Reading Financial Reports for Dummies (13 page)

✓

Goodwill:
A company needs this account only when it has bought another company. Frequently, a business that purchases another business pays more than the actual value of its assets minus its liabilities.

The premium paid, which may account for things such as customer loyalty, exceptional workforce, and great location, is listed on the books as goodwill.

✓

Intellectual property:
This category includes copyrights, patents, and written work or products for which the company has been granted exclusive rights. For example, the government grants patents to a company or individual that invents a new product or process. These assets are amortized, which is similar to depreciation, because intellectual property has a limited lifespan. The amortization account is
Accumulated amortization — Intellectual Property.

Having exclusive rights to a product allows a company to hold off competition, which can mean a lot of extra profits. Patented products can often command a much higher price than products that aren’t patented.

Liability accounts

Money a company owes to creditors, vendors, suppliers, contractors, employees, government entities, and anyone else who provides products or services to the company is called a
liability.

54
Part I: Getting Down to Financial Reporting Basics
Current liabilities

Current liabilities
include money owed in the next 12 months. The following accounts are used to record current liability transactions:

✓

Accounts payable:
This account includes all the payments to suppliers, vendors, contractors, and consultants that are due in less than one year.

Most of the payments made on these accounts are for invoices due in less than two months.

✓

Sales tax collected:
This account tracks taxes collected for the state, local, or federal government on merchandise sold by the company.

Firms record daily transactions in this account as they collect cash and make payments (usually monthly) to government agencies.

✓

Accrued payroll taxes:
This account includes any taxes that must be paid to the state or federal government based on taxes withheld from employees’ checks. These payments are usually made monthly or quarterly.

✓

Credit card payable:
This account tracks the payments to corporate credit cards. Some companies use these accounts as management tools for tracking employee activities and set them up by employee name, department name, or whatever method the company finds useful for monitoring credit card use.

Long-term liabilities

Long-term liabilities
include money due beyond the next 12 months. The following are accounts that companies use to record long-term liability transactions:

✓

Loans payable:
This account tracks debts, such as mortgages or loans on vehicles, that are incurred for longer than one year.

✓

Bonds payable:
This account tracks corporate bonds that have been issued for a term longer than one year. Bonds are a type of debt sold on the market that must be repaid in full with interest.

Equity accounts

Equity accounts
reflect the portion of the assets that isn’t subject to liabilities and is therefore owned by a company’s shareholders. If the company isn’t incorporated, the ownership of the partners or sole proprietors is represented in this part of the balance sheet in an account called
Owner’s equity
or
Shareholders’ equity.
The following is a list of the most common equity accounts:

Chapter 4: Digging into Accounting Basics

55

✓

Common Stock:
This account reflects the value of the outstanding shares of common stock. Each share of common stock represents a portion of ownership, and this portion is calculated by multiplying the number of outstanding shares times the value of each share. Even companies that haven’t sold stock in the public marketplace but have incorporated list shareholders on the incorporation documents and list the value of their shares on the balance sheet. Each common stock shareholder has a vote in the company’s operations.

✓

Preferred stock:
This account reflects the value of outstanding shares of preferred stock, which falls somewhere between bonds and shares of stock. Although a company has no obligation to repay the preferred shareholder for his investment, it does promise him dividends. If, for some reason, the dividends can’t be paid, they’re accrued for payment in later years. Any unpaid preferred stock dividends must be paid before a company pays dividends to common stock shareholders. Preferred shareholders don’t vote in the firm’s operations. If the business is liquidated, preferred shareholders receive their share of the assets before common shareholders.

✓

Retained Earnings:
This account tracks the profits or losses for a company each year. These numbers reflect earnings retained rather than paid out as dividends to shareholders and show a company’s long-term success or failure.

Revenue accounts

At the top of every income statement is the revenue brought in by the company. This revenue is offset by any costs directly related to it. The top section of the income statement includes sales, cost of goods sold, and gross margin. Below this section and before the profit and loss section, it shows the expenses. In this section, I review the key accounts in the Chart of Accounts that make up the income statement (see Chapter 7).

Revenue

A company records all sales of products or services in revenue accounts. The following are the accounts used to record revenue transactions:

✓

Sales of goods or services:
This account tracks the company’s revenues for the sale of its products or services.

✓

Sales discounts:
This account tracks any discounts the company offers to increase its sales. If a company is heavily discounting its products, it may be competing intensely, or interest in the product may be falling.

56
Part I: Getting Down to Financial Reporting Basics
A company outsider probably doesn’t see these numbers, but if you’re reading the reports prepared for internal management purposes, this account gives you a view of how discounting is used.

✓

Sales returns and allowances:
This account tracks problem sales from unhappy customers. A large number here may reflect customer dis-satisfaction, which could be the result of a quality-control problem.

A company outsider probably doesn’t see these numbers, but internal management financial reports show this information. A dramatic increase in this number is usually a red flag for company management.

Cost of goods sold

A company tracks the costs directly related to the sale of goods or services in cost of goods sold accounts. The details are usually found only on internally distributed income statements and aren’t distributed to company outsiders. Cost of goods sold is usually shown as a single line item, but it includes the transactions from all these accounts:

✓

Purchases:
This account tracks the cost of merchandise a company buys. A manufacturing company has a very extensive tracking system for its cost of goods that includes accounts for items like raw materials, components, and labor that are used to produce the final product.

✓

Purchase discounts:
This account tracks any cost savings a company is able to negotiate because of accelerated payment plans or volume buying. For example, if a vendor offers a 2 percent discount when a customer pays an invoice within 10 days rather than the normal 30 days, the vendor tracks this cost saving in purchase discounts.

✓

Purchase returns and allowances:
This account tracks any transactions involving the return of any damaged or defective products to the manufacturer or vendor.

✓

Freight charges:
This account tracks the costs of shipping the goods sold.

Expense accounts

Any costs not directly related to generating revenue are considered
expenses.

Expenses fall into four categories: operating, interest, depreciation or amortization, and taxes. A large company can have hundreds of expense accounts, so I don’t name each one but give you a broad overview of the types of expense accounts that fall into each of these categories:

✓

Operating expenses:
The largest share of expense accounts falls under the umbrella of operating expenses, which include advertising, dues and subscriptions, equipment rental, store rental, insurance, legal and
Chapter 4: Digging into Accounting Basics

57

accounting fees, meals, entertainment, salaries, office expenses, postage, repairs and maintenance, supplies, travel, telephone, utilities, vehicle expenses, and just about anything else that goes into the cost of operating a business and isn’t directly related to selling a company’s products.

✓

Interest expenses:
Interest paid on a company’s debt is reflected in the accounts for interest expenses — from credit cards, loans, bonds, or any other type of debt the company may carry.

✓

Depreciation and amortization expenses:
I discuss how depreciation is calculated in “Digging into depreciation and amortization,” earlier in this chapter. The process for amortization is similar. The amount written off each year for any type of asset is tracked in the depreciation and amortization accounts, and the expenses related to depreciation and amortization in each individual year are shown on the income statement.

✓

Taxes:
A company pays numerous types of taxes. Sales taxes aren’t listed in the expense area because they’re paid by customers and accrued as a liability until paid. Taxes withheld from employee paychecks are also accrued as a liability and aren’t listed as an expense.

The types of taxes that
are
expenses for a company include the employer’s half of Social Security and Medicare taxes; unemployment taxes and other related payroll taxes that vary depending on state; and corporate taxes, if the company has incorporated. Businesses that aren’t incorporated don’t have to pay taxes on income. Instead, the owners report that income on their personal tax returns. I talk more about taxes and company structure in Chapter 3.

Differentiating Profit Types

A company doesn’t actually make different kinds of profits, but it has different ways to track a profit and compare its results with those of similar companies. The three key profit types are gross profit, operating profit, and net profit. In Chapter 11, I discuss how these profit types are used to test a company’s viability.

Gross profit

The
gross profit
reflects the revenue earned minus any direct costs of generating that revenue, such as costs related to the purchases or production of goods before any expenses, including operating, taxes, interest, depreciation, and amortization. The gross profit isn’t actually part of the Chart of Accounts. You calculate the number for the income statement to show the profit made by a company before expenses.

58
Part I: Getting Down to Financial Reporting Basics
Operating profit

The
operating profit
is the next profit figure you see on the income statement.

This number measures a company’s earning power from its ongoing operations. The operating profit is calculated by subtracting operating expenses from gross profit. Some companies include depreciation and amortization expenses in this calculation, calling this line item
EBIT,
or
earnings before
interest and taxes
.

Others add an additional line called
EBITDA,
or
earnings before interest,
taxes,
depreciation, and amortization.
Accountants started using EBITDA in the 1980s because it provided analysts a number they could use to compare profitability among companies and it eliminated the effects of financing and accounting.

Interest is a financial decision. A company has the choice to finance new product development or other major projects by selling bonds, taking loans, or issuing stock. If the company chooses to raise money using bonds or loans, it has to pay interest. Money raised by issuing stock doesn’t have interest costs. I talk more about this difference and the impact on a company’s profits in Chapter 11.

Taxes, believe it or not, are also an accounting game. Most corporations report different tax numbers on their financial statements than they actually pay to the government because of various tax write-offs they’re able to use to reduce their tax bill.

Companies don’t actually pay out cash for depreciation and amortization expenses. Instead, depreciation and amortization are an accounting requirement that comes into play when determining the value of assets.

Net profit

Net profit
is the bottom line after all costs, expenses, interest, taxes, depreciation, and amortization have been deducted. Net profit reflects how much money a company makes. If the company isn’t incorporated, it can pay out the profit to shareholders or company owners, or it can reinvest the money in growing itself. Firms add reinvested money to the retained earnings account on the balance sheet.