Accounting FORDUMmIES‰4THEDITION Accounting FORDUMmIES‰ 4THEDITIONBy John A. Tracy, CPA Accounting. Download Intermediate Accounting For Dummies ebook free by Maire Loughran in pdf/epub/mobi. Accounting and finance have a language of their own with a variety of statements nies do not publish a trading account as such, they are free to use what-.
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to all of you! I hope I have done you proud with Accounting Workbook For Dummies. is, “There's no such thing as a free lunch,” but I digress.) Well, there's. As of today we have 78,, eBooks for you to download for free. No annoying ads, no download limits, Nonprofit Bookkeeping & Accounting for Dummies. These records are maintained by using an accounting system. Accounting for . business organization and is relatively free from legal complexities. One major.
I guarantee that Warren Buffett knows accounting and how to read financial statements. Affecting both insiders and outsiders People who need to know accounting fall into two broad groups: insiders and outsiders. Business managers are insiders; they have the authority and responsibility to run a business. They need a good understanding of accounting terms and the methods used to measure profit and put values on assets and liabilities.
Chapter 1: Accounting: The Language of Business, Investing, Finance, and Taxes Accounting information is indispensable for planning and controlling the financial performance and condition of the business.
Likewise, administrators of nonprofit and governmental entities need to understand the accounting terminology and measurement methods in their financial statements. The rest of us are outsiders. We are not privy to the day-to-day details of a business or organization. Therefore, we need to have a good grip on the financial statements included in the financial reports.
For all practical purposes, financial reports are the only source of financial information we get directly from a business or other organization.
By the way, the employees of a business — even though they obviously have a stake in the success of the business — do not necessarily receive its financial reports. Only the investors in the business and its lenders are entitled to receive the financial reports. Of course, a business could provide this information to those of its employees who are not shareowners, but generally speaking most businesses do not.
The financial reports of public businesses are in the public domain, so their employees can easily secure a copy. However, financial reports are not automatically mailed to all employees of a public business.
In our personal financial lives, a little accounting knowledge is a big help for understanding investing in general, how investment performance is measured, and many other important financial topics. Keep in mind that this is not a book on bookkeeping and recordkeeping systems.
I offer a brief explanation of procedures for capturing, processing, and storing accounting information in Chapter 3. Even experienced bookkeepers and accountants should find some nuggets in that chapter.
However, this book is directed to users of accounting information. I focus on the end products of accounting, particularly financial statements, and not how information is accumulated.
Overcoming the stereotypes of accountants I recently saw a cartoon in which the young son of clowns is standing in a circus tent and is dressed as a clown, but he is holding a business briefcase.
He is telling his clown parents that he is running away to join a CPA firm. Why is this funny? As a CPA and accounting professor for more than 40 years, I have met and known a large number of accountants. Most accountants are not as gregarious as used-car sales people though some are.
Accountants certainly are more detail-oriented than your average person. Accountants use very little math no calculus and only simple algebra. Accountants are very good at one thing: They want to see both sides of financial transactions: the give and take.
If you walked down a busy street in Chicago, New York, or Los Angeles, I doubt that you could pick out the accountants. I have no idea whether accountants have higher or lower divorce rates than others, whether they go to church more frequently, whether most are Republicans or Democrats, or if they generally sleep well at night. I do think that accountants are more honest in paying their income taxes than other people, although I have no proof of this.
Well, a great deal of the information you use in making personal finance and investing decisions is accounting information. You have a stake in the financial performance of the business you work for, the government entities you pay taxes to, the churches and charitable organizations you donate money to, the retirement plan you participate in, the businesses you download from, and the healthcare providers you depend on. The financial performance and viability of these entities has a direct bearing on your personal financial life and well-being.
For example, as an employee your job security and your next raise depend on the business making a profit. If the business suffers a loss, you may be laid off or asked to take a reduction in pay or benefits.
Business managers get paid to make profit happen. If the business fails to meet its profit objectives or suffers a loss, its managers may be replaced or at least not get their bonuses. As an author, I hope my publisher continues to make profit so I can keep receiving my royalty checks.
I hope the stores I trade with make profit and continue in business. The federal government and many states depend on businesses making profit to collect income taxes from them. When you sign a mortgage on your home, you should understand the accounting method the lender uses to calculate the interest amount charged on your loan each period. Individual investors need to understand accounting basics in order to figure their return on invested capital. And it goes without saying that every organization, profit-motivated or not, needs to know how it stands financially.
All economic activity requires information. The more developed the economic system, the more the system depends on information. Much of the information comes from the accounting systems used by the businesses, institutions, individuals, and other players in the economic system.
Some of the earliest records of history are the accounts of wealth and trading activity. The need for accounting information was a main incentive in the development of the numbering system we use today. The history of accounting is quite interesting but beyond the scope of this book.
Taking a Peek into the Back Office Every business and not-for-profit entity needs a reliable bookkeeping system see Chapter 3.
Keep in mind that accounting is a much broader term than bookkeeping. For one thing, accounting encompasses the problems in measuring the financial effects of economic activity. Furthermore, accounting includes the function of financial reporting of values and performance measures to those that need the information. Business managers and investors, and many other people, depend on financial reports for information about the performance and condition of the entity.
Of course the financial information base should be complete, accurate, and timely. Every recordkeeping system needs quality controls built into it, which are called internal controls or internal accounting controls.
Accountants design the internal controls for the bookkeeping system, which serve to minimize errors in recording the large number of activities that an entity engages in over the period.
The internal controls that accountants design are also relied on to detect and deter theft, embezzlement, fraud, and dishonest behavior of all kinds. In accounting, internal controls are the ounce of prevention that is worth a pound of cure. I explain internal controls in Chapter 3. Here, I want to stress the importance of the bookkeeping system in operating a business or any other entity.
These back-office functions are essential for keeping operations running smoothly, efficiently, and without delays and errors. This is a tall order, to say the least. Based on detailed private information in personnel files and earnings-to-date information, the correct amounts of income tax, social security tax, and several other deductions from gross wages have to be determined. Stubs, which report various information to employees each pay period, have to be attached to payroll checks.
The total amounts of withheld income tax and social security taxes, plus the employment taxes imposed on the employer, have to be paid to federal and state government agencies on time. Retirement, vacation, sick pay, and other benefits earned by the employees have to be updated every pay period.
In short, payroll is a complex and critical function that the accounting department performs. Many businesses outsource payroll functions to companies that specialize in this area.
The accounting department makes sure that the cash is deposited in the appropriate checking accounts of the business and that an adequate amount of coin and currency is kept on hand for making change for customers.
Accountants balance the checkbook of the business and control who has access to incoming cash receipts. In larger organizations, the treasurer may be responsible for some of these cash flow and cashhandling functions.
The accounting department prepares all these checks for the signatures of the business officers who are authorized to sign checks. The accounting department keeps all the supporting business documents and files to know when the checks should be paid, makes sure that the amount to be paid is correct, and forwards the checks for signature.
A typical business makes many downloads during the course of a year, many of them on credit, which means that the items bought are received today but paid for later. So this area of responsibility includes keeping files on all liabilities that arise from downloads on credit so that cash payments can be processed on time.
Not that I expected something exciting, but I figured it would at least be interesting. I was wrong in that sense.
Perhaps I wanted to test the Accountant waters and see what it was like. I had hoped to brush up on some of the Accounting Jargon and maybe refresh my memories of what exactly Accounting is.
The major parts of importance discuss how to read Financial Statements and other forms of Financial Reports. For instance, while profit is reported, it is not an independent account. Sometimes it goes by Net Earnings or Earnings.
Controllers are responsible for hiring, training, evaluating, promoting, and sometimes firing the persons who hold the various bookkeeping and accounting positions in an organization — which range from payroll functions to the several different types of tax returns that have to be filed on time with different government agencies.
The controller is the lead person in the financial planning and budgeting process of the business organization. Furthermore, the controller designs the accounting reports that all the managers in the organization receive — from the sales and marketing managers to the downloading and procurement managers. All the tough accounting questions and problems get referred to the controller.
Smaller businesses may employ only one accountant. Smaller businesses often call in a CPA for advice and help. The Language of Business, Investing, Finance, and Taxes State incorporation laws typically require that someone in the business be designated the treasurer, who has fiduciary responsibilities.
Also, these laws usually require that someone be designated the secretary. The organizational charts of larger businesses usually put their controller under their vice president for finance, or chief financial officer CFO.
The accounting functions in a business are integrated with and work in close coordination with its financial, treasury, and secretary functions. A springboard to other careers Many CPAs move on to other careers.
A recent article in the Journal of Accountancy featured former CPAs who moved on to other interesting careers. After a few years in public accounting, I went back to school, got my Ph.
These days, the starting salaries for new assistant professors of accounting are well into six digits! In this chapter, you get some juicy details. Then, in Part II, you really get the goods. Think back to when you learned to ride a bicycle.
Chapter 1 is like getting on the bike and learning to keep your balance. In this chapter, you put on your training wheels and start riding. The financial effects of making profit are not as simple as you may think. Profitmaking activities cause changes in the financial condition of a business — but maybe not the changes you suppose.
Making profit leaves many footprints on the financial condition of a business. Also in this chapter, I briefly discuss financial accounting and reporting standards. Businesses comply with established rules for recording revenue, income, expenses, and losses; for putting values on assets and liabilities; and for presenting and disclosing information in their financial reports.
The basic idea is that all businesses should follow uniform methods for measuring and reporting profit performance, and reporting financial condition and cash flows. Consistency in accounting from business to business is the goal. I explain who makes the rules, and I discuss two important recent developments: Opening the Books on Accounting Introducing the Information Content of Financial Statements This chapter focuses on the basic information components of each financial statement reported by a business.
In this first step, I do not address the classification, or grouping, of these information packets within each financial statement.
The first step is to get a good idea of the information content reported in financial statements. Setting up the business example To better illustrate the three primary financial statements, I need a realistic business example. The information content of its financial statements depends on the line of business a company is in — in other words, which types of products and services it sells.
The financial statements of a movie theater chain are different from those of a bank, which are different from those of an airline, which are different from an automobile manufacturer. Here, I use a fairly common type of business example. Here are the particulars of the business I use for the example: Chapter 2: Dollar amounts in the three financials are rounded off to the nearest thousand, which is not uncommon.
Dollar amounts can be reported out to the last dollar, or even the last penny for that matter. But too many digits in a dollar amount are hard to absorb, so many businesses round off the dollar amounts in their financial statements. These financial statements are stepping-stone illustrations that are concerned mainly with the basic information components in each statement.
Full-blown, classified financial statements are presented in Part II of the book. The financial statements in this chapter do not include all the information you see in actual financial statements. Also, I use descriptive labels for each item rather than the terse and technical titles you see in actual financial statements. And I strip out subtotals that you see in actual financial statements because they are not necessary at this point.
Oops, I forgot to mention a couple of things about financial statements. I should give you quick heads-up on these points. Financial statements are rather stiff and formal. Financial statements would get a G in the movies rating system. Seldom do you see any graphics or artwork in a financial statement itself, although you do see a fair amount of photos and graphics elsewhere in the financial reports of public companies.
However, I might mention that in his annual letter to the stockholders of Berkshire Hathaway, Warren Buffett includes some wonderful humor to make his points.
The income statement The income statement is the all-important financial statement that summarizes the profit-making activities of a business over a period of time. Figure shows the basic information content for an external income statement: The income statement in Figure shows six lines of information: Virtually all income statements disclose at least the four expenses shown in Figure The first two expenses cost of goods sold and selling, general, and administrative expenses take a big bite out of sales revenue.
The other two expenses interest and income tax are relatively small as a percent of annual sales revenue but important enough in their own right to be reported separately. Opening the Books on Accounting Figure Basic information components of the income statement. For example, a business could disclose separate expenses for advertising and sales promotion, depreciation, salaries and wages, research and development, and delivery and shipping — though reporting these expenses is not common.
Businesses do not disclose the compensation of top management in their external financial reports although this information can be found in the proxy statements of public companies that are filed with the Securities and Exchange Commission.
These internal profit performance reports to the managers of a business include a good deal more detailed information about expenses, and about sales revenue also. Reporting just four expenses to managers as shown in Figure would not do.
Sales revenue is from the sales of products and services to customers. Income refers to amounts earned by a business from sources other than sales; for example, a real estate rental business receives rental income from its tenants. In the example, the business has only sales revenue. As I mention above, businesses report the expenses shown in Figure — cost of goods sold expense, selling and general expenses, interest expense, and income tax expense.
Further breakdown of expenses is at the discretion of the business. Net income, being the bottom line of the income statement after deducting all expenses from sales revenue and income, if any , is called, not surprisingly, the bottom line.
It is also called net earnings. A few companies call it profit or net profit, but such terminology is not common. The income statement gets the most attention from business managers, lenders, and investors not that they ignore the other two financial statements. The very abbreviated versions of income statements that you see in the financial press, such as in The Wall Street Journal, report the top line sales revenue and income and the bottom line net income and not much more.
Refer to Chapter 4 for much more information on income statements. Financial Statements and Accounting Standards The balance sheet Figure shows the building blocks basic information components of a typical balance sheet.
One reason the balance sheet is called by this name is that its two sides balance, or are equal in total amounts. Generally speaking, five or more assets are reported in a typical balance sheet, starting with cash, and then receivables, and then cost of products held for sale, and so on down the line.
Generally five or more liabilities are disclosed, starting with trade credit liabilities from downloading on credit , and then unpaid expenses, and then proceeding through the interest-bearing debts of the business.
Basic information components of the balance sheet. Opening the Books on Accounting Most businesses need a variety of assets.
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You have cash, which every business needs, of course. Businesses that sell products carry an inventory of products awaiting sale to customers.
Businesses need long-term resources that are generally called property, plant, and equipment; this group includes buildings, vehicles, tools, machines, and other resources needed in their operations. I include just four basic assets in Figure These are the hardcore assets that a business selling products on credit would have. In this example, the business owns these so-called fixed assets. They are fixed because they are held for use in the operations of the business and are not for sale, and their usefulness lasts several years or longer.
So, where does a business get the money to download its assets? Most businesses borrow money on the basis of interest-bearing notes or other credit instruments for part of the total capital they need for their assets. Also, businesses download many things on credit and at the balance sheet date owe money to their suppliers, which will be paid in the future. These operating liabilities are never grouped with interest-bearing debt in the balance sheet.
The accountant would be tied to the stake for doing such a thing. Note that liabilities are not intermingled among assets — this is a definite no-no in financial reporting. You cannot subtract certain liabilities from certain assets and only report the net balance. You would be given 20 lashes for doing so. Well, not likely — unless the business has been losing money hand over fist. In the vast majority of cases a business has more total assets than total liabilities.
For two reasons: Sometimes this amount is referred to as net worth, because it equals total assets minus total liabilities. However, net worth is not a good term because it implies that the business is worth the Chapter 2: The market value of a business, when it needs to be known, depends on many factors.
A balance sheet could be whipped up anytime you want, say at the end of every day. In fact, some businesses such as banks and other financial institutions need daily balance sheets, but most businesses do not prepare balance sheets that often. In external financial reports those released outside the business to its lenders and investors , a balance sheet is required at the close of business on the last day of the income statement period.
If its annual or quarterly income statement ends, say, September 30; then the business reports its balance sheet at the close of business on September Its more formal name is the statement of financial condition. Just a reminder: The profit for the most recent period is found in the income statement; periodic profit is not reported in the balance sheet. The profit reported in the income statement is before any distributions from profit to owners. By the way, notice that the balance sheet in Figure is presented in a top and bottom format, instead of a left and right side format.
Either the vertical or horizontal mode of display is acceptable. You see both the portrait and the landscape layouts in financial reports. The statement of cash flows To survive and thrive, business managers confront three financial imperatives: Opening the Books on Accounting The income statement reports whether the business made a profit.
The balance sheet reports the financial condition of the business. Smart business managers hardly get the word net income or profit out of their mouths before mentioning cash flow.
Business is a two-headed dragon in this respect. Ignoring cash flow can pull the rug out from under a successful profit formula. Still, some managers are preoccupied with making profit and overlook cash flow.
For external financial reporting, the cash flows of a business are divided into three categories, which are shown in Figure The actual cash inflows from revenues and outflows for expenses run on a different timetable than when the sales revenue and expenses are recorded for determining profit. I give a more comprehensive explanation of the differences between cash flows and sales revenue and expenses in Chapter 6. The second part of the statement of cash flows sums up the long-term investments made by the business during the year, such as constructing a new production plant or replacing machinery and equipment.
If the business sold any of its long-term assets, it reports the cash inflows from these divestments in this section of the statement of cash flows. The cash flows of other investment activities if any are reported in this part of the statement as well.
The third part of the statement sums up the dealings between the business and its sources of capital during the period — borrowing money from lenders and raising new capital from its owners. Cash outflows to pay debt are reported in this section, as well as cash distributions from profit paid to the owners of the business. As you can see in part 3 of the statement of cash Chapter 2: By the way, in this example the business did not make cash distributions from profit to its owners.
I should make one point clear here: I could tell you that the statement of cash flows is relatively straightforward and easy to understand, but that would be a lie. The statements of cash flows reported by most businesses are frustratingly difficult to read. More about this issue in Chapter 6.
Figure presents the statement of cash flows for the business example as simply as I can possibly make it. Actual cash flow statements are much more complicated than the brief introduction to this financial statement that you see in Figure Basic information components in the statement of cash flows.
Opening the Books on Accounting Imagine you have a highlighter pen in your hand, and the three basic financial statements of a business are in front of you. What are the most important numbers to mark? Financial statements do not have any numbers highlighted; they do not come with headlines like newspapers.
You have to find your own headlines. Bottom-line profit net income in the income statement is one number you would mark for sure. Another key number is cash flow from operating activities in the statement of cash flows. This gap between profit and cash flow from operating activities is not unusual. Where is it? Is there some accounting sleight of hand going on?
These are good questions, and I will try to answer them as directly as I can without hitting you over the head with a lot of technical details at this point. Remember that the business sells on credit and its customers take time before actually paying the business.
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For example, a business that sells products downloads or makes the products, and then holds the products in inventory for some time before it sells the items to customers. Cash is paid out before the cost of goods sold expense is recorded. This is one example of a difference between cash flow connected with an expense and the amount recorded in the income statement for the expense. In Chapter 6, I explain the several factors that cause cash flow and bottom-line profit to diverge.
At this point the key idea to hold in mind is that the sales revenue reported in the income statement does not equal cash collections from customers during the year, and expenses do not equal cash payments during the year. Cash flow almost always is different from net income. Gleaning Key Information from Financial Statements The whole point of reporting financial statements is to provide important information to people who have a financial interest in the business — mainly its outside investors and lenders.
From that information, investors and lenders are able to answer key questions about the financial performance and condition of the business.
I discuss some of these key questions in this section. In Chapters 13 and 17, I discuss a longer list of questions and explain financial statement analysis. Here, I use the data from Figures and the dollar amounts are in thousands: Opening the Books on Accounting Profit looks pretty thin compared with annual sales revenue.
The company earns only 5 percent return on sales. In other words, 95 cents out of every sales dollar goes for expenses, and the company keeps only 5 cents for profit.
Many businesses earn 10 percent or higher return on sales. Is there enough cash? Cash is the lubricant of business activity. A business should keep enough cash on hand to keep things running smoothly even when there are interruptions in the normal inflows of cash. A business has to meet its payroll on time, for example. Keeping an adequate balance in the checking account serves as a buffer against unforeseen disruptions in normal cash inflows.
This cash balance is available for general business purposes. If there are restrictions on how it can use its cash balance, the business is obligated to disclose the restrictions. Interestingly, businesses do not have to comment on their cash balance. So, it has enough cash to pay these liabilities. Lenders are more interested in the ability of the business to control its cash flows, so that when the time comes to pay off loans it will be able to do so.
They know that the other, non-cash assets of the business will be converted into cash flow. Receivables will be collected, and products held in inventory will be sold and the sales will generate cash flow.
On the other hand, if it turns out that the business is not able to collect its receivables and is not able to sell its products, it would end up in deep doo-doo.
In the example, the business has an ending cash balance equal to 35 days of sales, calculated as follows: Can you trust the financial statement numbers? Whether the financial statements are correct or not depends on the answers to two basic questions: What can I tell you? There are a lot of crooks and dishonest persons in the business world who think nothing of manipulating the accounting numbers and cooking the books.
Also, organized crime is involved in many businesses. In short, there is a risk that the financial statements of a business could be incorrect and seriously misleading. Opening the Books on Accounting To increase the credibility of their financial statements, many businesses hire independent CPA auditors to examine their accounting systems and records and to express opinions on whether the financial statements conform to established standards.
In fact, some business lenders insist on an annual audit by an independent CPA firm as a condition of making the loan. The outside, non-management investors in a privately owned business could vote to have annual CPA audits of the financial statements.
Public companies have no choice; under federal securities laws, a public company is required to have annual audits by an independent CPA firm. Two points: CPA audits are not cheap, and these audits are not always effective in rooting out financial reporting fraud by high-level managers. I discuss these and other points in Chapter Why no cash distribution from profit? In this example the business did not distribute any of its profit for the year to its owners. Distributions from profit by a business corporation are called dividends.
Why not? In most cases, this would be the upper limit on how much cash a business would distribute from profit to its owners. But you got no cash return on your investment in the business. But you did not see any of this increase in your wallet. Deciding whether to make cash distributions from profit to shareowners is in the hands of the directors of a business corporation. Its shareowners elect the directors, and in theory the directors act in the best interests of the shareowners.
Generally the main reason for not making cash distributions from profit is to finance the growth of the business — to use all the cash flow from profit for expanding the assets needed by the business at the higher sales level. Ideally, the directors of the business would explain their decision not to distribute any money from profit to the shareowners. But, generally, no such comments are made in financial reports. Financial Statements and Accounting Standards Is making profit ethical?
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Many people have the view that making profit is unethical; they think profit is a form of theft — from employees who are not paid enough, from customers who are charged too much, from finding loopholes in the tax laws, and so on. I must admit that profit critics are sometimes proved right because some businesses make profit by using illegal or unethical means, such as false advertising, selling unsafe products, paying employees lower wages than they are legally entitled to, deliberately under-funding retirement plans for employees, and other immoral tactics.
Of course in making profit a business should comply with all applicable laws, conduct itself in an ethical manner, and play fair with everyone it deals with.
In my experience most businesses strive to behave according to high ethical standards, although under pressure they cut corners and take the low road in certain areas. Keep in mind that businesses provide jobs, pay several kinds of taxes, and are essential cogs in the economic system. Even though they are not perfect angels, where would we be without them? Keeping in Step with Accounting and Financial Reporting Standards The unimpeded flow of capital is absolutely critical in a free market economic system and in the international flow of capital between countries.
To make these decisions, they need the accounting information provided in financial statements of businesses. Imagine the confusion that would result if every business were permitted to invent its own accounting methods for measuring profit and for putting values on assets and liabilities. What if every business adopted its own individual accounting terminology and followed its own style for presenting financial statements?
Such a state of affairs would be a Tower of Babel. Recognizing U.
Opening the Books on Accounting complied with GAAP in reporting its cash flows, profit-making activities, and financial condition — unless the business makes very clear that it has prepared its financial statements using some other basis of accounting or has deviated from GAAP in one or more significant respects.
If GAAP are not the basis for preparing its financial statements, a business should make very clear which other basis of accounting is being used and should avoid using titles for its financial statements that are associated with GAAP.
For example, if a business uses a simple cash receipts and cash disbursements basis of accounting — which falls way short of GAAP — it should not use the terms income statement and balance sheet. The general consensus backed up by law is that businesses should use consistent accounting methods and terminology. General Motors and Microsoft should use the same accounting methods; so should Wells Fargo and Apple.
Of course, businesses in different industries have different types of transactions, but the same types of transactions should be accounted for in the same way. That is the goal.
There are upwards of 10, public companies in the United States and easily more than a million private-owned businesses. Now, am I telling you that all these businesses should use the same accounting methods, terminology, and presentation styles for their financial statements? Putting it in such a stark manner makes me suck in my breath a little. The correct answer is that all businesses should use the same rulebook of GAAP.
However, the rulebook permits alternative accounting methods for some transactions. Furthermore, accountants have to interpret the rules as they apply GAAP in actual situations. The devil is in the details. In the United States, GAAP constitute the gold standard for preparing financial statements of business entities although the gold is somewhat tarnished, as I discuss in later chapters.
The presumption is that any deviations from GAAP would cause misleading financial statements. If a business honestly thinks it should deviate from GAAP — in order to better reflect the economic reality of its transactions or situation — it should make very clear that it has not complied with GAAP in one or more respects. If deviations from GAAP are not disclosed, the business may have legal exposure to those who relied on the information in its financial report and suffered a loss attributable to the misleading nature of the information.
Financial Statements and Accounting Standards Financial accounting and reporting by government and not-for-profit entities In the grand scheme of things, the world of financial accounting and reporting can be divided into two hemispheres: A large body of authoritative rules and standards called generally accepted accounting principles GAAP have been hammered out over the years to govern accounting methods and financial reporting of business entities in the United States.
Accounting and financial reporting standards have also evolved and been established for government and not-for-profit entities. This book centers on business accounting methods and financial reporting. Financial reporting by government and not-for-profit entities is a broad and diverse territory, which is beyond the scope of this book.
Federal, state, and local government entities issue financial reports that are in the public domain, although few taxpayers are interested in reading them. The members or participants may have an equity interest or ownership share in the organization and, thus, they need financial reports to apprise them of their financial status with the entity. Government and other not-for profit entities should comply with the established accounting and financial reporting standards that apply to their type of entity.
Many not-forprofit entities use accounting methods different than business GAAP — in some cases very different — and the terminology in their financial reports is somewhat different than in the financial reports of business entities.
Getting to know the U. The basic idea behind the development of GAAP is to measure profit and to value assets and liabilities consistently from business to business — to establish broad-scale uniformity in accounting methods for all businesses. The idea is to make sure that all accountants are singing the same tune from the same hymnal. The purpose is also to establish realistic and objective methods for measuring profit and putting values on assets and liabilities.
The authoritative bodies write the tunes that accountants have to sing. Opening the Books on Accounting Who are these authoritative bodies? Also, the federal Securities and Exchange Commission SEC has broad powers over accounting and financial reporting standards for companies whose securities stocks and bonds are publicly traded.
Actually, the SEC outranks the FASB because it derives its authority from federal securities laws that govern the public issuance and trading in securities.
GAAP also include minimum requirements for disclosure, which refers to how information is classified and presented in financial statements and to the types of information that have to be included with the financial statements, mainly in the form of footnotes. The SEC makes the disclosure rules for public companies. Disclosure rules for private companies are controlled by GAAP.
Chapter 12 explains the disclosures that are required in addition to the three primary financial statements of a business the income statement, balance sheet, and statement of cash flows. The official set of GAAP rules is big — more than a thousand pages! These rules have evolved over many decades — some rules remaining the same for many years, some being superseded and modified from time to time, and new rules being added.
Like lawyers who have to keep up on the latest court cases, accountants have to keep up with the latest developments at the FASB and SEC and other places as well. Some people think the rules have become too complicated and far too technical. However, if the rules are not specific and detailed enough, different accountants will make different interpretations that will cause inconsistency from one business to the next regarding how profit is measured and how assets and liabilities are reported in the balance sheet.
So, the FASB is between a rock and a hard place. For the most part it issues rules that are rather detailed and technical. In short, the flow of capital has become international. Accounting and financial reporting standards in other countries are not bound by U. GAAP, and in fact there are significant differences that cause problems. The IASB was founded in Over 7, public companies have their securities listed on the several stock exchanges in the European Union EU countries.
Just the opposite: They are on a convergence course. They are working together toward developing global standards that all businesses would follow, regardless of which country a business is domiciled in. Of course political issues and national pride come into play. The term harmonization is favored, which sidesteps difficult issues regarding the future roles of the FASB and IASB in the issuance of international accounting standards. One major obstacle deterring the goal of world-wide accounting standards concerns which sort of standards should be issued: Its pronouncements have been very detailed and technical.
The idea is to leave very little room for differences of interpretation. Under this approach, accounting standards are stated in fairly broad general language and the detailed interpretation of the standards is left to accountants in the field.
The two authoritative bodies have disagreed on some key accounting issues, and the road to convergence of accounting standards will be rocky, in my view. The stability, development, and growth of an economy depend on securing capital from both inside and outside the country.
The flow of capital across borders by investors and lenders gives enormous impetus for the development of uniform international accounting standards.
Stay tuned; in the coming decade I think we will see more and more convergence of accounting standards in different countries.
Then again, I could be dead wrong. Noting a divide between public and private companies Traditionally, GAAP and financial reporting standards were viewed as equally applicable to public companies generally large corporations and private generally smaller companies. Today, however, we are witnessing a growing distinction between accounting and financial reporting standards for public versus private companies.
For example, many private companies still do not include a statement of cash flows in their financial reports, even though this has been a GAAP requirement since Private companies do not have many of the accounting problems of large, public companies.
For example, many public companies deal in complex derivative instruments, issue stock options to managers, provide highly developed defined-benefit retirement and health benefit plans for their employees, enter into complicated inter-company investment and joint venture operations, have complex organizational structures, and so on. Most private companies do not have to deal with these issues.
Finally, I should mention that smaller private businesses do not have as much money to spend on their accountants and auditors. Big companies can spend big bucks and hire highly qualified accountants. Furthermore, public companies are legally required to have annual audits by independent CPAs see Chapter The annual audit keeps a big business up-to-date on accounting and financial reporting standards. Frankly, smaller private companies are somewhat at a disadvantage in keeping up with accounting and financial reporting standards.
In other words, the accounting methods used for figuring taxable income and for figuring business profit before income tax are Chapter 2: Financial Statements and Accounting Standards in general agreement.
Having said this, I should point out that several differences do exist. A business may use one accounting method for filing its annual income tax returns and a different method for measuring its annual profit both internally for management reporting purposes and externally for preparing its financial statements to outsiders.
Many people argue that certain income tax accounting methods have had an unhealthy impact on GAAP. For example, the income tax law permits accelerated methods for depreciating long-lived operating assets — machines, tools, autos and trucks, and office equipment. Even the cost of buildings can be depreciated over shorter life spans than the actual lives of most buildings.
Other depreciation methods may be more realistic, but many businesses use accelerated depreciation methods both in their income tax returns and in their financial statements.
Following the rules and bending the rules An often repeated accounting story concerns three persons interviewing for an important accounting position. They are asked one key question: This story exaggerates, of course, but it does have an element of truth. Depending on estimates and assumptions The importance of estimates and assumptions in financial statement accounting is illustrated in a footnote you see in many annual financial reports such as the following: Examples of the more significant estimates include: The accountant can choose either pessimistic or optimistic estimates, and thereby record either conservative profit numbers or more aggressive profit numbers.
One key prediction made in preparing financial statements is called the going-concern assumption. The accountant assumes that the business is not facing imminent shutdown of its operations and the forced liquidations of its assets, and that it will continue as usual for the foreseeable future. If a business is in the middle of bankruptcy proceedings, the accountant changes focus to the liquidation values of its assets.
Many accounting standards leave a lot of wiggle room for interpretation.The asset values reported in the balance sheet are the amounts recorded when the assets were originally acquired — although I should mention that an asset is written down below its historical cost when the asset has suffered a loss in value.
The financial statements of a movie theater chain are different from those of a bank, which are different from those of an airline, which are different from an automobile manufacturer. Most businesses are in constant flux, and the chart of accounts has to keep up with these changes. Before his year tenure at Boulder, he was on the business faculty for four years at the University of California in Berkeley. Well, a great deal of the information you use in making personal finance and investing decisions is accounting information.
So the book is really useful. For example, the cost of goods sold expense is determined in a schedule that also requires inventory cost at the beginning of the year, downloads during the year, cost of labor during the year for manufacturers , other costs, and inventory cost at year-end.
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