Reading Financial Reports for Dummies (12 page)

In addition to establishing accounts to develop the balance sheet and make entries in the double-entry accounting system, companies must also set up accounts that they use to develop the
income statement
(also known as the
profit and loss statement,
or
P&L
), which shows a company’s revenue and 48
Part I: Getting Down to Financial Reporting Basics
expenses over a set period of time. (See Chapter 7 for more on revenue and expenses.) The double-entry accounting method impacts not only the way assets and liabilities are entered but also the way revenue and expenses are entered.

The effect of debits and credits on sales

If you’re a sales manager tracking how your department is doing for the year, you want to be able to decipher debits and credits. If you think an error may exist, your ability to read reports and understand the impact of debits and credits is critical. For example, anytime you think the income statement doesn’t accurately reflect your department’s success, you have to dig into the debits and credits to be sure your sales are being booked correctly.

You also need to be aware of the other accounts — especially revenue and expense accounts — that are used to book transactions that impact your department.

A common entry that impacts both the balance sheet and the income statement is one that keeps track of the amount of cash customers pay to buy the company’s product. If the customers pay $100, here’s how the entry looks:

Account

Debit

Credit

Cash

$100

Sales revenue

$100

In this case, both the cash account and the sales revenue account increase.

One increases using a debit, and the other increases using a credit. Yikes — I know this can be so confusing! Whether an account increases or decreases from a debit or a credit depends on the type of account it is. See Table 4-1 to find out when debits and credits increase or decrease an account.

Table 4-1

Effect of Debits and Credits

Account

Debits

Credits

Assets

Increases

Decreases

Liabilities

Decreases

Increases

Income

Decreases

Increases

Expenses

Increases

Decreases

Make a copy of Table 4-1 and tack it up where you review your department’s accounts until you become familiar with the differences.

Chapter 4: Digging into Accounting Basics

49

Digging into depreciation

and amortization

Depreciation and amortization are accounting methods used to track the use of an asset and record its value as it ages. Tangible assets (those you can touch or hold in your hand, like cars or inventory) are
depreciated
(reduced in value by a certain percentage each year to show that the tangible asset is being used up). Intangible assets (things like intellectual property or patents) are
amortized
(reduced in value by a certain percentage each year to show that the intangible asset is being used up)
.

For example, each vehicle a company owns loses value throughout the normal course of business every year. Cars or trucks are usually estimated to have five years of useful life. Suppose a company pays $30,000 for a car. To calculate its depreciation on a five-year schedule, divide $30,000 by 5 to get $6,000 in depreciation. Each of the five years this car is in service, the company records a depreciation expense of $6,000.

When the company makes the initial purchase of the vehicle using a loan, it records the purchase this way:

Account

Debit

Credit

2008 ABC company car

$30,000

Loans payable — Vehicles

$30,000

In this transaction, both the debit and credit increase the accounts affected.

The debit recording the car purchase increases the total of the assets in the vehicle account, and the credit recording the new loan also increases the total of the loans payable for cars.

The company records its depreciation expenses for the car at the end of each year this way:

Account Debit

Credit

Depreciation expense

$6,000

Accumulated depreciation —

$6,000

Vehicles

The debit in this case increases the expense for depreciation. The credit increases the amount accumulated for depreciation. The line item
Accumulated depreciation — Vehicles
is listed directly below the asset
Vehicles
on the balance sheet and is shown as a negative number to be subtracted from the value of the
Vehicles
assets. This way of presenting the information on the balance sheet helps the financial report reader quickly see how old an asset is and how much value and useful life it has.

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Part I: Getting Down to Financial Reporting Basics
A similar process
, amortization,
is used for intangible assets, such as patents. Just like with depreciation, a company must write down the value of a patent as it nears expiration. Amortization expenses appear on the income statement, and the value of the asset is shown on the balance sheet. The line item
Patent
is shown first on the balance sheet with another line item called
Accumulated amortization
below it. The
Accumulated amortization
line shows how much has been written down against the asset in the current year and any past years. This gives the financial report reader a way to quickly calculate how much value is left in a company’s patents.

Checking Out the Chart of Accounts

A company groups the accounts it uses to develop the financial statements in the
Chart of Accounts,
which is a listing of all open accounts that the accounting department can use to record transactions, according to the role of the accounts in the statements. All businesses have a Chart of Accounts, even if it’s so small that they don’t even realize they do and have never formally gone about designing it.

The Chart of Accounts for a business sort of builds itself as the company buys and sells assets for its use and records revenue earned and expenses incurred in its day-to-day operations.

If you work for a company and have responsibility for its transactions, you’ll have a copy of the Chart of Accounts, so you know which account you want to use for each transaction. If you’re a financial report reader with no internal company responsibilities, you won’t get to see this Chart of Accounts, but you do need to understand what goes into these different accounts to understand what you’re seeing in the financial statements.

The granddaddy of bookkeeping

Every transaction a company makes during ledger by just putting the end-of-month totals the year eventually finds its way into the gen-for outstanding customer accounts. The actual

eral ledger. Although companies often use detail of the transactions that take place during the
general ledger
just for a summary of what

the month involving accounts receivable are

happens in each of their accounts, some com-

in an accounts receivable subledger. In addi-

panies include details about specific transac-

tion, accounting records show details for each

tions in their subledgers. For example, accounts

customer, including what they bought and how

receivable is likely summarized in the general

much they still owe.

Chapter 4: Digging into Accounting Basics

51

Each account in a Chart of Accounts is given a number. This clearly defined structure helps accountants move from job to job and still quickly get a handle on the Chart of Accounts. Also, because most companies use computerized accounting, the software is developed with these numerical definitions. Some companies make up an alphabetical listing of their Chart of Accounts with numbers in parentheses to make finding accounts easier for managers who are unfamiliar with the structure.

The accounts in the Chart of Accounts appear in the following order:

✓

Balance sheet asset accounts (usually in the number range of 1000–1999)

✓

Liability accounts (with numbers ranging from 2000–2999)

✓

Equity accounts (3000–3999)

✓

Income statement accounts/Revenue accounts (4000–4999)

✓

Expense accounts (5000–6999)

In the old days, these accounts were recorded on paper, and finding a specific transaction on the dozens or even hundreds of pages was a nightmare.

Today, because most companies use computerized accounting, you can easily design a report to find most types of transactions electronically by grouping them by account type, customer, salesperson, product, or almost any other configuration that helps you decipher the entries.

To help you become familiar with the types of accounts in the Chart of Accounts and the types of transactions in those accounts, I review the most common accounts in this section in the order in which you’ll most likely read them in a financial report. I assign the accounts numbers that are most commonly generated by computer programs, but you may find that your company uses a different numbering system.

Asset accounts

Asset accounts come first in the Chart of Accounts, with the most current accounts (those that the company will use in less than 12 months) listed before the long-term accounts (those that the company will use in more than 12 months).

Tangible assets

Assets you can hold in your hand are
tangible assets,
and they include
current assets and long-term assets.
Current assets
are assets that will be used up in the next 12 months. The following are examples of current-asset accounts: 52
Part I: Getting Down to Financial Reporting Basics

✓

Cash in checking:
This account is always the first one listed. Businesses use this account most often, depositing their cash received as revenue and their cash paid out to cover bills and debt here.

✓

Cash in savings:
This account is where firms keep cash that isn’t needed for daily operations. It usually earns interest until the company decides how it wants to use this surplus cash.

✓

Cash on hand:
This account
tracks the actual cash the company keeps at its business locations. Cash on hand includes money in the cash registers as well as petty cash. Most companies have several different cash-on-hand accounts. For example, a store may have its own account for tracking cash in the registers, and each department may have its own petty-cash account. How these accounts are structured depends on the company and the security controls it has in place to manage the cash on hand. Companies always leave plenty of room for additions in this account category.

✓

Accounts receivable:
In
this account, businesses record transactions in which customers bought products on store or company credit. Only companies that use the accrual method of accounting need this account.

✓

Inventory:
This account tracks the cost of products the company has available for sale, whether it purchases the products from other companies or produces them in-house. Businesses adjust this account periodically throughout the year to reflect the changes in inventory affected by sales or other factors, such as breakage or theft. Although some firms use a computerized inventory system that adjusts the account almost instantaneously, others adjust the account only at the end of an accounting period.

Long-term assets
are assets that will be held for more than 12 months. The following are common long-term asset accounts:

✓

Land:
This account is used to record any purchases of land as a company asset. Companies list land separately because it doesn’t depreciate in value like the building or buildings sitting on it do.

✓

Buildings:
This account lists the value of any buildings the company owns. This value is always a positive number.

✓

Accumulated depreciation:
This account tracks the depreciation of company-owned buildings. Each year, the firm deducts a portion of the building’s value based on the building’s costs and the number of years the building will have a productive life.

✓

Leasehold Improvements:
This account tracks improvements to buildings that the company leases rather than buys. In most cases, when a company leases retail or warehouse space, it must pay the costs of improving the property for its unique business use. These improvements are also depreciated, so the company uses a companion depreciation account called
Accumulated depreciation — Leasehold improvements.

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✓

Vehicles:
This account tracks the cars, trucks, and other vehicles that a business owns. The initial value added to this account is the value of the vehicles when put into service. Vehicles are also depreciated, and the depreciation account is
Accumulated depreciation — Vehicles.

✓

Furniture and Fixtures:
This account tracks all the desks, chairs, and other fixtures a company buys for its offices, warehouses, and retail stores. Yes, these items, too, are depreciated, and the depreciation account is named
Accumulated depreciation — Furniture and fixtures.

✓

Equipment:
This account tracks any equipment a company purchases that’s expected to have a useful life of more than one year. This equipment includes computers, copiers, cash registers, and any other equipment needs. The depreciation account is
Accumulated depreciation —

Equipment.

Intangible assets

Companies also hold intangible assets, which have value but are often difficult to measure. The following are the most common intangible assets in the Chart of Accounts: