Accounting Workbook For Dummies

Part I

Business Accounting Basics

In this part . . .

Accountants are the scorekeepers of business. Without accounting, a business couldn’t function; it wouldn’t know whether it’s making a profit; and it wouldn’t know its financial condition. Bookkeeping – the recording-keeping part of accounting – must be done well to make sure that all the financial information needed to run the business is complete, accurate and reliable. This part of the book walks you through the basic bookkeeping cycle – from making original entries through adjusting entries, to financial statements. Before jumping into the mechanics of bookkeeping, however, we explain the financial effects and the manifold effects of sales and expenses on assets and liabilities.

Chapter 1

Elements of Business Accounting

In This Chapter

Working with the accounting equation

Understanding the differences between cash- and accrual-based accounting

Examining the three primary business financial statements

Seeing the effects of crooked accounting on financial statements

The starting point in accounting is to identify the entity that you’re accounting for. A business entity can be legally organised as a partnership, limited company (Ltd) or a public limited company (PLC). Alternatively, a business entity simply may consist of the business activities of an individual, in which case it’s called a sole proprietorship. Regardless of how the business entity is legally established, it’s treated as a separate entity or distinct person for accounting purposes.

Keeping the Accounting Equation in Balance

The accounting equation (Assets = Liabilities + Owners’ capital) says a lot in very few words. This equation is like the visible part of an iceberg – loads of important points are hidden under the water.

tip.eps Notice the two sides to the equation: assets on one side of the equals sign and claims against the assets on the other side. These claims arise from credit extended to the business (liabilities) and capital invested by owners in the business (owners’ capital). (The claims of liabilities are significantly different to the claims of owners; liabilities have seniority and priority for payment over the claims of owners.)

Suppose that a business has £10 million total assets. These assets didn’t fall down like manna from heaven (as one of the authors’ old accounting professor was fond of saying). The money for the assets came from somewhere. The business’s creditors (to whom the firm owes its liabilities) may have supplied, say, £4 million of its total assets. Therefore, the owners’ capital sources provided the other £6 million.

Business accounting is based on the two-sided nature of the accounting equation. Both assets and sources of assets are accounted for, which leads, quite naturally, to double entry accounting. Double entry, in essence, means two-sided, and is based on the general economic exchange model, as follows: in economic transactions, something is given and something is received in exchange. For example, we recently bought an iPod from Apple Computer. Apple gave us the iPod and received our money. Another example involves a business that borrows money from its bank. The business signs a loan agreement promising to return the money at a future date and to pay interest over the time the money is borrowed. In exchange for the loan agreement, the business receives the money. (Check out Chapter 3 for how to implement double entry accounting.)

Q. Is each of the following equations correct? What key point does each equation raise?

a. £250,000 Assets = £100,000 Liabilities + £100,000 Owners’ capital

b. £2,345,000 Assets = £46,900 Liabilities + £2,298,100 Owners’ capital

c. £26,450 Assets = £675,000 Liabilities – £648,550 Owners’ capital

d. £4,650,000 Assets = £4,250,000 Liabilities + £400,000 Owners’ capital

A. Each accounting equation offers an important lesson.

a. Whoops! This accounting equation doesn’t balance, and so clearly something’s wrong. The Liabilities, owner’s capital or some combination of both is £50,000 too low; or the two items on the right-hand side may be correct, in which case total assets are overstated £50,000. With an unbalanced equation such as this one, the accountant definitely needs to find the error or errors and make appropriate correcting entries.

b. This accounting equation balances, but, wow! Look at the very small size of liabilities relative to assets. This kind of contrast isn’t typical. The liabilities of a typical business usually account for a much larger percentage of its total assets.

c. This accounting equation balances, but the business has a large negative owners’ capital. Such a large negative amount of owners’ capital means the business has suffered major losses that have wiped out almost all its assets. You wouldn’t want to be one of this business’s creditors (or one of its owners).

d. This accounting equation balances and is correct, but you should notice that the business is highly leveraged, which means that the ratio of debt to capital (liabilities divided by owners’ capital) is very high, more than 10 to 1. This ratio is quite unusual.

1. Which of the following is the normal way to present the accounting equation?

a. Liabilities = Assets – Owners’ capital

b. Assets – Liabilities = Owners’ capital

c. Assets = Liabilities + Owners’ capital

d. Assets – Liabilities – Owners’ capital = 0

Solve It

2. A business has £485,000 total liabilities and £1,200,000 total owners’ capital. What is the amount of its total assets?

Solve It

3. A business has £250,000 total liabilities. At start-up, the owners invested £500,000 in the business. Unfortunately, the business has suffered a cumulative loss of £200,000 up to the present time. What is the amount of its total assets at the present time?

Solve It

4. A business has £175,000 total liabilities. At start-up, the owners invested £250,000 capital. The business has earned £190,000 cumulative profit since its creation, all of which has been retained in the business. What is the total amount of its assets?

Solve It

Distinguishing Between Cash- and Accrual-Based Accounting

Cash-based accounting refers to keeping a record of cash inflows and cash outflows. Individuals use cash-based accounting when keeping their chequebooks, because people need to know their day-to-day cash balance and need a journal of their cash receipts and cash expenditures during the year for filing their annual income tax returns.

Individuals have assets other than cash (such as cars, computers and homes), and they have liabilities (such as credit card balances and home mortgages). Hardly anyone we know keeps accounting records of their noncash assets and their liabilities (aside from putting bills to pay and receipts for major purchases in folders). Most people keep a chequebook, and that’s all as regards their personal accounting.

Although it’s perfect for individuals, cash-based accounting just doesn’t make the grade for the large majority of businesses. Cash-based accounting doesn’t provide the information that managers need to run a firm or the information necessary to prepare business tax returns and financial reports. Some small businesses are able to use cash-based accounting for the filing of their VAT returns. There’s a turnover limit applied to VAT cash accounting; it can only be used if your estimated taxable turnover during the next tax year is not more than £1.35 million (correct at the time of writing).

remember.eps Most businesses apply accrual-based accounting methods. This method ensures that the business records revenue at the time the sale is made (rather than when the cash has been received for the goods), and records expenses to match with the sales revenue or at least in the period benefitted.

Most firms keep track of their cash inflows and outflows, of course, but accrual-based accounting allows them to record all the assets and liabilities of the business. Also, accrual-based accounting keeps track of the money the owners invested in the business and the accumulated profit retained in the business. In short, accrual-based accounting has a much broader scope than cash-based accounting.

A big difference between cash- and accrual-based accounting concerns how they measure annual profit of a business. With cash-based accounting, profit simply equals the total of cash inflows from sales minus the total of cash outflows for expenses of making sales and running the business, or in other words, the net increase in cash from sales and expenses. With the accrual-based accounting method, profit is measured differently because the two components of profit – sales revenue and expenses – are recorded differently.

remember.eps When using accrual-based accounting, a business records sales revenue when a sale is made and the products and/or services are delivered to the customer, whether the customer pays cash on the spot or receives credit and doesn’t pay the business until sometime later. Sales revenue is recorded before cash is actually received. The business doesn’t record the cost of the goods (products) sold as an expense until sales revenue is recorded, even though the business paid out cash for the products weeks or months earlier. Furthermore, with accrual-based accounting, a business records operating expenses as soon as they’re incurred (as soon as the business has a liability for the expense), even though the expenses aren’t paid until sometime later.

Cash-based accounting doesn’t reflect economic reality for businesses that sell and buy on credit, carry stocks, invest in long-lived operating assets and make long-term commitments for such things as employee pensions and retirement benefits. When you look beyond small cash-based business, you quickly realise that businesses need the comprehensive recordkeeping of accrual-based accounting. We like to call it ‘economic reality accounting’.

The following example question focuses on certain fundamental differences between cash-based and accrual-based accounting regarding the recording of sales revenue and expenses for the purpose of measuring profit.

Q. You started a new business one year ago. You’ve been busy dealing with so many problems that you haven’t had time to sit down and look at whether you made a profit or not. You haven’t run out of cash (which for a start-up venture is quite an accomplishment), but you understand that the sustainability of the business depends on making a profit. The following two summaries present cash flow information for the year and information about two assets and a liability at year-end:

Revenue and Expense Cash Flows For First Year

£558,000 cash receipts from sales

£375,000 cash payments for purchases of products

£340,000 cash payments for other expenses

Assets and Liabilities at Year-End

£52,000 debtors from customers for sales made to them during the year

£85,000 cost of products in stock that haven’t yet been sold

£25,000 liability for unpaid expenses

Compare the profit or loss of your business for its first year according to the cash- and accrual-based accounting methods.

A. Profit according to cash-based accounting equals the cash inflow from sales minus the total of cash outflows for expenses (and the total of cash outflows for expenses equals the purchases of products plus other expenses). Thus, under cash-based accounting, your business has a loss for the year:

Sales revenue: £558,000

Less expenses: £715,000

Loss: £157,000

Under accrual-based accounting, you record different amounts for sales revenue and the two expenses, which are calculated as follows:

Sales revenue: £610,000 (£558,000 cash receipts from sales + £52,000 year-end debtors)

Cost of Goods Sold: £290,000 (£375,000 cash payments for purchases – £85,000 year-end stock)

Other expenses: £ £365,000 (£340,000 cash payments for other expenses + £25,000 year-end liability for unpaid expenses)

Loss: £45,000

To answer Questions 5 to 8, please refer to the summary of revenue and expense cash flows and the summary of two assets and a liability at year-end presented in the preceding example question.

5. What would be the amount of accrual-based sales revenue for the year if the business’s year-end debtors had been £92,000?

Solve It

6. What would be the amount of accrual-based Cost of Goods Sold expense for the year if the business’s cost of products held in stock at year-end had been £95,000?

Solve It

7. What would be the amount of accrual-based other expenses for the year if the business’s liability for unpaid expenses at year-end had been £30,000?

Solve It

8. Based on the changes for the example given in Questions 5, 6 and 7, determine the profit or loss of the business for its first year.

Solve It

Summarising Profit Activities in the Profit and Loss Statement

As crass as it sounds, business managers get paid to make profit happen. Management literature usually stresses the visionary, leadership and innovative characteristics of business managers, but these traits aren’t worth much if the business suffers losses year after year or fails to establish sustainable profit performance. After all, businesses are profit-motivated, aren’t they?

Therefore, the Profit and Loss Statement takes centre stage in business financial reports. The Profit and Loss Statement summarises a business’s revenue and other income, expenses, losses and bottom-line profit or loss for a period. The Profit and Loss Statement gets top billing over the other two primary financial statements (the balance sheet and the cash flow statement), which we discuss in the later sections ‘Assembling a Balance Sheet’ and ‘Partitioning the Statement of Cash Flows’. The Profit and Loss Statement is referred to informally as the Profit & Loss or P&L statement, although these titles are seldom used in external financial reports.

Financial reporting standards demand that a Profit and Loss Statement is presented annually to owners. But financial reporting rules are fairly permissive regarding exactly what information should be reported and how it’s presented (see Chapter 5 for the full scoop on Profit and Loss Statement disclosure).

Q. Take a look at this extremely abbreviated and condensed Profit and Loss Statement for a business’s most recent year. (Note: a formal Profit and Loss Statement in a financial report must disclose more information than you see here.)

This business sells products, which are also called goods or merchandise. The cost of products sold to customers during the year was £14,300,000. Expand the condensed Profit and Loss Statement to reflect this additional information.

A. Profit and Loss Statement reporting requires a business to show the Cost of Goods (products) Sold as a separate expense and deduct it immediately below sales revenue. The difference must be reported as gross margin (or Gross Profit). Therefore, the condensed Profit and Loss Statement should be expanded as follows:

9. One rule of the Profit and Loss Statement reporting is that interest expense and income tax expense is reported separately. The £10,010,000 ‘Other expenses’ in the Profit and Loss Statement for the answer to the example question includes £350,000 interest expense and £910,000 income tax. Rebuild the Profit and Loss Statement given the information for these additional two expenses. Hint: profit before interest expense is usually labelled ‘operating earnings’, and profit after interest and before income tax expense is usually labelled ‘earnings before income tax’.

Solve It

10. Please refer to the Profit and Loss Statement for the answer to the example question. Suppose the business distributed £650,000 cash to its shareowners from its profit (net income) for the year. Is this cash disbursement treated as an expense?

Solve It

Assembling a Balance Sheet

The balance sheet (also called the statement of financial position) is one of the three primary financial statements that businesses report (the other two being the Profit and Loss Statement and the cash flow statement). The balance sheet summarises the assets, liabilities and owners’ capital accounts of a business at an instant in time. Prepared at the close of business on the last day of the profit period, the balance sheet presents a ‘freeze frame’ look at the business’s financial condition.

Preparing and reporting a balance sheet takes time, so by the time you read a balance sheet, it’s already somewhat out-of-date. The business’s stream of activities and operations doesn’t stop, which means that from the date at which the balance sheet was prepared to when you read it, the business will have engaged in many transactions. These subsequent transactions may have significantly changed its financial condition. For more on the balance sheet, turn to Chapter 6.

In accounting, the term balance refers to the sterling amount of an account, after recording all increases and decreases in the account caused by business activities. The balance sheet reports the balances of asset, liability and owners’ capital accounts, but it also refers to the equality, or balance, of the accounting equation (see the section ‘Keeping the Accounting Equation in Balance’ earlier in this chapter).

Q. The following list summarises the assets and liabilities of a business at the close of business on the last day of its most recent profit period:

Amounts owed by customers to the business: £485,000

Cost of unsold products (that is to be sold next period): £678,000

Cash balance on deposit in current account with bank: £396,000

Amounts owed by business for unpaid purchases and expenses: £438,000

Loans owed to bank (on which interest is paid): £500,000

Original cost of long-term operating assets that are being depreciated over their useful lives to the business: £950,000

Accumulated depreciation of long-term operating assets: £305,000

Using this information, prepare the business’s balance sheet.

A.

Note: This balance sheet isn’t classified into current assets and current liabilities. Also, owners’ capital isn’t classified. (Chapter 6 explains the balance sheet in greater detail.)

Now use the balance sheet shown in the preceding example to answer Questions 13 to 16.

11. Suppose £950,000 of owners’ capital consists of profit earned and not distributed by the business. What is this amount usually called in the balance sheet? And, what is the other amount of owners’ capital called in the balance sheet?

Solve It

12. The business appears unable to pay its liabilities. The two liabilities total £938,000, but the business has a cash balance of only £396,000. Do you agree?

Solve It

13. Can you tell the amount of profit the business earned in the period just ended?

Solve It

14. In a balance sheet, assets usually are listed in the order of their liquidity (how quickly they convert to cash). Cash is listed first, followed by the asset closest to being converted into cash and so on. Is the sequence of assets correct according to the normal rules for presenting assets in balance sheets?

Solve It

Partitioning the Cash Flow Statement

You can argue that the cash flow statement is the most important of the three primary financial statements. Why? Because in the long run, everything comes down to cash flows. Profit recorded on the accrual basis of accounting has to be turned into cash – and the sooner the better. Otherwise, profit doesn’t provide money for growing the business and paying distributions to owners.

By themselves, the Profit and Loss Statement and balance sheet don’t provide information about the cash flow generated by the business’s profit-making, or operating, activities. But people who use financial reports (business managers, lenders and investors) want to see cash flow information. In short, financial reporting standards require a cash flow statement.

Accountants normally categorise the cash flow into three different types:

Cash flows from operating activities, which include inflows from sales and cash outflows from expenses.

Investing activities, which include the purchase and construction of long-term operating assets such as land, buildings, equipment, machinery, vehicles and tools. If a business realises cash from the disposal of such assets, the proceeds are included in this category of cash flows.

Financing activities, which include borrowing money from debt sources and paying loans at maturity as well as raising capital from shareowners and returning capital to them. Cash distributions from profit are included in this category of cash flows.

Q. The cash flow statement for a business’s most recent year is presented as follows. Based on the information provided, can the amount of cash flow be determined from operating activities?

A. You can determine the amount of cash flow from operating activities by the following calculations:

£2,120,000 net cash needed for capital expenditures + £355,000 cash balance increase = £2,475,000 total cash needed

£2,475,000 total cash needed – £1,775,000 net cash provided from financing activities = £700,000 cash flow from operating activities

Cash flow from operating activities is explained in more detail in Chapter 8.

You can condense a cash flow statement, such as the one for the example, into its four basic components as follows (negative numbers appear in parentheses):

If you know three of the four components in a condensed cash flow statement, you can determine the fourth factor. Suppose that you know the increase or decrease in cash during the year (which is easy enough to determine by comparing the ending cash balance with the beginning cash balance). And suppose that you can quickly determine the cash flow from investing activities and the cash flow from financing activities (because not many transactions of these two types exist during the year).

Knowing these three factors, you can quickly determine the cash flow from operating activities. The remainder of the increase or decrease in cash during the year is attributable to operating activities.

Questions 15 to 18 give you three of the four components in a condensed cash flow statement and ask you to solve for the unknown factor.

15. Three of the four components of cash flow for the year of a business are as follows:

Determine the increase or decrease in cash during the year.

Solve It

16. Three of the four components of cash flow for the year of a business are as follows:

Determine cash flow from investing activities for the year.

Solve It

17. Three of the four components of cash flow for the year of a business are as follows:

Determine cash flow from financing activities for the year.

Solve It

18. Three of the four components of cash flow for the year of a business are as follows:

Determine cash flow from operating activities for the year.

Solve It

Tracing How Dishonest Accounting Distorts Financial Statements

Obviously, a business needs to keep its accounting system as honest as the day is long. In preparing its financial statements, a business should be forthright and not misleading. Unfortunately some businesses cheat in their accounting and financial reporting. Now, there’s cheating and then there’s real cheating. So what’s the difference?

Many businesses perform cosmetic surgery on their accounts, touching up their financial condition and profit performance. This practice is popularly called massaging the numbers. Professional investors (as in mutual fund managers) and lenders (as in banks) know that many businesses employ a certain amount of accounting manipulation, and as a practical matter not much can be done about it.

warning_bomb.eps On another level, some businesses resort to accounting fraud to put a better sheen on profit performance and conceal financial problems. Accounting fraud is popularly called cooking the books. Think of massaging the numbers as fibbing or putting a spin on the truth and cooking the books as out-and-out lying with the intent to deceive and mislead.

In recent years the incidence of accounting fraud has risen alarmingly. (Does Enron ring any bells?) Accounting fraud is illegal and perpetrators are subject to prosecution under criminal law. Plus, victims can sue the persons responsible for the fraud.

Q. Suppose that a business has engaged in some accounting fraud to boost its profit for the year just ended. Assume that the business didn’t commit any accounting fraud before this year (which may not be true, of course). As the result of fraudulent entries in its accounts, the £2,340,000 bottom-line profit reported in its Profit and Loss Statement was overstated £385,000. How does this dishonest accounting distort the business’s balance sheet?

A. Owners’ capital is overstated £385,000 because profit increases owners’ capital. And the overstatement of profit may have involved the overstatement of assets, the understatement of liabilities or a combination of both. To correct this error, owners’ capital should be decreased £385,000. In addition, assets should be decreased £385,000 or liabilities should be increased £385,000 (or some combination of both).

19. Suppose a business commits accounting fraud by deliberately not writing down its stock of £268,000, which is the cost of certain products that it can no longer sell and are going to be thrown in the junk heap. How should its balance sheet be adjusted to correct for this accounting fraud, ignoring income tax effects? (Use the answer template provided.)

Solve It

20. Suppose a business commits accounting fraud by deliberately not recording £465,000 liabilities for unpaid expenses at the end of the year. How should its balance sheet be adjusted to correct for this accounting fraud, ignoring income tax effects? (Use the answer template provided.)

Solve It

Answers to Problems on Elements of Business Accounting

Here are the answers to the practice questions presented earlier in this chapter.

1. Which of the following is the normal way to present the accounting equation?

c. Assets = Liabilities + Owners’ capital

The other three accounting equations are correct from the algebraic equation point of view. However, the accounting equation is usually shown with assets on one side and the two broad classes of claims against the assets on the other side. Note: you see answer (b) (Assets – Liabilities = Owners’ capital) when the purpose is to emphasise the net worth of a business, or its assets less its liabilities.

2. A business has £485,000 total liabilities and £1,200,000 total owners’ capital. What is the amount of its total assets?

Total assets = £1,685,000, which is the total of £485,000 liabilities plus £1,200,000 owners’ capital.

3. A business has £250,000 total liabilities. When it was started the owners invested £500,000 in the business. Unfortunately, the business has suffered a cumulative loss of £200,000 up to the present time. What is the amount of its total assets at the present time?

Total assets = £550,000, which is the total of £250,000 liabilities plus £300,000 owners’ capital.

Notice that the original £500,000 that the owners invested in the business is reduced by the £200,000 cumulative loss of the business, and the owners’ capital is now only £300,000.

4. A business has £175,000 total liabilities. Originally, at the time of starting the business, the owners invested £250,000 capital. The business has earned £190,000 cumulative profit since it started (all of which has been retained in the business). What is the total amount of its assets?

Total assets = £615,000, which is the total of £175,000 liabilities and £440,000 owners’ capital.

Notice that in addition to the original £250,000 capital invested by owners, the business has earned £190,000 profit, so its