Accounting For Dummies, 4th edition
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350 Accounting For Dummies, 4th Edition
generally accepted accounting principles (GAAP): The authoritative standards and approved accounting methods that should be used by businesses domiciled in the United States and private nonprofit organizations to measure and report their revenue and expenses; to present their assets, liabilities, and owners’ equity; and to report their cash flows in their financial statements. GAAP are not a straitjacket; these official standards are loose enough to permit alternative interpretations by accountants.
goodwill: In the broad business sense, this term generally refers to brand name recognition or to the well-known and respected reputation of a company. Goodwill in this usage means the business has an important asset that is not reported in its balance sheet. In the accounting context, however, goodwill has a more restricted meaning. To be recorded and appear in the balance sheet of a business, goodwill must actually be purchased, such as by buying an established brand name or buying a company with an excellent reputation. Only purchased goodwill is reported as an asset in the balance sheet. The cost of (purchased) goodwill may or may not be amortized (charged off to expense over the years).
gross margin (profit): Equals sales revenue less cost of goods sold for the period. Making adequate gross margin is the starting point for making a bottom-line profit.
income smoothing: Manipulating the timing of when sales revenue and/or expenses are recorded in order to produce a smoother profit trend with narrower fluctuations from year to year. Also called massaging the numbers, the implementation of profit-smoothing procedures needs the implicit or explicit approval of top-level managers, because these techniques require the override of normal accounting procedures for recording sales revenue and expenses. CPA auditors generally tolerate a reasonable amount of profit smoothing — which is also called earnings management.
income statement: This financial statement summarizes sales revenue (and income) and expenses (and losses) for a period and reports one or more profit lines. Also, any extraordinary gains and losses are reported in this financial statement. The income statement is one of the three primary financial statements of a business included in its financial report and is also called the earnings statement, the operating statement, or other similar titles.
internal (accounting) controls: Forms, procedures, and precautions that are established primarily to prevent and minimize errors and fraud (beyond the forms and procedures that are needed for record keeping). Common internal control are: requiring the signature of two managers to approve transactions over a certain amount; restricting entry and exit routes of employees; using surveillance cameras; forcing employees to take their vacations; separating duties; and conducting surprise inventory counts and inspections.
International Accounting Standards Board (IASB): The authoritative financial reporting standards–setting body for businesses outside the United
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States (mainly European Union companies at the present time). The IASB issues broad, general-language standards (a “principles-based approach”), in contrast to the technically detailed pronouncements of the Financial Accounting Standards Board (FASB). The two are working together toward the harmonization of accounting and financial reporting practices in the United States and the member nations of the EU.
investing activities: One of three classes of cash flows reported in the statement of cash flows. Mainly, these outlays are the major investments in long-term operating assets. A business may dispose of some of its fixed assets during the year, and proceeds from these disposals are reported in this section of the statement of cash flows.
last-in, first-out (LIFO): A widely used accounting method by which costs of products when they are sold are charged to cost of goods sold expense in reverse chronological order. One result is that the ending inventory cost value consists of the costs of the earliest goods purchased or manufactured. The actual physical flow of products seldom follows a LIFO sequence. The method is justified on the grounds that the cost of goods sold expense should reflect the cost of replacing the products sold, and the best approximations are the most recent acquisition costs.
lower of cost or market (LCM): A special accounting test applied to inventory that can result in a write-down and charge to expense for the loss in value of products held for sale. The recorded costs of products in inventory are compared with their current replacement costs (market price) and with net realizable value if normal sales prices have been reduced. If either value is lower, then recorded cost is written down to this lower value.
management (managerial) accounting: The branch of accounting that prepares internal financial statements and other accounting reports and analyses to help managers carry out their planning, decision-making, and control functions. Most of the detailed information in these reports is confidential and is not circulated outside the business. Internal profit reports focus on margin and sales volume, and they should separate variable expenses from fixed expenses. Management accounting includes budgeting, developing and using standard costs, and working closely with managers regarding how costs are allocated.
manufacturing overhead costs: Refers to those costs that are indirect and cannot be naturally matched or linked with manufacturing particular products, or even to a department or step in the production process. One example is the annual property tax on the buildings in which all the company’s manufacturing activities are carried out. Many overhead costs are fixed and cannot be decreased over the short run — such as payment for the general liability insurance carried by a business. Production overhead costs are allocated among the different products manufactured during the period in order to account for the full cost of each product. In this way, the manufacturing overhead costs are absorbed into product cost.
352 Accounting For Dummies, 4th Edition
margin: Equals sales revenue minus cost of goods sold expense and minus all variable expenses. (In other words, margin is profit before fixed expenses are deducted.) On a per-unit basis, margin equals sales price less product cost per unit and less variable expenses per unit. Margin is an exceedingly important measure for analyzing profit behavior and in making sales price decisions.
market cap: The total value of a business calculated by multiplying the current market price of its capital stock times the total number of capital stock shares issued by the business. This calculated amount is not money that has been invested in the business, which is subject to the whims of the stock market.
massaging the numbers: See income smoothing. It’s also called earnings management or juggling the books, and it sometimes includes the practice of window dressing.
net income: Equals sales revenue less all expenses for the period; also any extraordinary gains and losses for the period are counted in the calculation to get bottom-line net income. Bottom line means everything has been deducted from sales revenue (and other income the business may have) so that the last profit line in the income statement is the final amount of profit for the period. Instead of net income, you may see terms such as net earnings, earnings from operations, or just earnings. You do not see the term profit very often.
operating activities: Generally this term refers to the profit-making activities of a business — that is, the mainstream sales and expense transactions of a business.
operating liabilities: Refers to the liabilities from making purchases on credit for items and services needed in the normal, ongoing operating activities of a business. The term also includes the liabilities for the accumulation, or accrual, of unpaid expenses in order to record a full cost of the expenses for the period (such as accumulated vacation pay earned by employees that will not be taken until later).
owners’ equity: The ownership capital base of a business. Owners’ equity derives from two sources: investment of capital in the business by the owners (for which capital stock shares are issued by a corporation) and profit that has been earned by the business but has not been distributed to its owners (called retained earnings for a corporation).
pass-through tax entity: A type of legal organization that does not itself pay income tax but instead serves as a conduit of its annual taxable income. The business passes through its annual taxable income to its owners, who include their respective shares of the amount in their individual income tax returns.
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Partnerships are pass-through tax entities by their very nature. Limited liability companies (LLCs) and corporations with 100 or fewer stockholders (called S corporations) can elect to be treated as pass-through tax entities.
preferred stock: A second type, or class, of capital stock that is issued by a business corporation in addition to its common stock. Preferred stock derives its name from the fact that it has certain preferences over the common stock: It is paid cash dividends before dividends can be paid to common stockholders; and, in the event of liquidating the business, preferred stock shares must be redeemed before any money is returned to the common stockholders. Owners of preferred stock usually do not have voting rights, and the stock may be callable by the corporation, which means that the business has to right to redeem the shares for a certain price per share.
prepaid expenses: Expenses that have been paid in advance, or up front, for future benefits. The amount of cash outlay is entered in the prepaid expenses asset account. For example, a business writes a $60,000 check today for fire insurance coverage over the following six months. The total cost is first entered in the asset account; then, each month, $10,000 is taken out of the asset and charged to expense. Prepaid expenses are usually much smaller than a business’s inventory, accounts receivable, and cash assets.
price/earnings (P/E) ratio: The current market price of a capital stock divided by its trailing 12 months’ diluted earnings per share (EPS) — or its basic earnings per share if the business does not report diluted EPS.
product cost: Equals the purchase cost of goods that are bought and then resold by retailers and wholesalers (distributors). In contrast, a manufacturer combines different types of production costs to determine product cost: direct (raw) materials, direct labor, and overhead costs.
profit: A very general term that is used with different meanings. It may mean gains minus losses, or other kinds of increases minus decreases. In business, the term means sales revenue (and other sources of income) minus expenses (and losses) for a period of time, such as one year. In an income statement, the final or bottom-line profit is most often called net income. For public companies, net income is put on a per-share basis, called earnings per share.
profit and loss (P&L) report: A popular title for internal profit performance reports to managers (that are not circulated outside the company). The term has a certain ring to it that sounds good, but if you consider it closely, how can a business have profit and loss at the same time?
property, plant, and equipment: The term generally used in balance sheets instead of fixed assets.
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proxy statement: The annual solicitation from a corporation’s top executives and board of directors to its stockholders that requests that they vote a certain way on matters that have to be put to a vote at the annual meeting of stockholders. In larger public corporations, most stockholders cannot attend the meeting in person, so they delegate a proxy (stand-in person) to vote their shares yes or no on each proposal on the agenda.
Public Company Accounting Oversight Board (PCAOB): The regulatory agency of the U.S. federal government created by the Sarbanes-Oxley Act of 2002, which was enacted in response to fallout from a number of high-profile accounting fraud scandals that the CPA auditors of the businesses failed to discover. This board has broad powers over auditors of public businesses and the public businesses themselves.
quality of earnings: A pejorative term that raises questions about the reliability of the net income reported by a business. The issue is whether the profit accounting methods of a business are correct in the circumstances, and it raises the possibility that reported profit may be overstated.
quick ratio: Calculated by dividing the total of cash, accounts receivable, and marketable securities (if any) by total current liabilities. This ratio measures the capability of a business to pay off its current short-term liabilities with its cash and near-cash assets. Note that inventory and prepaid expenses, the other two current assets, are excluded from assets in this ratio (which is also called the acid-test ratio.)
retained earnings: One of two basic sources of the owners’ equity of a business (the other being capital invested by the owners). Annual profit (net income) increases this account, and distributions from profit to owners decrease the account. The balance in the retained earnings account does not refer to cash or any particular asset.
return on assets (ROA): Equals the ratio of some measure of profit divided by some measure of assets, and is expressed as a percent. Caution: There is no one measure of profit or total assets for calculating this ratio. Different ROA ratios have different uses. The main purpose of calculating ROA is to test whether a business is using its assets so that it can pay its cost of capital, which includes interest on its debt and a satisfactory rate of return on equity (ROE) for its owners.
return on equity (ROE): Equals net income (minus preferred stock dividends if any) divided by the book value of owners’ equity (minus the amount of preferred stock) and is expressed as a percent. ROE is the basic measure of how well a business is doing in generating earnings, or return on the owners’ capital investment in the business.
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return on investment (ROI): A very broad and general term that refers to the income, profit, gain, or earnings on a capital investment, expressed as a percentage of the amount invested. Two relevant ROI ratios for a business are return on assets (ROA) and return on equity (ROE).
Securities and Exchange Commission (SEC): The federal agency (established by the federal Securities Exchange Act of 1934) that has jurisdiction and broad powers over the public issuance and trading of securities (stocks and bonds) by business corporations. Although it has the power to legislate accounting standards, the SEC has largely deferred to the Financial Accounting Standards Board (FASB). The SEC has authority over the Public Company Accounting Oversight Board (PCAOB).
solvency: Refers to the ability of a business (or other entity) to pay its liabilities on time. The current ratio and quick ratio are used to assess the shortterm solvency of a business.
statement of cash flows: One of the three primary financial statements of a business, which summarizes its cash inflows and outflows during a period according to a threefold classification: cash flow from operating activities, investing activities, and financing activities.
statement of changes in owners’ (stockholders’) equity: More in the nature of a supplementary schedule than a full-fledged financial statement in its own right. Its purpose is to summarize the changes in the owners’ equity accounts during the year, including distributing cash dividends, issuing additional stock shares, buying some of its own capital stock shares, reporting special types of technical gains and losses that are not reported in the income statement, and who knows what else.
variable costs: Costs that are sensitive to changes in sales volume or sales revenue. In contrast, fixed costs do not change over the short run in response to changes in sales activity.
window dressing: An accounting trick or ruse that makes the liquidity and short-term solvency of a business look better than it really was on the balance sheet date. The books are held open a few business days after the close of the accounting year in order to record additional cash receipts (as if the cash collections had occurred on the last day of the year). This term does not refer to manipulating profit (see income smoothing). A reasonable amount of window dressing is not viewed as accounting fraud.
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Index
• Symbols and
Numerics •
( ) (parentheses) around numbers, 3
$ (dollar signs), in income statements, 3 - (minus signs), negative numbers, 3, 80 10-K form, 262, 275, 335
• A •
abandoning product lines, 93 ABC (activity-based costing),
235, 343
accelerated depreciation definition, 145
financial statement differences, 145 fixed assets, 299–300
IRS rules, 155–156 accountability, 272
accountants. See also CPA (certified public accountant)
careers in accounting, 27–29 CFO (chief financial officer), 29 CMA (certified management
accountant), 62–63 college degrees, 62–63 continuing education, 63 controllers, 28–29 education, 62–63
hiring guidelines, 62–63 insiders, 14–15 integrity, 63
outsiders, 15 related careers, 29 starting salaries, 29
stereotypes of, 15–16 accounting
actual costs versus economic, 227 versus bookkeeping, 54
definition, 343
methods, effects of changing, 93, 306 policies, choosing, 252, 326–327 range of uses, 17–18
software for, 72–74
in your personal life, 16–17 accounting department, 20–21 accounting equation, 25, 68, 69, 84, 97,
207, 343
accounting fraud. See also internal (accounting) controls; tricks of the trade
arm’s length bargaining, 71 controls, reviewing, 329–330 cooking the books, 72 definition, 343
discovery, recent failures, 318–319 embezzlement, 70–72
juggling accounts, 72 kickbacks, 70
losses, effects on profit, 306 money laundering, 71 related parties, 71
sales skimming, 70
shifting revenue and expenses, 71 in small businesses, 65
warning signs in reports, 340–341
Accounting Workbook For Dummies, 2 accounts. See also books
accumulated depreciation, 61 allowance for doubtful accounts, 61 balance sheet, 35–36, 61
balancing, 69–70 bookkeeping cycle, 56–57 chart of, 59–60
complete set. See general ledger contra, 61
definition, 60 general ledger, 60
358 Accounting For Dummies, 4th Edition
accounts (continued) income statement, 61
index of. See chart of accounts juggling, 72. See also accounting fraud negative, 61
required categories, 59–60 source documents, 61–62
standardized recording procedures, 61–62
types of, 61 accounts payable
cash flows, versus net income, 129–130
definition, 344 expenses, 111
managerial accounting, 300 profit-making activities, 89–90
accounts receivable as assets, 86
balance, statement differences, 143 changes, effects on cash flow,
126–127 definition, 344 sales revenues, 109 status, 297
accrual-basis accounting definition, 344
sales on credit, 86
window dressing cash flows, 147 accrued expenses payable
changes, effects on cash flow, 129–130
definition, 344 expenses, 111, 113 liability, 146
managerial accounting, 300–301 profit-making activities, 89–90
accumulated depreciation balance sheets, 110–111 contra accounts, 61 definition, 344
financial statement differences, 145–146
fixed assets, 145–146, 299–300 acid-test ratio, 287–288, 344
active reading, 135–136. See also reading reports
activities. See transactions Activity-based costing (ABC), 235, 343 actual cost/actual output method, 239 actual costs, 224, 230
actual profits, versus smoothed, 260–261
adjusted trial balance, 58 adjusting entries, 65, 344
adjustments to net income, 124–125 adverse (negative) auditor opinion,
313
AICPA (American Institute of Certified
Public Accountants), 50, 319 aligning dollar amounts, 4 allied transactions, 91–92
allocated fixed operating expenses, 197 allowances, effects on profit, 305 allowances for doubtful accounts, 61 amortization, 112, 344
arm’s length bargaining, 71
Arthur Anderson & Company, 318–319 asset accounts, 86–89
asset impairment write-downs, 157 asset turnover ratio, 108, 303, 345 asset/liability ratio, 105
assets amortization, 112 buying, 36
cash, 36
connection to sales revenues, 107 control benchmarks, 108
cost, versus depreciation, 110–111 fixed. See fixed assets
goodwill, 112 intangible, 112 inventory, 36 versus liabilities, 36 liquid, 287
long-term resources. See fixed assets net operating assets, 288–289
net worth, 36 non-cash, 107
property, plant, and equipment. See fixed assets
quick, 287
and solvency, 104 turning over, 108 valuation, 226 writing down, 93, 95
assets, balance sheets amortization, 112 cash, 36
connections to sales revenues, 107 control benchmarks, 108
fixed, 36
fixed, depreciation, 110–111 goodwill, 112
intangible, 112 inventory, 36 non-cash, 107 sources of, 24 turning over, 108 types of, 36 values, 24
assumptions of financial statements, 51
audit committees, 320 audit judgment failure, 319 audit trails, 66, 74 auditing firms, 315–316
auditing the auditors, 319–320 audits. See also internal (accounting)
controls alternatives to, 313
Arthur Anderson & Company, 318–319
audit judgment failure, 319 auditing the auditors, 319–320
clean (unqualified) opinion, 313–314 cost of, 312–313
definition, 345 description, 313 disclosures, 256 Enron, 318–319 ethical duties, 316–317
federal requirements for, 312–313
Index 359
field audits, IRS, 66
fraud controls, reviewing, 329–330 fraud discovery, recent failures,
318–319
going concern, reservations about, 315
need for, 312–313
negative (adverse) opinion, 313 professional skepticism, 316–317 qualified opinion, 314
responses to irregularities, 317 tips for reading, 291–292
average cost method, 152
avoiding income tax, versus evading, 302
• B •
bad debt, 143, 297, 345 balance, definition, 102
balance sheet accounts, 35–36, 61 balance sheets. See also financial
statements accounting equation, 25 balance, 102
book value, 117–118. See also owners’ equity
budgeted, 208 contents, 35–37 definition, 345 disclosure, 251–256
double-entry bookkeeping, 25 due diligence, 249
example, 35–37, 101–102 external, 101–103 humor in, 256 importance of, 26–27
versus income statements, 102 internal, 103
liabilities, 24 management’s role, 248–249 market values, 117–118
multiyear statements, 105–106 net worth, 36