Reading Financial Reports for Dummies (11 page)

In this scenario, the investment banker tries to sell the stock but doesn’t guarantee the number of shares that will sell.

✓

They decide which stock exchange to list the stock on.
The New York Stock Exchange (NYSE) has the highest level of requirements. If a company wants to list on this exchange, it must have a pretax income of at least $10 million over the last three years and 2,200 or more shareholders. The NASDAQ and American Stock Exchange have lower requirements. Companies can also sell stock over-the-counter, which means the stock isn’t listed on any exchange, so selling the stock both as an IPO

and after the IPO is much harder.

Chapter 3: Public or Private: How Company Structure Affects the Books
41

Making a public offering

After the company and the investment banker agree to work together and set the terms for the public offering, as well as the commission structure (how the investment banker gets paid), the banker prepares the registration statement to be filed with the SEC.

After the registration is filed, the SEC imposes a “cooling-off period” to give itself time to investigate the offering and to make sure all necessary information is disclosed in the documents. The length of the cooling-off period depends on how complete the documents are and whether the SEC asks for additional information. During the cooling-off period, the underwriter produces the
red herring,
which is an initial prospectus that includes the information in the SEC registration without the stock price or effective date.

After the underwriter completes the red herring, the company and the investment bankers do
road shows
— presentations held around the country to introduce the business to major institutional investors and start building interest in the pending IPO. A company can’t transact sales until the SEC

approves the registration information, but it can start generating excitement and getting feedback about the IPO at these meetings.

When the SEC finishes its investigation and approves the offering, an
effective
date
, or the date of the stock offering, can be set. The company and investment bankers then sit down and establish a final stock price. Although they discuss the stock price in initial conversations, the final price can’t be set until the actual effective date is known. Market conditions can change significantly from the time the company first talks with investment bankers and the date when the stock is finally offered publicly. Sometimes, the company and investment banker decide to withdraw or delay an IPO if a market crisis creates a bad climate for introducing a new stock, or if the road shows don’t identify enough interested major investors.

After the stock price is set, the stock is sold to the public. The company gets the proceeds minus any commissions paid to the investment bankers.

42
Part I: Getting Down to Financial Reporting Basics
Chapter 4

Digging into Accounting Basics

In This Chapter

▶ Understanding the two main accounting methods

▶ Deciphering debits and credits

▶ Examining the Chart of Accounts

▶ Looking at the different types of profit

Ah, the language of financial accounting — debits, credits, double-entry accounting! Just reading the words makes your heart beat faster, doesn’t it? The language and practices of accountants can get the best of anyone, but there’s a method to the madness, and figuring out that method is a crucial first step to understanding financial reports. In this chapter, I help you understand the logic behind the baffling and unique world of financial accounting. And you won’t even need a pocket protector!

Making Sense of Accounting Methods

Officially, two types of accounting methods dictate how a company’s transactions are recorded in its financial books: cash-basis accounting and accrual accounting. The key difference between the two types is how the company records cash coming into and going out of the business. Within that simple difference lies a lot of room for error — or manipulation. In fact, many of the major corporations involved in financial scandals have gotten in trouble because they played games with the nuts and bolts of their accounting method. I talk more about those games in Chapter 23.

Cash-basis accounting

In
cash-basis accounting,
companies record expenses in financial accounts when the cash is actually laid out, and they book revenue when they actually hold the cash in their hot little hands or, more likely, in a bank account. For 44
Part I: Getting Down to Financial Reporting Basics
example, if a painter completes a project on December 30, 2008, but doesn’t get paid for it until the owner inspects it on January 10, 2009, the painter reports those cash earnings on his 2009 tax report. In cash-basis accounting, cash earnings include checks, credit-card receipts, or any other form of revenue from customers.

Smaller companies that haven’t formally incorporated, and most sole proprietors, use cash-basis accounting because the system is easier for them to use on their own, meaning they don’t have to hire a large accounting staff.

Accrual accounting

If a company uses
accrual accounting,
it records revenue when the actual transaction is completed (such as the completion of work specified in a contract agreement between the company and its customer), not when it receives the cash. That is, the company records revenue when it earns it, even if the customer hasn’t paid yet. For example, a carpentry contractor who uses accrual accounting records the revenue he earns when he completes the job, even if the customer hasn’t paid the final bill yet.

Expenses are handled in the same way. The company records any expenses when they’re incurred, even if it hasn’t paid for the supplies yet. For example, when a carpenter buys lumber for a job, he may very likely do so on account and not actually lay out the cash for the lumber until a month or so later when he gets the bill.

All incorporated companies must use accrual accounting according to the
generally accepted accounting principles
(GAAP) because revenues are matched to expenses in the same month they occur. If you’re reading a corporation’s financial reports, what you see is based on accrual accounting.

Why method matters

The accounting method a business uses can have a major impact on the total revenue it reports, as well as on the expenses it subtracts from the revenue to get the bottom line. Here’s how:

✓

Cash-basis accounting:
Expenses and revenues aren’t carefully matched on a month-to-month basis. Expenses aren’t recognized until the money is actually paid out, even if the expenses are incurred in previous months, and revenues earned in previous months aren’t recognized until the cash is actually received. However, cash-basis accounting excels in tracking the actual cash available.

Chapter 4: Digging into Accounting Basics

45

✓

Accrual accounting:
Expenses and revenue are matched, providing a company with a better idea of how much it’s spending to operate each month and how much profit it’s making. Expenses are recorded (or accrued) in the month incurred, even if the cash isn’t paid out until the next month. Revenues are recorded in the month the project is completed or the product is shipped, even if the company hasn’t yet received the cash from the customer.

The way a company records payment of payroll taxes, for example, differs with these two methods. In accrual accounting, each month the company sets aside the amount it expects to pay toward its quarterly tax bills for employee taxes using an
accrual
(paper transaction in which no money changes hands). The entry goes into a
tax liability account
(an account for tracking tax payments that have been made or must still be made). If the company incurs $1,000 of tax liabilities in March, that amount is entered in the tax liability account even if the firm hasn’t yet paid out the cash. That way, the expense is matched to the month in which it’s incurred.

In cash accounting, the company doesn’t record the liability until it actually pays the government the cash. Although it incurs tax expenses each month, the company using cash accounting shows a higher profit during two months every quarter and possibly even shows a loss in the third month when the taxes are paid.

To see how these two methods can result in totally different financial statements, imagine that a carpenter contracts a job with a total cost to the customer of $2,000. The carpenter’s expected expenses for the supplies, labor, and other necessities are $1,200, so his expected profit is $800. He contracts the work on December 23, 2008, and completes the job on December 31, 2008, but he isn’t paid until January 3, 2009. The contractor takes no cash upfront and instead agrees to be paid in full at completion.

If he uses the cash-basis accounting method, because no cash changes hands, he doesn’t have to report any revenues from this transaction in 2008.

But say he lays out the cash for his expenses in 2008. In this case, his bottom line is $1,200 less with no revenue to offset it, and his net profit (the amount of money his company earns, minus expenses) for the business in 2008 is lower. This scenario may not necessarily be a bad thing if he’s trying to reduce his tax hit for 2008.

If you’re a small-business owner looking to manage your tax bill and you use cash-basis accounting, you can ask vendors to hold off payments until the beginning of the next year to reduce your net income, thereby lowering your tax payments for the year.

46
Part I: Getting Down to Financial Reporting Basics
Incentives and the bottom line

To improve the bottom line, many companies

salesperson hadn’t met quota or was compet-

offer their salespeople different kinds of incen-

ing to win a sales contest.

tives at the end of a month, quarter, or year. The

If a company gets really aggressive with its

more the salespeople sell, the more income the

end-of-period revenue-booking practices, it can

company records, allowing it to report stronger

inflate its actual earnings, especially if sales-

earnings for that period.

people allow customers to sign orders with the

You’ve probably seen this concept put into promise that they can cancel their orders early action if you’ve ever made a major pur-in the next month or accounting period. Some

chase, such as a car, at the end of the month.

companies have gotten into trouble by record-

You probably found that you could be much ing sales on products that weren’t yet shipped more aggressive with your negotiations if the

in order to make a quarterly or monthly goal.

If the same carpenter uses accrual accounting, his bottom line is different. In this case, he books his expenses when they’re actually incurred. He also records the income when he completes the job on December 31, 2008, even though he doesn’t get the cash payment until 2009. His net income is increased by this job, and so is his tax hit. Chapter 7 covers the ins and outs of reporting income on the income statement.

Understanding Debits and Credits

You probably think of the word
debit
as a reduction in your cash. Most non-accountants see debits only when they’re taken out of their banking account.

Credits likely have a more positive connotation in your mind. You see them most frequently when you’ve returned an item and your account is credited.

Forget everything you
think
you know about debits and credits! You’re going to have to erase these assumptions from your mind in order to understand
double-entry accounting,
which is the basis of most accounting done in the business world.

Both cash-basis and accrual accounting use this method, in which a credit may be added to or subtracted from an account, depending on the type of account. The same is true with debits; sometimes they add to an account, and sometimes they subtract from an account.

Chapter 4: Digging into Accounting Basics

47

Double-entry accounting

When you buy something, you do two things: You get something new (say, a chair), and you have to give up something to get it (most likely, cash or your credit line). Companies that use double-entry accounting show both sides of every transaction in their books, and those sides must be equal.

Probably at least 95 percent of businesses in the U.S. use double-entry accounting, whether they use the cash-basis or accrual accounting method.

It’s the only way a business can be certain that it has considered both sides of every transaction.

For example, if a company buys office supplies with cash, the value of the office supplies account increases, while the value of the cash account decreases. If the company purchases $100 in office supplies, here’s how it records the transaction on its books:

Account

Debit

Credit

Office supplies

$100

Cash

$100

In this case, the debit increases the value of the office supplies account and decreases the value of the cash account. Both accounts are
asset accounts,
which means both accounts represent things the company owns that are shown on the balance sheet. (The
balance sheet
is the financial statement that gives you a snapshot of the assets, liabilities, and shareholders’ equity as of a particular date. I cover balance sheets in greater detail in Chapter 6.) The assets are balanced or offset by the
liabilities
(claims made against the company’s assets by creditors, such as loans) and the
equity
(claims made against the company’s assets, such as shares of stock held by shareholders).

Double-entry accounting seeks to balance these assets and claims against these assets. In fact, the balance sheet of a company is developed using this formula:

Assets = Liabilities + Owner’s equity

Profit and loss statements