bankers.
42 Part I: Getting Down to Financial Reporting Basics Chapter 4
Digging into Accounting Basics
In This Chapter
▶ Understanding the two main accounting methods
▶ Deciphering debits and credits
▶ Examining the Chart of Accounts
▶ Looking at the different types of profit
Ah, the language of financial accounting — debits, credits, double-entry accounting! Just reading the words makes your heart beat faster, doesn’t it? The language and practices of accountants can get the best of anyone, but there’s a method to the madness, and figuring out that method is a crucial first step to understanding financial reports. In this chapter, I help you understand the logic behind the baffling and unique world of financial accounting. And you won’t even need a pocket protector!
Making Sense of Accounting Methods
Officially, two types of accounting methods dictate how a company’s transactions are recorded in its financial books: cash-basis accounting and accrual accounting. The key difference between the two types is how the company records cash coming into and going out of the business. Within that simple difference lies a lot of room for error — or manipulation. In fact, many of the major corporations involved in financial scandals have gotten in trouble because they played games with the nuts and bolts of their accounting method. I talk more about those games in Chapter 23.
Cash-basis accounting
In cash-basis accounting, companies record expenses in financial accounts when the cash is actually laid out, and they book revenue when they actually hold the cash in their hot little hands or, more likely, in a bank account. For 44 Part I: Getting Down to Financial Reporting Basics example, if a painter completes a project on December 30, 2008, but doesn’t get paid for it until the owner inspects it on January 10, 2009, the painter reports those cash earnings on his 2009 tax report. In cash-basis accounting, cash earnings include checks, credit-card receipts, or any other form of revenue from customers.
Smaller companies that haven’t formally incorporated, and most sole proprietors, use cash-basis accounting because the system is easier for them to use on their own, meaning they don’t have to hire a large accounting staff.
Accrual accounting
If a company uses accrual accounting, it records revenue when the actual transaction is completed (such as the completion of work specified in a contract agreement between the company and its customer), not when it receives the cash. That is, the company records revenue when it earns it, even if the customer hasn’t paid yet. For example, a carpentry contractor who uses accrual accounting records the revenue he earns when he completes the job, even if the customer hasn’t paid the final bill yet.
Expenses are handled in the same way. The company records any expenses when they’re incurred, even if it hasn’t paid for the supplies yet. For example, when a carpenter buys lumber for a job, he may very likely do so on account and not actually lay out the cash for the lumber until a month or so later when he gets the bill.
All incorporated companies must use accrual accounting according to the generally accepted accounting principles (GAAP) because revenues are matched to expenses in the same month they occur. If you’re reading a corporation’s financial reports, what you see is based on accrual accounting.
Why method matters
The accounting method a business uses can have a major impact on the total revenue it reports, as well as on the expenses it subtracts from the revenue to get the bottom line. Here’s how:
✓
Cash-basis accounting: Expenses and revenues aren’t carefully matched on a month-to-month basis. Expenses aren’t recognized until the money is actually paid out, even if the expenses are incurred in previous months, and revenues earned in previous months aren’t recognized until the cash is actually received. However, cash-basis
42 Part I: Getting Down to Financial Reporting Basics Chapter 4
Digging into Accounting Basics
In This Chapter
▶ Understanding the two main accounting methods
▶ Deciphering debits and credits
▶ Examining the Chart of Accounts
▶ Looking at the different types of profit
Ah, the language of financial accounting — debits, credits, double-entry accounting! Just reading the words makes your heart beat faster, doesn’t it? The language and practices of accountants can get the best of anyone, but there’s a method to the madness, and figuring out that method is a crucial first step to understanding financial reports. In this chapter, I help you understand the logic behind the baffling and unique world of financial accounting. And you won’t even need a pocket protector!
Making Sense of Accounting Methods
Officially, two types of accounting methods dictate how a company’s transactions are recorded in its financial books: cash-basis accounting and accrual accounting. The key difference between the two types is how the company records cash coming into and going out of the business. Within that simple difference lies a lot of room for error — or manipulation. In fact, many of the major corporations involved in financial scandals have gotten in trouble because they played games with the nuts and bolts of their accounting method. I talk more about those games in Chapter 23.
Cash-basis accounting
In cash-basis accounting, companies record expenses in financial accounts when the cash is actually laid out, and they book revenue when they actually hold the cash in their hot little hands or, more likely, in a bank account. For 44 Part I: Getting Down to Financial Reporting Basics example, if a painter completes a project on December 30, 2008, but doesn’t get paid for it until the owner inspects it on January 10, 2009, the painter reports those cash earnings on his 2009 tax report. In cash-basis accounting, cash earnings include checks, credit-card receipts, or any other form of revenue from customers.
Smaller companies that haven’t formally incorporated, and most sole proprietors, use cash-basis accounting because the system is easier for them to use on their own, meaning they don’t have to hire a large accounting staff.
Accrual accounting
If a company uses accrual accounting, it records revenue when the actual transaction is completed (such as the completion of work specified in a contract agreement between the company and its customer), not when it receives the cash. That is, the company records revenue when it earns it, even if the customer hasn’t paid yet. For example, a carpentry contractor who uses accrual accounting records the revenue he earns when he completes the job, even if the customer hasn’t paid the final bill yet.
Expenses are handled in the same way. The company records any expenses when they’re incurred, even if it hasn’t paid for the supplies yet. For example, when a carpenter buys lumber for a job, he may very likely do so on account and not actually lay out the cash for the lumber until a month or so later when he gets the bill.
All incorporated companies must use accrual accounting according to the generally accepted accounting principles (GAAP) because revenues are matched to expenses in the same month they occur. If you’re reading a corporation’s financial reports, what you see is based on accrual accounting.
Why method matters
The accounting method a business uses can have a major impact on the total revenue it reports, as well as on the expenses it subtracts from the revenue to get the bottom line. Here’s how:
✓
Cash-basis accounting: Expenses and revenues aren’t carefully matched on a month-to-month basis. Expenses aren’t recognized until the money is actually paid out, even if the expenses are incurred in previous months, and revenues earned in previous months aren’t recognized until the cash is actually received. However, cash-basis
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