Accounting For Dummies, 4th edition

checking account.) The total of accounts with debit balances should equal the total of accounts with credit balances. When the total of debit balance accounts equals the total of credit balance accounts, the books are in balance.

Balanced books don’t necessarily mean that all accounts have correct balances. Errors are still possible. The bookkeeper may have recorded debits or credits in wrong accounts, or may have entered wrong amounts, or may have missed recording some transactions altogether. Having balanced books simply means that the total of accounts with debit balances equals the total of accounts with credit balances. The important thing is whether the books (the accounts) have correct balances, which depends on whether all transactions and other developments have been recorded correctly.

Juggling the Books to Conceal

Embezzlement and Fraud

Fraud and illegal practices occur in large corporations and in one-owner/ manager-controlled small businesses — and in every size business in between. Some types of fraud are more common in small businesses, including sales skimming (not recording all sales revenue, to deflate the taxable income of the business and its owner) and the recording of personal expenses through the business (to make these expenses deductible for income tax). Some kinds of fraud are committed mainly by large businesses, including paying bribes to public officials and entering into illegal conspiracies to fix prices or divide the market. The purchasing managers in any size business can be tempted to accept kickbacks and under-the-table payoffs from vendors and suppliers.

Some years ago we hosted a Russian professor who was a dedicated Communist. I asked him what surprised him the most on his first visit to the United States. Without hesitation he answered “The Wall Street Journal.” I was puzzled. He then explained that he was amazed to read so many stories about business fraud and illegal practices in the most respected financial newspaper in the world. At the time of revising this chapter, the backdating of management stock options is very much in the news. Many financial reporting fraud stories are on the front pages. And there are a number of stories of companies that agreed to pay large fines for illegal practices (usually without admitting guilt).

A gray area in financial reporting

I’m fairly sure that none of this is news to you. You know that fraud and illegal practices happen in the business world. My point in bringing up this unpleasant topic is that fraud and illegal practices require manipulation of a business’s accounts. For example, if a business pays a bribe it does not record the amount in a bald-faced account called “bribery expense.” Rather the business disguises the payment by recording it in a legitimate expense account (such as repairs and maintenance expense, or legal expense). If a business records sales revenue before sales have taken place (a not uncommon type of fraud), it does not record the false revenue in a separate account called “fictional sales revenue.” The bogus sales are recorded in the regular sales revenue account.

Here’s another example of an illegal practice. Money laundering involves taking money from illegal sources (such as drug dealing) and passing it through a business to make it look legitimate — to give the money a false identity. This money can hardly be recorded as “revenue from drug sales” in the accounts of the business. If an employee embezzles money from the business, he has to cover his tracks by making false entries in the accounts or by not making entries that should be recorded.

Manipulating accounts to conceal fraud, illegal activities, and embezzlement is generally called juggling the accounts. Another term you probably have heard is cooking the books. Although this term is sometimes used in the same sense of juggling the accounts, the term cooking the books more often refers to deliberate accounting fraud, in which the main purpose is to produce financial statements that tell a better story than are supported by the facts.

When the accounts have been juggled or the books have been cooked, the financial statements of the business are distorted, incorrect, and misleading. Lenders, other creditors, and the owners who have capital invested in the business rely on the company’s financial statements. Also, a business’s managers and board of directors (the group of people who oversee a business corporation) may be misled — assuming that they’re not a party to the fraud, of course — and may also have liability to third-party creditors and investors for their failure to catch the fraud. Creditors and investors who end up suffering losses have legal grounds to sue the managers and directors (and perhaps the independent auditors who did not catch the fraud) for damages suffered.

I think that most persons who engage in fraud cheat on their federal income taxes; they don’t declare the ill-gotten income. Needless to say, the IRS is on constant alert for fraud in federal income tax returns, both business and personal returns. The IRS has the authority to come in and audit the books of the business and also the personal income tax returns of its managers and investors. Conviction for income tax evasion is a felony, I might point out.

Using Accounting Software

It would be possible, though not very likely, that a very small business would keep its books the old-fashioned way — record all transactions and do all the other steps of the bookkeeping cycle with pen and paper and by making handwritten entries. However, even a small business has a relatively large number of transactions that have to be recorded in journals and accounts, to say nothing about the end-of-period steps in the bookkeeping cycle (refer to Figure 3-1).

When mainframe computers were introduced in the 1950s and 1960s, one of their very first uses was for accounting chores. However, only large businesses could afford these electronic behemoths. Smaller businesses didn’t use computers for their accounting until some years after personal computers came along in the 1980s. But, as the saying goes, “We’ve come a long way, baby.” A bewildering array of accounting computer software packages is available today.

Make sure your accounting software leaves very good audit trails, which you need for management control, for your CPA when auditing your financial statements, and for the IRS when it decides to audit your income tax returns. The lack of good audit trails looks very suspicious to the IRS.

Online accounting systems that permit remote input and access over the Internet or a local area network with multiple users present special security problems. Think twice before putting your accounting system online.

Smaller businesses, and even many medium-size businesses, don’t have the budget to hire full-time information system and information technology specialists. They use consultants to help them select accounting software packages, install software, and get it up and running. Like other computer software, accounting programs are frequently revised and updated. A consultant can help keep a business’s accounting software up-to-date, correct flaws and security weaknesses in the program, and take advantage of its latest features.

Presenting a Typical Income Statement

At the risk of oversimplification, I would say that businesses make profit three basic ways:

Selling products (with allied services) and controlling the cost of the products sold and other operating costs

Selling services and controlling the cost of providing the services and other operating costs

Investing in assets that generate investment income and market value gains and controlling operating costs

Obviously, this list isn’t exhaustive, but it captures a large slice of business activity. In this chapter, I concentrate on the first category of activity: selling products. Products range from automobiles to computers to food to clothes to jewelry. The customers of a business may be the final consumers in the economic chain, or a business may sell to other businesses.

Figure 4-1 presents a typical profit report for a product-oriented business; this report, called the income statement, would be sent to its outside owners and lenders. The report could just as easily be called the net income statement because the bottom-line profit term preferred by accountants is net income, but the word net is dropped off the title. Alternative titles for the external profit report include earnings statement, operating statement, statement of operating results, and statement of earnings. (Note that profit reports distributed to managers inside a business are usually called P&L [profit and loss] statements, but this moniker is not used in external financial reporting.)