Accounting for DUMmIES 4th

By John A. Tracy, CPA

Accounting

FOR

DUMmIES‰

4TH EDITION

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Accounting For Dummies®

, 4th Edition

Published by

Wiley Publishing, Inc.

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Copyright © 2008 by Wiley Publishing, Inc., Indianapolis, Indiana

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About the Author

John A. Tracy (Boulder, Colorado) is Professor of Accounting, Emeritus, at

the University of Colorado in Boulder. Before his 35-year tenure at Boulder,

he was on the business faculty for four years at the University of California

in Berkeley. Early in his career he was a staff accountant with Ernst & Young.

John is the author of several books on accounting and finance, including The

Fast Forward MBA in Finance, How To Read a Financial Report, and Small

Business Financial Management Kit For Dummies with his son Tage Tracy.

John received his BSC degree from Creighton University. He earned his MBA

and PhD degrees at the University of Wisconsin in Madison. He is a CPA (inac￾tive) in Colorado.

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Dedication

For our grandchildren — Alexander, Ryan, Mitchel, Paige, Katrina, Claire,

Eric, MacKenzie, Madison, Tanner, Karsen, and Brody.

Author’s Acknowledgments

I’m deeply grateful to everyone at Wiley Publishing who helped produce this

book. Their professionalism, courtesy, and good humor were much appreci￾ated. I supplied some words, and the editors and production staff at Wiley

molded them into the finished product.

Out of the blue, I got a call in 1996 from Kathy Welton, then Vice President

and Publisher for the Consumer Publishing Group of the For Dummies books.

Kathy asked if I’d be interested in doing this book. It didn’t take me very long

to say yes. Thank you again, Kathy!

I can’t say enough nice things about Pam Mourouzis, who was project editor

on the first edition of the book. The book is immensely better for her insights

and advice. The two copyeditors on the book — Diane Giangrossi and Joe

Jansen — did a wonderful job. Mary Metcalfe provided valuable suggestions

on the manuscript. Thanks to Holly McGuire and Jill Alexander who encour￾aged me to revise the book. The second edition benefited from the editing by

Norm Crampton and Ben Nussbaum.

I thank Stacy Kennedy, acquisitions editor, for asking me to do this and the

previous revision. Joan Friedman was the project editor on this and the

previous edition. Evidently, Wiley assigned me the best editor they have.

Joan kept a steady hand on the tiller as we sailed through the choppy waters

of the revisions. Joan was a delight to work with, and it goes without saying

that she made the book much better. Thank you most sincerely Joan, and I

hope to work with you again on the next revision.

One reason I like to write books goes back to an accounting class in my

undergraduate days at Creighton University in Omaha. I took a course taught

by the Dean of the Business School, Dr. Floyd Walsh. I turned in a term paper,

and he said that it was very well written. I have never forgotten that compli￾ment. I think my old Prof would be proud of this book and might even give me

an “A” on the assignment.

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Publisher’s Acknowledgments

We’re proud of this book; please send us your comments through our Dummies online registration

form located at www.dummies.com/register/.

Some of the people who helped bring this book to market include the following:

Acquisitions, Editorial, and

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Project Editor: Joan Friedman

(Previous Editions: Norm Crampton,

Pam Mourouzis)

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Technical Editor: Michael Newman, PhD

Editorial Manager: Jennifer Ehrlich

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Editorial Assistants: Erin Calligan Mooney,

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Composition Services

Project Coordinator: Katie Key

Layout and Graphics: Brooke Graczyk,

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Proofreaders: Laura Albert, John Greenough,

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Indexer: Infodex Indexing Services, Inc.

Publishing and Editorial for Consumer Dummies

Diane Graves Steele, Vice President and Publisher, Consumer Dummies

Joyce Pepple, Acquisitions Director, Consumer Dummies

Kristin A. Cocks, Product Development Director, Consumer Dummies

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Publishing for Technology Dummies

Andy Cummings, Vice President and Publisher, Dummies Technology/General User

Composition Services

Gerry Fahey, Vice President of Production Services

Debbie Stailey, Director of Composition Services

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Contents at a Glance

Introduction .................................................................1

Part I: Opening the Books on Accounting......................11

Chapter 1: Accounting: The Language of Business, Investing, Finance, and Taxes....13

Chapter 2: Financial Statements and Accounting Standards......................................31

Chapter 3: Bookkeeping and Accounting Systems.......................................................53

Part II: Figuring Out Financial Statements ...................75

Chapter 4: Reporting Revenue, Expenses, and the Bottom Line................................77

Chapter 5: Reporting Assets, Liabilities, and Owners’ Equity....................................97

Chapter 6: Reporting Cash Flows.................................................................................119

Chapter 7: Choosing Accounting Methods: Different Strokes for Different Folks....137

Part III: Accounting in Managing a Business..............159

Chapter 8: Deciding the Legal Structure for a Business............................................161

Chapter 9: Analyzing and Managing Profit..................................................................183

Chapter 10: Financial Planning, Budgeting, and Control...........................................205

Chapter 11: Cost Concepts and Conundrums ............................................................223

Part IV: Preparing and Using Financial Reports..........245

Chapter 12: Getting a Financial Report Ready for Release .......................................247

Chapter 13: How Lenders and Investors Read a Financial Report...........................271

Chapter 14: How Business Managers Use a Financial Report ..................................293

Chapter 15: Audits and Accounting Fraud ..................................................................311

Part V: The Part of Tens ............................................321

Chapter 16: Ten Accounting Tips for Managers .........................................................323

Chapter 17: Ten Tips for Reading a Financial Report ................................................333

Glossary: Slashing Through the Accounting

Jargon Jungle...........................................................343

Index .......................................................................357

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Table of Contents

Introduction..................................................................1

About This Book...............................................................................................1

Conventions Used in This Book .....................................................................2

What You’re Not To Read ................................................................................4

Foolish Assumptions .......................................................................................5

How This Book Is Organized...........................................................................6

Part I: Opening the Books on Accounting ...........................................6

Part II: Figuring Out Financial Statements...........................................7

Part III: Accounting in Managing a Business.......................................7

Part IV: Preparing and Using Financial Reports .................................8

Part V: The Part of Tens.........................................................................8

Glossary...................................................................................................8

Icons Used in This Book..................................................................................9

Where to Go from Here....................................................................................9

Part I: Opening the Books on Accounting ......................11

Chapter 1: Accounting: The Language of Business,

Investing, Finance, and Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13

Accounting Is Not Just for Accountants......................................................14

Affecting both insiders and outsiders ...............................................14

Overcoming the stereotypes of accountants....................................15

Relating accounting to your personal financial life .........................16

Looking for Accounting in All the Right Places..........................................17

Taking a Peek into the Back Office...............................................................18

Focusing on Transactions .............................................................................21

Taking the Pulse of a Business: Financial Statements ...............................23

Meeting the balance sheet and the accounting equation ...............24

Reporting profit and loss, and cash flows.........................................25

Respecting the importance of this trio..............................................26

Considering Accounting Careers .................................................................27

Certified public accountant (CPA) .....................................................27

The controller: The chief accountant in an organization................28

A springboard to other careers ..........................................................29

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Chapter 2: Financial Statements and Accounting Standards . . . . . . .31

Introducing the Information Content of Financial Statements.................32

Setting up the business example........................................................32

The income statement .........................................................................33

The balance sheet ................................................................................35

The statement of cash flows ...............................................................37

How Profit and Cash Flow from Profit Differ ..............................................40

Gleaning Key Information from Financial Statements ...............................41

How’s profit performance?..................................................................41

Is there enough cash? ..........................................................................42

Can you trust the financial statement numbers?

Are the books cooked?.....................................................................43

Why no cash distribution from profit? ..............................................44

Keeping in Step with Accounting and Financial Reporting Standards....45

Recognizing U.S. standards.................................................................45

Getting to know the U.S. standard setters ........................................47

Going worldwide...................................................................................48

Noting a divide between public and private companies.................49

Recognizing how income tax methods influence

accounting methods.........................................................................50

Following the rules and bending the rules........................................51

Chapter 3: Bookkeeping and Accounting Systems . . . . . . . . . . . . . . . .53

Bookkeeping and Beyond..............................................................................54

Pedaling Through the Bookkeeping Cycle..................................................54

Managing the Bookkeeping and Accounting System.................................59

Categorize your financial information: The chart of accounts.......59

Standardize source document forms and procedures ....................61

Hire competent, trained personnel....................................................62

Enforce strong — I mean strong! — internal controls .....................63

Complete the process with end-of-period procedures....................65

Leave good audit trails ........................................................................66

Look out for unusual events and developments ..............................66

Design truly useful reports for managers .........................................67

Double-Entry Accounting for Single-Entry Folks........................................68

Juggling the Books to Conceal Embezzlement and Fraud ........................70

Using Accounting Software...........................................................................72

Part II: Figuring Out Financial Statements....................75

Chapter 4: Reporting Revenue, Expenses, and the Bottom Line . . . . .77

Presenting a Typical Income Statement......................................................78

Taking care of some housekeeping details .......................................79

Your job: Asking questions!.................................................................81

Finding Profit ..................................................................................................84

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Getting Particular about Assets and Liabilities..........................................86

Making sales on credit → Accounts receivable asset......................86

Selling products → Inventory asset...................................................87

Prepaying operating costs → Prepaid expense asset......................87

Fixed assets → Depreciation expense ...............................................88

Unpaid expenses → Accounts payable, accrued expenses

payable, and income tax payable ..................................................89

Summing Up the Financial Effects of Profit.................................................91

Reporting Extraordinary Gains and Losses................................................92

Closing Comments .........................................................................................95

Chapter 5: Reporting Assets, Liabilities, and Owners’ Equity . . . . . . .97

Understanding That Transactions Drive the Balance Sheet.....................98

Presenting a Balance Sheet.........................................................................100

Kicking balance sheets out into the real world ..............................102

Internal balance sheets............................................................103

External balance sheets...........................................................103

Judging solvency ................................................................................103

Current (short-term) assets ....................................................104

Current (short-term) liabilities ...............................................104

Current ratio..............................................................................105

Preparing multiyear statements.......................................................105

Coupling the Income Statement and Balance Sheet ................................106

Sizing up assets and liabilities..........................................................108

Sales revenue and accounts receivable...........................................109

Cost of goods sold expense and inventory.....................................109

Fixed assets and depreciation expense...........................................110

SG&A expenses and their three balance sheet accounts..............111

Intangible assets and amortization expense ..................................112

Debt and interest expense ................................................................113

Income tax expense and income tax payable .................................114

Net income and cash dividends (if any)..........................................114

Financing a Business....................................................................................115

Costs and Other Balance Sheet Values......................................................117

Chapter 6: Reporting Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .119

Seeing the Big Picture of Cash Flows.........................................................119

Meeting the Statement of Cash Flows .......................................................122

Dissecting the Difference Between Cash Flow and Net Income .............125

Accounts receivable change .............................................................126

Inventory change................................................................................127

Prepaid expenses change..................................................................127

The depreciation factor.....................................................................128

Changes in operating liabilities ........................................................129

Putting the cash flow pieces together .............................................130

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Sailing Through the Rest of the Statement of Cash Flows ......................131

Investing activities .............................................................................131

Financing activities ............................................................................132

Trying to Pin Down “Free Cash Flow”........................................................134

Being an Active Reader ...............................................................................135

Chapter 7: Choosing Accounting Methods:

Different Strokes for Different Folks . . . . . . . . . . . . . . . . . . . . . . . . . . .137

Reading Statements with a Touch of Skepticism .....................................138

Recognizing a business’s bias...........................................................138

Contrasting aggressive and conservative numbers.......................139

Figuring Out Why Financial Statements Differ .........................................141

Cash balance.......................................................................................142

Accounts receivable balance ............................................................143

Inventory and cost of goods sold expense .....................................144

Cost of fixed assets, accumulated depreciation,

and depreciation expense .............................................................145

Accrued expenses payable liability balance...................................146

Wrapping things up............................................................................147

Calculating Cost of Goods Sold and Cost of Inventory ...........................148

The FIFO (first-in, first-out) method.................................................149

The LIFO (last-in, first-out) method .................................................150

The average cost method..................................................................152

Recording Inventory Losses under the Lower of Cost

or Market (LCM) Rule ..............................................................................153

Appreciating Depreciation Methods..........................................................154

Scanning the Expense Horizon...................................................................156

Part III: Accounting in Managing a Business...............159

Chapter 8: Deciding the Legal Structure for a Business . . . . . . . . . .161

Studying the Sources of Business Capital.................................................162

Deciding on debt ................................................................................162

Tapping two sources of owners’ equity...........................................163

Recognizing the Legal Roots of Business Entities ...................................165

Incorporating a Business ............................................................................165

Issuing stock shares...........................................................................166

Offering different classes of stock shares .......................................167

Determining the market value of stock shares...............................169

Keeping alert for dilution of share value.........................................170

Recognizing conflicts between stockholders and managers........172

Considering Partnerships and Limited Liability Companies..................173

Going It Alone: Sole Proprietorships .........................................................176

xiv Accounting For Dummies, 4th Edition

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Choosing the Right Legal Structure for Income Tax................................178

C corporations....................................................................................179

S corporations ....................................................................................180

Partnerships and LLCs ......................................................................181

Chapter 9: Analyzing and Managing Profit . . . . . . . . . . . . . . . . . . . . . .183

Helping Managers Do Their Jobs ...............................................................184

Following the organizational structure............................................184

Centering on profit centers...............................................................185

Presenting a P&L Template.........................................................................186

Reporting operating expenses on the object

of expenditure basis .......................................................................187

Reporting operating expenses on their cost behavior basis........187

Separating variable and fixed expenses ..........................................189

Variable expenses .....................................................................189

Fixed expenses..........................................................................190

Stopping at operating earnings ........................................................191

Focusing on margin — the catalyst of profit...................................192

Answering Two Critical Profit Questions..................................................192

How did you make profit? .................................................................192

How did you increase profit? ............................................................194

Looking More Closely at the Profit Center P&L Report ..........................195

Sales volume .......................................................................................195

Sales revenue ......................................................................................195

Cost of goods sold..............................................................................196

Variable operating expenses.............................................................196

Fixed operating expenses..................................................................197

Using the P&L Template for Decision-Making Analysis...........................198

Tucking Away Some Valuable Lessons ......................................................199

Recognize the leverage effect caused by fixed

operating expenses ........................................................................199

Don’t underestimate the impact of small

changes in sales price ....................................................................200

Know your options for improving profit .........................................201

Closing with a Boozy Example....................................................................202

Chapter 10: Financial Planning, Budgeting, and Control . . . . . . . . . .205

Exploring the Reasons for Budgeting ........................................................206

Modeling reasons for budgeting.......................................................207

Planning reasons for budgeting........................................................208

Management control reasons for budgeting...................................209

Additional benefits of budgeting, and a note of caution ...............210

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Realizing That Not Everyone Budgets.......................................................212

Avoiding budgeting ............................................................................212

Relying on internal accounting reports...........................................213

Making reports useful for management control ...................213

Making reports useful for decision-making...........................213

Making reports clear and straightforward ............................214

Watching Budgeting in Action ....................................................................214

Developing your profit strategy and budgeted profit report........216

Budgeting cash flow for the coming year........................................218

Considering Capital Expenditures and Other Cash Needs .....................220

Chapter 11: Cost Concepts and Conundrums . . . . . . . . . . . . . . . . . . . .223

Looking down the Road to the Destination of Costs ...............................224

Are Costs Really That Important?..............................................................225

Becoming More Familiar with Costs..........................................................226

Direct versus indirect costs ..............................................................228

Fixed versus variable costs...............................................................229

Relevant versus irrelevant costs ......................................................229

Actual, budgeted, and standard costs.............................................230

Product versus period costs.............................................................231

Assembling the Product Cost of Manufacturers ......................................232

Minding manufacturing costs ...........................................................232

Classifying costs properly.................................................................234

Calculating product cost ...................................................................236

Examining fixed manufacturing costs and production capacity......237

The burden rate ........................................................................237

Idle capacity ..............................................................................238

The effects of increasing inventory........................................238

Puffing Profit by Excessive Production .....................................................240

Shifting fixed manufacturing costs to the future............................240

Cranking up production output........................................................241

Being careful when production output is out

of kilter with sales volume.............................................................243

Part IV: Preparing and Using Financial Reports...........245

Chapter 12: Getting a Financial Report Ready for Release . . . . . . . .247

Recognizing Management’s Role................................................................248

Keeping in Mind the Purpose of Financial Reporting..............................249

Staying on Top of Accounting and Financial Reporting Standards .......250

Making Sure Disclosure Is Adequate .........................................................251

Footnotes: Nettlesome but needed..................................................252

Other disclosures in financial reports.............................................254

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Putting a Spin on the Numbers (But Not Cooking the Books) ...............256

Window dressing for fluffing up the cash balance .........................257

Sanding the rough edges off profit...................................................258

The pressure on public companies........................................259

Compensatory effects ..............................................................259

Two profit histories..................................................................260

Management discretion in the timing

of revenue and expenses......................................................261

Going Public or Keeping Things Private ...................................................263

Reports from publicly owned companies .......................................263

Reports from private businesses .....................................................264

Dealing with Information Overload............................................................265

Browsing based on your interests....................................................265

Recognizing condensed versions.....................................................266

Using other sources of business information.................................267

Statement of Changes in Owners’ Equity..................................................267

Chapter 13: How Lenders and Investors Read a Financial Report . . . .271

Knowing the Rules of the Game .................................................................272

Becoming a More Savvy Investor...............................................................273

Comparing Private and Public Business Financial Reports....................274

Analyzing Financial Statements with Ratios.............................................276

Gross margin ratio..............................................................................278

Profit ratio ...........................................................................................280

Earnings per share (EPS), basic and diluted...................................280

Price/earnings (P/E) ratio .................................................................282

Dividend yield.....................................................................................283

Book value and book value per share..............................................284

Return on equity (ROE) ratio............................................................286

Current ratio .......................................................................................287

Acid-test ratio .....................................................................................287

Return on assets (ROA) ratio and financial leverage gain ............288

Frolicking Through the Footnotes .............................................................289

Checking for Ominous Skies in the Auditor’s Report..............................291

Chapter 14: How Business Managers Use a Financial Report . . . . .293

Building on the Foundation of the External Financial Statements ........294

Seeking out problems and opportunities........................................294

Avoiding information overload.........................................................294

Gathering Financial Condition Information ..............................................295

Cash......................................................................................................296

Accounts receivable...........................................................................297

Inventory .............................................................................................298

Prepaid expenses ...............................................................................298

Fixed assets and accumulated depreciation...................................299

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Accounts payable...............................................................................300

Accrued expenses payable ...............................................................300

Income tax payable ............................................................................301

Interest-bearing debt..........................................................................302

Owners’ equity....................................................................................303

Culling Profit Information............................................................................303

Margin: The catalyst of profit ...........................................................304

Sales revenue and expenses .............................................................305

Digging into Cash Flow Information...........................................................306

Distinguishing investing and financing cash flows

from operating cash flows .............................................................307

Managing operating cash flows ........................................................308

Chapter 15: Audits and Accounting Fraud . . . . . . . . . . . . . . . . . . . . . . .311

Exploring the Need for Audits ....................................................................312

What’s in an Auditor’s Report ....................................................................313

The clean (unqualified) opinion.......................................................313

Other kinds of audit opinions...........................................................314

Who’s Who in the World of Audits.............................................................315

Standing Firm When Companies Massage the Numbers, or Not ...........316

Discovering Fraud, or Not...........................................................................318

Who Audits the Auditors?...........................................................................319

Part V: The Part of Tens .............................................321

Chapter 16: Ten Accounting Tips for Managers . . . . . . . . . . . . . . . . . .323

Reach Break-Even, and Then Rake in Profit..............................................323

Set Sales Prices Right...................................................................................324

Distinguish Profit from Cash Flow .............................................................325

Call the Shots on Accounting Policies.......................................................326

Budget Wisely ...............................................................................................327

Get the Accounting Information You Need ...............................................328

Tap into Your CPA’s Expertise.....................................................................329

Critically Review Your Fraud Controls ......................................................329

Lend a Hand in Preparing Your Financial Reports...................................330

Sound Like a Pro in Talking about Your Financial Statements ...............331

Chapter 17: Ten Tips for Reading a Financial Report . . . . . . . . . . . . .333

Get in the Right Frame of Mind ..................................................................333

Decide What to Read ...................................................................................335

Improve Your Accounting Savvy ................................................................336

Judge Profit Performance............................................................................336

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Track Profit into Earnings per Share .........................................................337

Confront Extraordinary Gains and Losses................................................338

Compare Cash Flow and Profit ...................................................................339

Look for Signs of Financial Distress...........................................................340

Recognize the Risks of Restatement and Fraud .......................................340

Remember the Limits of Financial Reports ..............................................341

Glossary: Slashing Through the Accounting

Jargon Jungle............................................................343

Index........................................................................357

Table of Contents xix

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