Accounting DeMYSTiFieD

The McGraw-Hill Companies, Inc.

Contents

Excerpt

CHAPTER 1

Where Did All This Lingo Come From?

Business is very simple. Money flows into an organization, and money flows out.But we in the finance and accounting profession sometimes get a little out ofhand giving fancy names to very simple concepts. This fancy lingo can cause morethan a little bit of confusion. So it is helpful to envision accounting as aforeign language. Most of the rules and concepts are perfectly intuitive andsimple; you just have to know what to call them.

The title of this book, Accounting Demystified, is very appropriate. Itis definitely attributing too much romance and intrigue to the profession tocall it a mystery, but it does probably sell a few more books than the title,Clarifying Accounting Lingo. (This is why I am writing and someone elseis marketing this book!)

CHAPTER OBJECTIVES

• Describe the origin and general purpose of accounting

• Introduce the three key financial statements

I want to give you the ability to have an intelligent conversation with anaccountant or finance person. I want you to be able to justify your actions interms that the folks holding the purse strings can understand and appreciate. Iwant you to be able to go to meetings with your management team and understandwhat the heck they are talking about. I don't want you to have to nod your headlike you understand when you don't, so I am going to give you the knowledge toask intelligent questions regarding finance.

What I am not going to do is bore you or muddy the waters with a load ofunnecessary detail. You know, I was out of college and already had my certifiedpublic accountant (CPA) certificate before all the detail the accountingprofessors had me memorize gelled together in my head to form a big picture. Iam going to take the opposite approach with you. We are going to start with thebig picture and then go into a bit of detail. We are not going to go into superdetail. I think it is best to keep it at a high level.

I am not going to tell you how to handle an advance repurchase agreement onstock or how to calculate a bond discount. This is too much detail for 99.99percent of the population—and probably you. However, if you do need thiskind of detail, this book will give you the basis to start asking thosequestions and understanding what the finance person says in response.

As Glinda the Good Witch says in The Wizard of Oz, "It is always best tostart at the beginning." So let's take a minute to get a sense of how thissystem we have in place began a long time ago. It actually started in a veryromantic and sometimes mysterious and dramatic place—Italy.

The Birth of the Accountant

The system we use today to track money in business was invented in Italy duringthe Renaissance. An Italian merchant invented it so that he could easilysummarize his results at the end of the day. The system had a simple method ofchecks and balances to make sure that everything he had recorded was donecorrectly.

The Italian merchant called his system the double-entry accountingsystem, and it was very simple to understand. Each and every transactionmust balance. The "ins" had to equal the "outs." This is the root of debits andcredits that we will talk about in more detail in Chapter 6.

For instance, let's say this merchant sold jewelry. When he sold a piece ofjewelry, the jewelry went out of his business. In return something camein— some cash. Through a series of entries in his books, the inswould equal the outs.

With this system, the merchant could make sure that every transaction wasrecorded completely because the books had to balance. If the books didn'tbalance, the merchant knew that he had missed something.

This system also was useful in that it posted the information to discreteaccounts or categories that could be summarized at the end of the day. Themerchant could look at his cash account category and see how much cash he hadbrought in that day; he could look at his jewelry inventory category to see howmuch jewelry he had left to sell. All very convenient.

This system was so convenient and useful that the merchant decided to share itwith his friends. His friends liked it, and because Italy was a trade center,soon businesses all over the world were using the system. (Don't ask me whatthey were doing previous to this; I imagine just keeping a list of cash on longsheets of parchment.)

But the folks who were the most excited about this new system were thelenders—the banks and financiers who gave merchants money to expand theirbusinesses. Before this system, the banks and financiers had to rely onsubjective information to decide who to loan money to. They made decisions basedon family reputation, where they lived, or what kind of carriage they drove. Nowthey could decide based on some real hard data.

The only problem is that everyone's data looked a little different because theyall used different rules. They chose how to treat a transaction according to howgood it made their books look.

For example, let's say that you are a sales representative for the famous artistMichelangelo. Your job is to find him commissions so that he can concentrate onhis art, not on selling. The head of the Medici family, a very influential andwealthy Italian family, has commissioned Michelangelo—through you—tosculpt a replica of David for the foyer of the family villa.

When do you record a sale in your books? When you shake hands with the head ofthe Medici clan and say, "We'll have it to you in three years"? Or whenMichelangelo puts chisel to marble? Or when the statue is installed in thevilla? Do you record a sale when you bill for the statue or when the Medicis payin cash?

All these viewpoints have validity. The lenders didn't like this at all. Theydesired consistency. They wanted everyone to use the same rules so that theirfinancial statements would be comparable. They wanted to know, when choosing toinvest in one of three businesses, which business actually was doing better.

The lenders demanded rules so that everyone would be consistent. It was thenthat accountants were born. Accountants are just the folks who know the rules onhow to keep the records consistent. A dark day in the annals of history, I know,but....

Gaps in GAAP?

Nowadays accounting rules are voluminous. The standards that accountants use tocreate financial statements are called generally accepted accountingprinciples (GAAP). There is a set of GAAP that applies to most everyone, andthen there is GAAP for specific industries. The oil and gas business hasdifferent transactions than a software developer, so we have to have differentrules for each group.

GAAP is created by a rule-making body called the Financial AccountingStandards Board (FASB, pronounced "faz-bee"). Governmental entities such ascities and counties have their own rule-setting body called the GovernmentalAccounting Standards Board (GASB, pronounced "gaz-bee").

Unfortunately, GAAP is full of gaps or loopholes. GAAP is designed to makefinancial statements comparable and consistent. And generally, most transactionsare treated conservatively, meaning that transactions are not recorded until weare absolutely sure that the transaction will occur or actually has occurred.

But some organizations take advantage of the gaps in GAAP just to make theirfinancial statements look a little bit better than those of their competitors.Wealthy folks hire savvy tax accountants to find shelters for their wealth sothat they don't have to pay so much tax. Corporations hire savvy accountants toenhance their financial results. In essence, the tax accountant is hired to takeadvantage of the loopholes in the tax code. Well, GAAP is also full of theseloopholes. You can't think of everything someone would do.

In the early 2000s, Enron was caught taking advantages of these loopholes topuff up its financial results. Years after the scandal broke, many members ofthe Enron executive team were still roaming free. Enron saw a loophole in GAAPand took full advantage of it.

Now, WorldCom was another story. The leaders at WorldCom took a hard-and-fastGAAP rule and broke it outright. They were immediately arrested and jailed.

And now that it appears that the accounting profession did not do a very goodjob regulating itself with GAAP and licensing efforts, the federal governmenthas stepped in to create even more rules and regulations for accountants tofollow. Now the profession is adopting international accounting standards thatwill change the look and contents of traditional financial statements.

Have I turned you off from a career in accounting yet? Wait, there's more! No,actually, I'll stop. It is too depressing to go on.

Another related profession was invented at the same time as accounting. It isthe group that comes in to make sure that you are following GAAP.Right—it's the auditors. Talk about some shakeups in aprofession—but that is another story for another book.

One Huge Database

Now back to this double-entry accounting system. How many transactions do youthink a behemoth organization such as IBM has per day? I don't even know, but Iknow it's plenty—tens of thousands at least.

All these transactions are captured in a huge database. Every company has one;it is called the general ledger. This general ledger, like any database,has fields of information. And according to how detailed you want to get, it canhave dozens of fields of information. Information the general ledger capturesincludes

• Date of transaction

• Amount of transaction

• Debit or credit

• Account title and code

• Budget code

• Vendor

• Purchase order number

• Invoice number

• Payment date

• Payment method

And the general ledger, just like any database, can be sorted just about any wayyou want. Accountants will tell you that this is not true because they don'twant to generate a bunch of different reports, but they can sort it by date, byamount, by account, by budget code, and so on.

So let's pretend that you and I work at IBM. You are a muckety-muck executivemanager, and I am your accountant. I am not very customer-focused; I just entertransactions and tell people no all day. So I print out the general ledger forthe week on that green-and-white striped general ledger paper with the holes inthe side, and I load it on a dolly. It is sorted by date entered. How big do youthink that stack would be? It easily could take me several dollies to deliverthe report to you.

So I walk into your office and dump the report at your feet and say, "Happydecision making!" and walk out. My job is done.

Is this what you want? No, you don't want all this detail; you want a summary.

The Three Key Financial Statements Are Just Summaries

That is all the three key financial statements are—summaries of thegeneral ledger from three different perspectives. They are the summaries thateveryone is used to seeing and using. Every publicly traded company in theUnited States generates these three key financial statements.

The balance sheet (Figure 1.1) is the super summary of thegeneral ledger. It is the general ledger rolled up into as few categories aspossible.

The balance sheet is called the balance sheet because it has to balance, justlike the general ledger does and just like every transaction entered into thegeneral ledger does.

I also call the balance sheet the mother of all financial statements. The othertwo financial statements are the babies of this mother.

Over the centuries, someone said, "I appreciate your sharing this balance sheetwith me, but I could use a little more detail. In particular, I could use alittle more detail about how you generated earnings." So we put a littlemagnifying glass on retained earnings and tracked how earnings were generatedwith the earnings statement.

Some call it the income statement (Figure 1.2), some theprofit and loss statement, the P&L, or even the statement ofearnings. No matter what it is called, it picks out only transactions fromthe general ledger that contributed to the earnings or the profit that theorganization generated. It is the baby of the balance sheet, giving us detailonly on earnings.

The third key financial statement was added to the bunch only recently. The FASBstarted requiring it after the savings and loan crisis. It, too, is a baby ofthe balance sheet because it takes one item off the balance sheet and gives usmore detail on where it came from. It focuses on cash, my favorite businessasset.

The cash-flow statement is very similar to your bank account statementthat you get at home. It tells you how much money you started the month with,how much cash you paid out, how much cash you deposited, and how much cash isleft at the end of the month (Figure 1.3).

Cash is the lifeblood of business; without it, you can't pay payroll, pay bills,or buy any inventory to sell.

Each of these financial statements will be described in greater detail in laterchapters. All the statements put together tell a story about thebusiness—and every story is unique. The income statement for a servicebusiness will look entirely different than the income statement for amanufacturing operation. Okay, not entirely different, but different enough tomake it interesting.

And these three key financial statements contain about 80 percent of thebusiness lingo that finance and accounting folks throw around on a regularbasis. So, if you get a grip on them, understand what they tell you and don'ttell you, and know how they are related to each other, you will have mastered agood portion of business-speak.

Liquidity, Profitability, Growth, and Financing

Most stories of how well a business is doing focus on three main questions:

• How flexible or liquid is the organization?

• How profitable is the organization?

• How is the business financed?

Each of these questions can be answered by looking at the three key financialstatements. Let's first look at the balance sheet and discuss liquidity andfinancing.

Summary

Luckily for me and for you, accounting isn't rocket science or molecularbiology! Think of it as a foreign language—a language that seeks tocategorize the ins and outs of resources in a business.

QUIZ

1. Accountants were born out of the need for?

A. Lender's desires for consistent, comparable record keeping

B. Acceptance of the double-entry system in business

C. Knowing when to bill for long-term orders, say, a statue that was to be made

D. A system that would improve Italy's trade with the rest of the world.

2. Cities and counties have their own accounting standards board called the____.

A. GAAP

B. FASB

C. GASB

D. FAF

3. Companies' daily financial transactions are captured in this hugedatabase called ____.

A. an earnings statement

B. the general ledger

C. a profit and loss statement

D. a cash-flow statement

4. Income statement, profit and loss statement, the P&L, and the earningsstatement are all different names for which of the following statements?

A. Earnings statement

B. The general ledger

C. Balance sheet

D. Cash-flow statement

5. FASB started requiring this financial statement after the savings andloan crisis of the 1980s.

A. Earnings statement

B. Profit and loss statement

C. Balance sheet

D. Cash-flow statement

6. The three key financial statements are _____.

A. unorganized lists of accounting data

B. summaries of the general ledger

C. too detailed to use

7. The cash-flow statement is similar to _____.

A. a cash register receipt

B. an income statement

C. a balance sheet

D. a bank account statement

8. The bottom line on the income statement is called _____.

A. net income

B. net worth

C. owners' equity

D. net assets

9. Balance sheet components include _____.

A. fixed assets, net income, and cash

B. fixed assets, cash, and accounts payable

C. cash, cost of goods sold, and operating expenses

10. Which of the following financial statements discloses the total amountof fixed assets held?

A. The income statement

B. The statement of shareholders' equity

C. The balance sheet

D. The cash-flow statement

(Continues...)
(Continues...)Excerpted from Accounting DeMYSTiFieD by Leita Hart-Fanta. Copyright © 2011 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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