying,andsummarizingeconomiceventsinaprocessthat
leadstothepreparationoffinancialstatements.
Auditing,ontheotherhand,isnotconcernedwiththepreparationofthe
accountingdata,butwiththeevaluationofthisdatatodetermineifitis
properlypresentedinaccordancewiththerulesofaccounting(GAAP)and
whetheritproperlyreflectstheeventsthathaveoccurredduringtheperi
odinquestion.
TypesofAuditors
Anauditorisanindividualwhocheckstheaccuracyandfairnessofthe
accountingrecordsofacompanyanddetermineswhetherthefinancial
statementsareinaccordancewiththeGenerallyAcceptedAccounting
Principles.Threedifferenttypesofauditorsaredescribedbelow.
TheCertifiedPublicAccountant(CPA)
CertifiedPublicAccountants(CPAs)areauditorswhoservetheneedsof
thegeneralpublicbyprovidingauditing,taxplanningandpreparation,and
managementconsultingservices.CPAscanworkasindividualsoras
AuditsandAuditors161
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employeesofafirm;thesefirmsrangeinsizefromoneindividualtointer
nationalpartnershipswithmorethantwothousandpartners.
Thelargestofthesefirmshaveofficesworldwideandarereferredtoas
theBigFour.Eventhoughtheyonlyemployabout12percentofallofthe
CPAsintheUnitedStates,theyactuallyperformtheauditsofabout85per
centofthelargestcorporationsintheworld.Thesefourcompaniesare:
Deloitte&Touche,Ernst&Young,KPMG,andPricewaterhouseCoopers.
Thoseindividualswhoactasindependentauditorsmustbelicensedto
performauditsbythestateinwhichtheypractice.Thelawsvaryfromstate
tostateastotherequirementsthatmustbemetinordertoobtainsuch
licenses.However,tobeissuedalicensetopracticeasaCPA,allstates
requiretheindividualtopassauniformexamination,whichispreparedand
gradedbytheAmericanInstituteofCPAs(AICPA).Inadditiontopassing
thisexamination,moststatesrequireanindividualtohavesomeexperience
workingwithanotherCPApriortobeinglicensed.Moststatesalsorequire
thatafterbeinglicensedtopracticeasapublicaccountant,CPAsmusttake
atleastacertainminimumamountofcontinuingeducationcoursework
eachyearinordertohavetheirlicenserenewed.
InternalAuditors
Internalauditorsareemployedbycompaniestoauditthecompaniesown
recordsandtoestablishasystemofinternalcontrol.Thefunctionsofthese
auditorsvarygreatly,dependingupontheneedsandexpectationsofmanage
ment.Ingeneral,theworkincludescomplianceaudits(tomakesurethe
accountingisincompliancewiththerulesofthecompanyandthelawsunder
whichtheyoperate)andoperationalaudits(areviewofanorganizations
operatingproceduresforefficiencyandeffectiveness).OperationalAudits
reviewthebusinessforefficientuseofresources;theyaremeanttohelpman
agementmakedecisionsthatwillmakethecompanymoreprofitable.
AswithCPAs,manyinternalauditorsarealsocertifiedbypassinga
nationallypreparedexamination.ThisexaminationisfortheCertificateof
InternalAuditingandispreparedbytheInstituteofInternalAuditors.
Internalauditorsgenerallymustreporttothehighestlevelofresponsi
bilitywithinthecompany;thismayincludetheBoardofDirectorsorthe
AuditCommitteeoftheBoardofDirectors.Thisisimportantbecauseit
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givestheinternalauditorsmoreindependencefromthemanagementteam
thattheyarereportingon.
Duringacompanysaudit,internalauditorsworkcloselywithwhatever
externalauditors(CPAs)havebeenhiredbythecompanyinordertoreduce
theamountoftimethattheoutsideauditorneedstospendwiththecom
pany.Giventhesizeoftheinternalauditstaffandtheirindependencewith
inthecompany,theymaybeaskedtoperformseveralofthetasksthatwould
havebeenpreparedbytheexternalauditors.Theexternalauditorsstillhave
theultimateresponsibilitytodetermineifthefinancialstatementsarepre
sentedinaccordancewithGenerallyAcceptedAccountingPrinciples,and
theyaretheoneswhosignthereportthatispresentedtothepublic.Using
internalauditorsissimplymeanttoreducethenumberofdetailedproce
duresthatwouldotherwisehavetobeperformedbytheexternalauditors.
GovernmentalAuditors
Asyouwouldexpect,governmentalauditorsareindividualswhoperform
theauditfunctionwithinoronbehalfofagovernmentalorganization.As
withtheothertwotypesofauditorsdescribedabove,theseindividualsalso
mustbeindependentfromtheindividualsorgroupsthattheyareauditing.
Thedifferentgovernmentalorganizationsthatmostcommonlyhireand
useauditorsincludetheUnitedStatesGeneralAccountingOffice(GAO).
Themajorfunctionofthisgroupistoperformtheauditfunctionfor
Congress.TheInternalRevenueServicehiresauditorstoenforcethefeder
altaxlawsasdefinedbytheCongressandinterpretedbythecourts.Several
othergovernmentalorganizationshireauditorstoensurethattheregula
tionsaffectingthoseentitiesundertheirjurisdictionsaremet.Someof
theseinclude:theBureauofAlcohol,Tobacco,andFirearms(ATF),the
DrugEnforcementAgency(DEA),andtheFederalBureauofInvestigation
(FBI).RatherthanfollowingGenerallyAcceptedAccountingPrinciples,
governmentauditsaredoneinaccordancewithasetofaccountingrules
establishedbytheGovernmentalAccountingStandardsBoard(GASB).
Themostcommondocumentissuedbyauditorsaspartoftheirreportsisthe
standardunqualifiedauditopinion.Itisissuedunderthefollowingsituations:
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1.Allfinancialstatementshavebeenexaminedbytheauditor.
2.Itisdeterminedthatthesefinancialstatementswerepreparedin
accordancewithGAAP.
3.Theauditorhasgatheredsufficientevidencetogiveanopinionon
thesestatements.
4.Theauditorisindependentofthecompanybeingaudited.
5.Theauditorhasfollowedthegenerallyacceptedrulesofauditing
calledGenerallyAcceptedAuditingStandards(GAAS).
TheGenerallyAcceptedAuditingStandardsthatauditorsmustfollow
arespelledoutintherulesoftheauditingprofessioninasetofstandards
thatisalwayschanging.Therulescomefromtwosources,theAICPAand
theSEC.Withthestandardsalwayschanging,thisprovidesanexampleof
howtheSECandtheAICPAcomplementandsupporteachothertohelp
ensurethatthefinancialstatementsissuedtothepublicpresentuseful
informationthatisrelevant,reliable,understandable,andsufficientforuse
inmakingdecisionsaboutfirmsandtheirmanagement.
Whenalloftheseconditionsaremet,areportliketheoneinFigure11.1
belowwillbeissued.Noticethatthereportisissuedonacomparativebasis,
andthereforethemanagementofthecompanymustattachtwoyearsof
financialstatements.
Thereporthasthreebasicsegments:1)theintroductoryparagraph,2)
thescopeparagraph,and3)theopinionparagraph.
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Figure11.1:THEUNQUALIFIEDAUDITOPINION(STANDARD)
SydneyandMaude
CertifiedPublicAccountants
7CircleDrive
CapeCod,MA02117
ReportofIndependentRegisteredPublicAccountingFirm
To:theBoardofDirectorsandShareholders,TheLasBrisasCompany
WehaveauditedtheaccompanyingBalanceSheetsofTheLasBrisas
CompanyasofDecember31,2006,and2005,andtherelatedstate
mentsofincome,shareholdersequity,andcashflowsfortheyearsthen
ended.Thesefinancialstatementsaretheresponsibilityofthe
Companysmanagement.Ourresponsibilityistoexpressanopinionon
thesefinancialstatementsbasedonouraudits.
Weconductedourauditsinaccordancewithauditingstandardsofthe
PublicCompanyAccountingOversightBoard.Thosestandardsrequirethat
weplanandperformtheaudittoobtainreasonableassuranceabout
whetherthefinancialstatementsarefreeofmaterialmisstatement.Anaudit
includesexamining,onatestbasis,evidencesupportingtheamountsand
disclosuresinthefinancialstatements.Anauditalsoincludesassessingthe
accountingprinciplesusedandsignificantestimatesmadebymanagement,
aswellasevaluatingtheoverallfinancialstatementpresentation.We
believethatourauditsprovideareasonablebasisforouropinion.
Inouropinion,thefinancialstatementsreferredtoabovepresentfairly,
inallmaterialrespects,thefinancialpositionoftheLasBrisasCompany
asofDecember31,2006,and2005andtheresultsofitsoperations
anditscashflowsfortheyearsthenendedinconformitywithaccount
ingprinciplesgenerallyacceptedintheUnitedStates.
SydneyandMaude,CPAs
CapeCod,Massachusetts
March17,2007
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SeeAppendixBfortheauditoptionintheStationCasinosAnnualReport.
ThePartsoftheReport
Therearesevenpartstoeverystandardauditreport.Theyinclude:
Figure11.2:STANDARDAUDITREPORT
1.ThereporttitleIndependentAuditorsReport
2.TheauditreportaddressTotheStockholders
3.IntroductoryparagraphWehaveaudited
4.ScopeparagraphWeconductedouraudits
5.OpinionparagraphInouropinion
6.SignatureofCAFirmSydneyandMaude,CPAs
7.AuditreportdateMarch17,2007.Thisdaterepresentswhenthe
workontheauditwascompleted,notthedatethereportwasissued.
Dependingonthesizeofthecompanybeingaudited,thereviewof
theevidencemaytaketwotothreemonths.
Thewordingonthisreportmayvaryslightlyfromauditortoauditor;
however,theoverallstructureandmeaningremainthesame.
Belowisabriefoverviewofthreeothertypesofauditreportsthatyou
mightencounterwhenreviewingfinancialstatementsandwithwhichyou
shouldbefamiliar.
Aqualifiedauditreportisissuedbytheauditorwhentheyconcludethat
thefinancialstatementsarepresentedinaccordancewithGAAP,exceptfor
somespecifieditemsbeingdifferent.
Anadverseauditreportisissuedbyauditorswhentheyconcludethat
thefinancialstatementsarenotpresentedfairlyinaccordancewiththe
rulesofaccounting(GAAP).
Adisclaimerauditreportisissuedbyauditorswhentheydonothave
enoughinformationtodeterminewhetherthefinancialstatementsarein
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accordancewiththeaccountingrules.Auditorswouldalsoissuethistypeof
reportiftheywerenotindependentofthecompanybeingaudited.
Asthebusinessworldbecomesmoreglobalandcomplex,sodothe
financialreportsthatcompaniesissue.Theinformationprovidedandthe
rulesthatgoverntheirpresentationhaveexplodedinnumberandcom
plexityduringthepasttwentyyears.Todayitisbecomingmoreandmore
difficultforthelayperson(nonaccountants)tofullyunderstandthese
presentations.Theauditorsreportofacompanysfinancialstatements
givesthereaderanduserofthesefinancialstatementsanassurancethat
thisinformationisinaccordancewithanestablishedsetofrules(GAAP)
andreviewedbytheauditorwhoisindependentofmanagement.
Theuseofanindependentauditcangenerallyassuretheuserthatthe
informationcontainedinacompanysfinancialstatementsisfreeofmate
rialerrorsandfraud.Thisassurancesupportstheuserinmakinginvestment
andanalyticaldecisionsaboutthecompanybeingreviewed.
Alert!
AuditsHaveTheirLimits:Theseauditsdonotguaranteethedollaraccuracyor
predictiveabilityofthesefinancialstatements.Itonlyguaranteesthattheyare
presentedinaccordancewithasetofaccountingrules(GAAP).Manypeople
believethattheauditorwilleitherstopordetectallfraudwithinanorganiza
tion,butthisisnotnecessarilythecase.Eventhoughauditorsdofollowproce
duresthathelpdetectfraud,theycannotdetectordiscloseallsuchinstances.
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GLOSSARY
BigFourAccountingFirms:ThefourlargestCAFirmsintheworld
withofficesworldwide.PricewaterhouseCoopers,KPMG,Deloitt&
Touche,andErnst&Youngperformtheauditsofthemajorityofthe
worldslargecompanies.
AdverseAuditReport:AtypeofreportissuedbyaCAFirmatthe
completionofanaudit.ThisreportisissuedwhentheCPAconcludesthat
thefinancialstatementsbeingauditedarenotinaccordancewith
GenerallyAcceptedAccountingPrinciples.
Audit:Theaccumulationandevaluationofevidenceaboutacompanys
financialstatementstodetermineiftheyareinaccordancewithGAAP.
Auditor:Theindividualwhocheckstheaccuracyandfairnessofthe
accountingrecordsofacompanyandissuesareportastowhetherthe
companysfinancialrecordsareinaccordancewithGenerallyAccepted
AccountingPrinciples.
CertifiedPublicAccountant(CPA):Auditorswhoservetheneedsof
thegeneralpublic.Theseindividualshavepassedanexamination,in
mostcaseshave150hoursofcollegecredits,haveworkedwithanother
CPAforaminimumoftwoyears,andcompletearequiredtwentytoforty
hoursofcontinuingeducationeachyear.Theirworkincludesauditing,tax
planningandpreparation,andmanagementconsulting.
ComplianceAudits:Anauditthatmakessuretheaccountingisincom
pliancewiththerulesbeingreviewed.Mostoftenthesetypesofauditsare
governmentalaudits,inthattheydeterminewhetherthefinancialstate
mentsareincompliancewithgovernmentregulations.Theycan,howev
er,alsobeusedtocheckcomplianceinotherinstances,suchaswhena
bankrequirescertainstipulationsbemetinorderforacompanyto
receiveortocontinuewithaloan.
DisclaimerAuditReport:AtypeofreportissuedbyaCAFirmatthe
heorshedoesnothaveenoughinformationtodeterminewhetherthe
financialstatementsareorarenotinaccordancewiththeaccountingrules.
GovernmentalAuditors:Theindividualswhoperformtheauditfunc
tionforagovernmentalorganizationsuchastheU.S.General
AccountingOffice(GAO),theInternalRevenueService(IRS),the
SecuritiesandExchangeCommission(SEC),BureauofAlcohol,Tobacco,
andFirearms(ATF),DrugEnforcementAgency(DEA),andtheFederal
BureauofInvestigation(FBI),aswellasstateandlocalgovernments.
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RatherthanfollowingGenerallyAcceptedAccountingPrinciples,gov
ernmentauditsaredoneinaccordancewithasetofaccountingrules
establishedbytheGovernmentalAccountingStandardsBoard(GASB).
Internalauditors:Theseauditorsareemployedbycompaniestoaudit
thecompanysownrecords.Theseindividualsarenotnecessarilycertified
publicaccountants(CPAs),butmanyarecertifiedinternalauditors(CIA).
Toensureautonomy,theseindividualsreportdirectlytotheauditcommit
teeorboardofdirectorsofthecompanyratherthantocompanyman
agement.
OperationalAudit:Areviewofanorganizationsoperatingproce
duresforthepurposeofmakingrecommendationsabouttheefficiency
andeffectivenessofbusinessobjectivesandcompliancewithcompany
policy.Thegoalofthistypeofanauditistohelpmanagersdischarge
theirresponsibilitiesandmaximizeprofitability.
QualifiedAuditReport:AtypeofreportissuedbyaCAFirmatthe
thefinancialstatementsbeingauditedarepresentedinaccordancewith
GAAP,exceptforsomespecifieditemsbeingdifferent;forexample,the
useofanonstandardtypeofInventoryevaluationisused.
PublicCompanyAccountingOversightBoard(PCAOB):
EstablishedbyCongressaspartoftheSarbanesOxleyLawof2002,the
PCAOBischargedwiththeresponsibilityofcreatingaccountingstan
dardsforpubliccompanies.TheBoardhastheadditionalresponsibilityto
makesurethatauditqualityisnotcompromisedandthatauditorper
formancemeetspublicexpectations.
UnqualifiedAuditReport:AtypeofreportissuedbyaCAFirmat
thecompletionofanaudit.ThisreportisissuedwhentheCPAconcludes
thatthefinancialstatementsbeingauditedarecompletelyinaccordance
withGenerallyAcceptedAccountingPrinciples.
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WhatResourcesAreAvailablefor
Accountants?
Theamountofinformationavailabletoaccountantsand
otherprofessionalsinbusinesscontinuestogroweach
day.Inthepast,accessingthisinformationwasextreme
lyburdensomeandtimeconsuming,buttheadventof
computersandtheInternethaveplacedanabundanceof
informationatyourfingertips.
TheInternethasalsochangedthewayinwhich
accountantsandauditorsdotheirwork.Financialreport
ing,financialinformationsystems,practicesinauditing,
managementandcontrol,taxaccounting,andforensic
accountinghaveallbeenchangedforthebetterbythe
Internetfor
Accountants
Appendix A
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Internet.WithoutunderstandingthepoweroftheInternet,anaccountant
isatalosstoaccessthewealthofinformationthatisavailable.
Thelistingbelowisonlypartialanddoesnotcoveralltopicsofinterest
toaccountants.However,partofthefunofbeingontheInternetissurfing
theWebtofindthelinksthataremostinterestingtoyouandtoyourpar
ticularinterests.Herearesomesitestogetyoustarted:
TheIRSHomepage
http://www.irs.ustreas.gov
TheNationalAssociationofEnrolledAgents
http://www.naea.org
TheAmericanInstituteofCertifiedPublicAccountants
http://www.aicpa.org/index.htm
TheAmericanAccountingAssociation
http://www.aaahq.org
TheFinancialAccountingStandardsBoard
http://www.fasb.org
TheAssociationofGovernmentAccountants
http://www.agacgfm.org
TheGovernmentalAccountingStandardsBoard
http://www.gasb.org
TheInstituteofInternalAuditors
http://www.theiia.org
TheInstituteofManagementAccountants
http://www.imanet.org
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TheAssociationofCertifiedFraudExaminers
http://www.acfe.com
TheInternationalAccountingStandardsBoard
http://www.iasb.org
StateAccountingSocietiesandBoards
http://www.aicpa.org/states/index.htm
AListingofCAFirms
http://www.cpafirms.com
TheSarbanesOxleyActExplained
http://sarbanesoxley.com
FreeAnnualReports
http://ftcom.ar.wilink.com
AccesstoFreeAuditPrograms
http://www.auditnet.org
Top10AccountingSoftwarePrograms
http://www.2020software.com
GlossaryofAccountingTerms
http://www.accountz.com/glossary.html
Top50OverlookedTaxDeductions
http://www.jacksonhewitt.com/resources_library_top50.asp
CorporateSECFilings
http://edgaronline.com
AppendixA:InternetforAccountants173
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FinancialCalculators
http://www.bcscpa.com/calcs/index.htm
http://www.fool.com/calcs/calculators.htm?source=LN
StockQuotes
http://quotes.nasdaq.com/asp/MasterDataEntry.asp?page=flashQuotes
Newspapers
NewYorkTimes(http://www.nytimes.com)
WallStreetJournal(http://wsj.com)
Onceagain,thisisjustastarterlist.Havefunsurfingthenet!
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Thefinancialstatementscontainedherearefromthe
actual2004annualreportofStationCasinos,Inc.,aLas
Vegasbasedcompanywhichoperatesseveralcasinos
andhotelsintheLasVegas,Nevada,area.Theywillgive
youanexcellentideaofwhatthesestatementslooklike
formajorcorporations.
Financial
Statements
StationCasinos,Inc.
Appendix
B
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AppendixB:FinancialStatementsStationCasinos,Inc.177
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Index
A
accountingequation,25,29,42,54,5658,60,77,79,81,82,88
accountspayable,26,28,35,39,40,42,46,48,68,71,86,91,97,156
accountsreceivable,27,34,41,43,48,49,52,57,59,61,67,68,70,71,86,
89,9092,97,98,127,133,134,155
AccrualBasisofAccounting,61
AmericanAccountingAssociation,160,172
AmericanInstituteofCertifiedPublicAccountants(AICPA),7,11,14,21,
164
assets,19,2643,105,128,145
contraasset,59,61,90,92,98
current,32,128131
intangible,32,33,42
longterm,16,32,36,39,43,88,92,150
shortterm,32,39,43,128
audit,160169
adverse,166,167,168
compliance,168
independent,167
operational,169
qualified,166,169
unqualified,163166,169
auditor,5,15,160169
governmental,163,168
internal,162,163,169
balancesheet,8,11,15,17,1943,46,49,54,56,57,59,60,61,62,6669,
80,87,88,90,92,106,110,111,113117,120,122,123,128,132,134,
154,155
bookkeeping,5,77,86
budget,150158
advantages,150,151
capital,154,158
cash,155157
master,151,152,158
sales,152,153
C
capitalstock,104,122
common,104106,109112,114,122
dividends,107,108,111,113,117,119,123
cash,107,108,111,117,122
stock,107,108,111115
preferred,104106,110,111,122,123
selling,109,110
split,108,109,115,123
CashBasisofAccounting,61
CertifiedPublicAccountants,7,11,14,21,160162,165,166,168,169,
172,173,221
corporation,4,9,10,11,16,18,22,27,98,101123,139,142,143,147,
148,162,175
costofgoodssold,47,50,5356,58,61,62,80,86,91,9397,127,131,
132,134,142,152154
credit,52,61,70,7687,91,93100,119,126,127,130,131,133,134,
138,168
currentratio,126128,134,135
D
debit,7687,91,93100,119
dividendpayoutratio,139,146,147
E
earningpershare(EPS),143,147
expense,8,17,2023,43,4663,67,69,70,77,78,8083,86,8894,
9699,113,139,141,142,144,145,148,150,152158
accumulateddepreciation,92
baddebt,47,50,52,61,90,91,93
depreciation,92,99
insurance,92
interest,92,93
F
FinancialAccountingStandardsBoard(FASB),7,11,14,22
financialstatement,1,35,712,1424,29,42,4663,66,67,73,87,90,
93,99,100,106,111,121,126148,160,161,163,164169,175,177,
179,181,183,185,187,189,191,193,195,197,199,201,203,205,
209,211,213,215,217
conservatism,20,21
EntityConcept,18,22
footnotes,15,17,22,137,147
GoingConcernPrinciple,18,19,22
HistoricalCostPrinciple,22
MaterialityPrinciple,20,22
obtainable,15,18,22
quantifiable,17
RealizableValuePrinciple,23
RecognitionPrinciple,23
relevant,15,23
reliable,15,16,23
shorttermratios,126,127
Index223
StableMonetaryUnitConcept,23
sufficient,15
understandable,15,17,23
verifiable,16,24
G
generaljournal,7582,84,93,98100,112,119
adjusting,8790,98
closing,9399
generalledger,75,82,8587,90,99,100
GenerallyAcceptedAccountingPrinciples(GAAP),7,11,14,15,48,66,
160,161,163,166,167
GenerallyAcceptedAuditingStandards(GAAS),160,164
GovernmentalAccountingStandardsBoard(GASB),163
grossprofit,47,5356,58,61,62,152154
H
historicalcost,29,42
I
incomestatement,8,11,17,20,21,4663,66,67,69,70,79,80,93,97,
111,120,134,148150,154,155
AccrualConcept,48
interest,52
incometaxes,47,48,52,62,144,145
InternalRevenueService(IRS),7,12,66,163
inventoryturnoverratio,127,131,132,134
L
liabilities,2643,128,145
current,128130
longterm,33
shortterm,33,39,128
N
netincome,8,20,46,47,49,5062,6771,90,94,98,99,107,138141,
143148,154,155
O
ownersequity,26,2830,33,3543,46,54,56,57,58,60,7784,88,98,
99,106,139,140
ownersinvestment,26,28,33,3537,39,40,46,69,78,79,8486,91,97,
106,140
P
P/Eratio,143,146,148
partnership,9,10,12,103,139,148,162
proprietorship,9,10,12,27,98,102,103,121,139,148
PublicCompanyAccountingOversightBoard(PCAOB),160,169
Q
qualityofearnings,137,138
quickratio,126129,135
R
retainedearnings,8,11,26,28,3335,41,43,54,5659,66,72,80,86,87,
91,93,94,9698,106,107,111123,139
returnoninvestment(ROI),137,139,142,148
revenue,5,7,8,12,23,27,4663,67,69,70,78,80,82,83,86,91,94,96,
98,99,131,150,152,154,163,168
Index225
S
SarbanesOxleyActof2002,160
SecuritiesandExchangeCommission(SEC),7,14,23,164
statementofcashflows,8,11,60,62,6673
financingactivities,72,73
investingactivities,7173
operatingactivities,6971,73
statementofretainedearnings,8
StatementsonAuditingStandards(SASs),160
stockholdersequity,111120,139,148
T
treasurystock,101,115121,123
trialbalance,8587,9092,9698,100
W
workingcapital,102,125127,129131,135
AbouttheAuthor
Dr.WayneA.Label,CPA,MBA,PhD,wasbornand
raisedinSanFrancisco.Hecompletedhisundergrad
uateworkinaccountingattheUniversityof
California,Berkeleyandthenwentontothe
UniversityofCalifornia,LosAngeleswherehe
receivedhisMBAandaPhDinaccounting.Heisa
CertifiedPublicAccountantinthestateofTexas.
HehastaughtatseveraluniversitiesintheUnitedStatesandabroad.
HewastheDirectoroftheSchoolofAccountancyattheUniversityof
HawaiiandchairmanoftheaccountingdepartmentattheUniversityof
Nevada,LasVegas.Dr.LabelalsotaughtfortheHarvardInstituteof
InternationalDevelopmentwherehehelpedtostarttheMastersDegree
PrograminAuditinginLaPaz,Bolivia.HereceivedaFordFoundation
granttoaidthebeginningofanMBAprogramattheCatholicUniversityin
RiodeJaneiro,Brazil.HehasalsotaughtaccountingcoursesinPeru,Chile,
Mexico,andGermany.
Dr.Labelhaspublishedthreebooksonaccounting,andoverthirtyarti
clesinprofessionaljournals.Heiscurrentlyteachingonlinecoursesforthe
UniversityofMarylandUniversityCollegeandUCLA.Dr.Labelhasalso
givenseminarsinaccountingandinternationalbusinessinnumerousloca
tionsthroughouttheUnitedStates,aswellasinLatinAmerica,Europe,and
Asia.
Dr.LabeldivideshistimebetweenPuertoVallarta,Mexico,andSan
Diego,California.
YoucanlearnmoreaboutDr.Labelathiswebsite:www.waynelabel.com.
Hecanbecontactedatwayne@waynelabel.com.
LABEL
FOR
Understandingbookkeeping
basics
Balancesheets
Statementsofcashflow
Assetsandliabilities
Incomestatements
Managingbudgets
Auditsandauditors
Doubleentryaccounting
Accountingratios
Andeverythingelse
youneedtoknow
AccountingforNonAccountantsisthemusthaveaccountingguide
forallofuswhohavenevertakenanaccountingclass,aremystifiedby
accountingjargonandhavenoclueaboutbalancesheets,incomestatements
orstatementsofcashflow.
Dr.WayneLabelcoversitallinastylethatseasytocomprehendandapply,
soyoucanunderstandtheaccountingsystemsthatwillhelpyourgrowing
businesssucceed.
Aquick,compactand
easytounderstand
resourcefornonaccountants.
Dr.WayneLabel,CPA,MBA,
Ph.D.,isaCertifiedPublic
Accountantinthestateof
Texas.Hehastaughtatseveral
universitiesintheUnited
Statesandabroad.Dr.Label
haspublishedthreebookson
accountingandover30articles
inprofessionaljournals.
YOU
BUSINE
QuickS
Fast,effectiveandeasytounderstand.
Forentrepreneursoranyonewhoneedsto
brushuponaccountingfast,thisbookwillhave
youupandrunninginnotime.

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