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Quick Start YOUR BUSINESS AccountingAccounting forfor Non-Non- AccountantsAccountants The fast and Manage yourManage your easy way to business betterbusiness better through expert accountingthrough expert accounting learn the basics explanations, examples,explanations, examples, techniques and tips!techniques and tips! Demystify debits and credits The cash flow statement Read a financial statement Create and manage Understand quality budgets effectively of earnings Work with auditors Understand corporate What are the key ratios transactions in understanding your How to put together an business income statement DR. WAYNE A. LABEL, CPA
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Copyright © 2006 by Wayne A. Label Cover and internal design © 2006 by Sourcebooks, Inc. © Copyright 2005 Station Casinos, Inc; Design: Kuhlmann Leavitt, Inc., St. Louis Sourcebooks and the colophon are registered trademarks of Sourcebooks, Inc. All rights reserved. No part of this book may be reproduced in any form or by any elec- tronic or mechanical means including information storage and retrieval systems— except in the case of brief quotations embodied in critical articles or reviews—without permission in writing from its publisher, Sourcebooks, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.—From a Declaration of Principles Jointly Adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations All brand names and product names used in this book are trademarks, registered trade- marks, or trade names of their respective holders. Sourcebooks, Inc., is not associated with any product or vendor in this book. Published by Sourcebooks, Inc. P.O. Box 4410, Naperville, Illinois 60567-4410 (630) 961-3900 FAX: (630) 961-2168 www.sourcebooks.com Library of Congress Cataloging-in-Publication Data Label, Wayne A. (Wayne Allan) Accounting for non-accountants : the fast and easy way to learn the basics / Wayne Label. p. cm. ISBN-13: 978-1-4022-1483-7 Includes bibliographical references and index. ISBN-13: 978-1-4022-0657-3 ISBN-10: 1-4022-0657-7 1. Accounting. 2. Financial statements. I. Title. II. Title: Accounting for nonaccoun- tants. HF5636.L33 2006 657—dc22 2006012421 Printed and bound in the United States of America. DR 10 9 8 7 6 5 4 3 2 1
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Contents ACKNOWLEDGMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .ix INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 CHAPTER 1: Introducing Accounting and Financial Statements . . . . . .3 • What Is Accounting? • Who Uses Accounting Information? • Financial Statements • How Different Business Entities Present Accounting Information CHAPTER 2: Generally Accepted Accounting Principles . . . . . . . . . . .13 • Who Are the SEC, AICPA, and the FASB? • Generally Accepted Accounting Principles (GAAP) CHAPTER 3: The Balance Sheet and Its Components . . . . . . . . . . . . .25 • Understanding the Balance Sheet • The Accounting Equation • The Components of the Balance Sheet • The Transactions Behind the Balance Sheet CHAPTER 4: The Income Statement . . . . . . . . . . . . . . . . . . . . . . . . . . .45 • Understanding the Income Statement • The Income Statement Illustrated • Transactions That Effect the Income Statement CHAPTER 5: Preparing and Using a Statement of Cash Flows . . . . .65 • What Is a Statement of Cash Flows? • Cash and Cash Equivalents • The Statement of Cash Flows Illustrated CHAPTER 6: Double-Entry Accounting . . . . . . . . . . . . . . . . . . . . . . . . .75 • The General Journal • The General Ledger • Adjusting Journal Entries • Closing Journal Entries
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CHAPTER 7: The Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .101 • The Corporation Defined • What Is Capital Stock? • Dividends and Splits • Incorporating Solana Beach Bicycle Company • What Is Treasury Stock? CHAPTER 8: Using Financial Statements for Short-Term Analysis . .125 • Using Short-Term Ratios • Current and Quick Ratios • Working Capital • Composition of Assets CHAPTER 9: Using Financial Statements for Long-Term Analysis . .137 • Quality of Earnings • Rate of Return on Investment • Sales-Based Ratios or Percentages • Earnings Data • Long-Term Debt Position • Dividend Data • Footnotes CHAPTER 10: Budgeting for Your Business . . . . . . . . . . . . . . . . . . . .149 • What Is a Budget? • Planning and Control • Advantages of Budgeting • The Master Budget • Sales Budget • Capital Budget • Budgeted Income Statement • The Cash Budget CHAPTER 11: Audits and Auditors . . . . . . . . . . . . . . . . . . . . . . . . . . .159 • What Is an Audit? • Types of Auditors • The Standard Audit Opinion Illustrated
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• The Parts of the Report • Other Types of Audit Reports • Why Audits Are Useful to You APPENDIX A: Internet for Accountants . . . . . . . . . . . . . . . . . . . . . . .171 APPENDIX B: Financial Statements—Station Casinos, Inc. . . . . . . . .175 INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .221 ABOUT THE AUTHOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .227
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Acknowledgments I would like to thank Ewurama Ewusi-Mensah and Rachel Jay at Sourcebooks for their tireless efforts to make this book readable and under- standable to the non-accountants of the world. I would also like to thank Drs. Bruce Lubich and Richard Samuelson for their time and effort in reading the manuscript, adding valuable insights, and making the book a better read. Finally, I would like to thank the thousands of students and users of my previous book on this same topic whose comments and suggestions have helped to improve this book.
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Introduction What is accounting? Who needs it? How does it benefit businesses? This book answers those questions for the non-accountant. Accounting provides information that helps people in business increase their chances of making decisions that will benefit their companies. Accounting is the language of business, and like other languages, it has its own terms and rules. Understanding this language and learning to interpret it is your first step to becoming successful in your own business and in your personal financial life as well. In your personal life you can use accounting information to make decisions about investing in the stock market, applying for a loan, and evaluating poten- tial jobs. Banks use accounting information to make decisions about granting loans. Government agencies base their regulations on accounting information. Accounting information can even be useful to non-business entities with an interest in how businesses affect local, national, or foreign communities and community members. Businesses use accounting information for planning and budgeting and for making decisions about borrowing and investing. Overall, accounting aids businesses in the process of making better decisions. The basics of accounting are the same regardless of the size or type of business. In Accounting for Non-Accountants, you will learn the basics of accounting through the examination of an imaginary small business, Solana Beach Bicycle Company. For more complex businesses, the economic trans- actions become more varied and complex as does the process of reporting them to various users. The foundation of it all, however, remains the same. This book will give you a solid foundation you will be able to use in any accounting situation you encounter. Whether you own a business or do not, even if you’ve never had any expe- rience with accounting and financial statements, this is the book for you. I hope that you find this book useful in helping you to understand these accounting issues as they apply to your small business and to your personal life. Please feel free to contact me at wayne@waynelabel.com with your thoughts on the book.
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1 Chapter Introducing Accounting and Financial Statements g What Is Accounting? g Who Uses Accounting Information? g Financial Statements g How Different Business Entities Present Accounting Information
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4 Accounting for Non-Accountants What Is Accounting? The purpose of accounting is to provide information that will help you make correct financial decisions. Your accountant’s job is to give you the information you need to run your business as efficiently as possible while maximizing profits and keeping costs low. QUICK Tip Finding an Accountant: Hiring a professional and ethical accountant to aid in your business operations can be critical to the success of your company. Meet with a few accountants before making a final choice so that you know your options and can select one whose experience and work style will be best suited to your needs and the needs of your business. Local chapters of your state societies of CPAs offer referral services that can help with this. Accounting plays a role in businesses of all sizes. Your kids’ lemonade stand, a one-person business, and a multinational corporation all use the same basic accounting principles. Accounting is legislated; it affects your taxes; even the president plays a role in how accounting affects you. The list goes on and on. Accounting is the language of business. It is the process of recording, classifying, and summarizing economic events through certain documents or financial statements. Like any other language, accounting has its own terms and rules. To understand how to interpret and use the information accounting provides, you must first understand this language. Understanding the basic concepts of accounting is essential to success in business. Different types of information furnished by accountants are shown in Figure 1.1 on the next page.
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Introducing Accounting and Financial Statements 5 Figure 1.1: TYPES OF INFORMATION PROVIDED BY ACCOUNTANTS • Information prepared exclusively by people within a company (managers, employees, or owners) for their own use. • Financial information required by various government agencies such as the Internal Revenue Service (IRS), Securities and Exchange Commission (SEC), and the Federal Trade Commission (FTC). • General information about companies provided to people outside the firm such as investors, creditors, and labor unions. Accounting and Bookkeeping Bookkeeping procedures and bookkeepers record and keep track of the business transactions that are later used to generate financial statements. Most bookkeeping procedures have been systematized, and, in many cases, can be handled by computer programs. Bookkeeping is a very important part of the accounting process, but it is just the beginning. There is currently no certification required to become a bookkeeper in the United States. Accounting is the process of preparing and analyzing financial statements based on the transactions recorded through the bookkeeping process. Accountants are usually professionals who have completed at least a bache- lor’s degree in accounting, and often have passed a professional examination, like the Certified Public Accountant Examination, the Certified Management Accountant Examination, or the Certified Fraud Auditor Examination. Accounting goes beyond bookkeeping and the recording of economic information to include the summarizing and reporting of this information in a way that is meant to drive decision making within a business. Who Uses Accounting Information? In the world of business, accounting plays an important role to aid in mak- ing critical decisions. The more complex the decision, the more detailed the information must be. Individuals and companies need different kinds of information to make their business decisions.
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6 Accounting for Non-Accountants Let’s start with you as an individual. Why would you be interested in accounting? Accounting knowledge can help you with investing in the stock market, applying for a home loan, evaluating a potential job, balancing a checkbook, and starting a personal savings plan, among other things. Managers within a business also use accounting information daily to make decisions, although most of these managers are not accountants. Some of the decisions they might make for which they will use accounting infor- mation are illustrated below in Figure 1.2 Figure 1.2: AREAS IN WHICH MANAGERS USE ACCOUNTING INFORMATION • Marketing (Which line of goods should the company emphasize?) • Production (Should the company produce its goods in the United States or open a new plant in Mexico?) • Research and Development (How much money should be set aside for new product development?) • Sales (Should the company expand the advertising budget and take money away from some other part of the marketing budget?) Without the proper accounting information these types of decisions would be very difficult, if not impossible, to make. Bankers continually use accounting information. They are in the business of taking care of your money and making money with your money, so they absolutely must make good decisions. Accounting is fundamental to their decision-making process. Figure 1.3 looks at some of the decisions bankers make using accounting information. Figure 1.3: AREAS IN WHICH BANKERS USE ACCOUNTING INFORMATION • Granting loans to individuals and companies • Investing clients’ money • Setting interest rates • Meeting federal regulations for protecting your money
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Introducing Accounting and Financial Statements 7 Government agencies such as the Internal Revenue Service (IRS), the Securities and Exchange Commission (SEC), the Federal Trade Commission (FTC), and the Bureau of Alcohol, Tobacco, and Firearms (ATF) base their regulation enforcement and compliance on the accounting information they receive. Accountability in Accounting A business’s financial statements can also be of great interest to other mem- bers of the local or national community. Labor groups might be interested in what impact management’s financial decisions have on their unions and other employees. Local communities have an interest in how a business’s financial decisions (for example, layoffs or plant closings) will impact their citizens. As the economy becomes more complex, so do the transactions within a business, and the process of reporting them to various users and making them understandable becomes more complex as well. A solid knowledge of accounting is helpful to individuals, managers, and business owners who are making their decisions based on the information accounting documents provide. Financial Statements Accountants supply information to people both inside and outside the firm by issuing formal reports that are called financial statements. The financial statements are usually issued at least once a year. In many cases they are issued quarterly or more often where necessary. A set of rules, called Generally Accepted Accounting Principles, govern the preparation of the financial statements. Generally Accepted Accounting Principles (GAAP) has been defined as a set of objectives, conventions, and principles to govern the preparation and presentation of financial statements. These rules can be found in volumes of documents issued by the American Institute of Certified Public Accountants (AICPA), the Financial Accounting Standards Board (FASB), the Internal Revenue Service (IRS), the Securities and Exchange Commission (SEC), and other regulatory bod- ies. In chapter 2 we look at some of the overriding principles of accounting as they apply to all businesses and individuals.
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8 Accounting for Non-Accountants The Basic Financial Statements The basic financial statements include the Balance Sheet, the Income Statement, the Statement of Cash Flows, and the Statement of Retained Earnings. We will look at these in depth in the following chapters and see how they all interact with each other. As we discuss these financial state- ments, you will see they are not as scary as you might have thought they would be. Many of the concepts will already be familiar to you. In the appendix, you can see examples of these financial statements from Station Casinos, Inc., a publicly traded company which operates several casinos and hotels in the Las Vegas, Nevada, area. The Balance Sheet is the statement that presents the Assets of the com- pany (those items owned by the company) and the Liabilities (those items owed to others by the company). The Income Statement shows all of the Revenues of the company less the Expenses, to arrive at the “bottom line,” the Net Income. The Statement of Cash Flows shows how much cash we started the peri- od with, what additions and subtractions were made during the period, and how much cash we have left over at the end of the period. The Statement of Retained Earnings shows how the balance in Retained Earnings has changed during the period of time (year, quarter, month) for which the financial statements are being prepared. Normally there are only two types of events that will cause the beginning balance to change: 1) the company makes a profit, which causes an increase in Retained Earnings (or the company suffers a loss, which would cause a decrease) and 2) the own- ers of the company withdraw money, which causes the beginning balance to decrease (or invest more money, which will cause it to increase). Alert! Seeing the Bigger Picture: None of these financial statements alone can tell the whole story about a company. We need to know how to read, understand, and analyze these statements as a package in order to make any kind of decisions about the company. In addition to the financial statements, you must understand the industry you are operating in and the general economy.
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Introducing Accounting and Financial Statements 9 Financial statements vary in form depending upon the type of business they are used in. In general there are three forms of business operating in the United States—proprietorships, partnerships, and corporations. How Different Business Entities Present Accounting Information Proprietorships are businesses with a single owner like you and me. These types of businesses tend to be small retail businesses started by entrepreneurs. The accounting for these proprietorships includes only the records of the business—not the personal financial records of the proprietor of the business. Alert! Don’t Mix and Match: The financial records of an individual owner of a busi- ness should never be combined with those of the business. They are two sepa- rate entities and need to be accounted for separately. Taking money from one of these entities (the business) for the other (the owner), must be accounted for by both entities. Partnerships are very similar to proprietorships, except that instead of one owner, there are two or more owners. In general most of these busi- nesses are small to medium-sized. However, there are some exceptions, such as large national or even international accounting or law firms that may have thousands of partners. As with the proprietorships, accounting treats these organizations’ records as separate and distinct from those of the individual partners. Finally, there are corporations. These are businesses that are owned by one or more stockholders. These owners may or may not have a manageri- al interest in the company. Many of these stockholders are simply private citizens who have money invested in the company by way of stocks that they have purchased. In a corporation a person becomes an owner by buying shares in the com- pany and thus becomes a stockholder. The stockholders may or may not
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