Understanding Business Accounting For Dummies®, 4th Edition
Published by: John Wiley & Sons, Ltd., The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom
www.wiley.com
This edition first published 2018
© 2018 by John Wiley & Sons, Ltd., Chichester, West Sussex
Registered Office
John Wiley & Sons, Ltd., The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom
For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book, please see our website at www.wiley.com
.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the permission of this publisher.
Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book.
LIMIT OF LIABILITY/DISCLAIMER OF WARRANTY: WHILE THE PUBLISHER AND AUTHOR HAVE USED THEIR BEST EFFORTS IN PREPARING THIS BOOK, THEY MAKE NO REPRESENTATIONS OR WARRANTIES WITH RESPECT TO THE ACCURACY OR COMPLETENESS OF THE CONTENTS OF THIS BOOK AND SPECIFICALLY DISCLAIM ANY IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. IT IS SOLD ON THE UNDERSTANDING THAT THE PUBLISHER IS NOT ENGAGED IN RENDERING PROFESSIONAL SERVICES AND NEITHER THE PUBLISHER NOR THE AUTHOR SHALL BE LIABLE FOR DAMAGES ARISING HEREFROM. IF PROFESSIONAL ADVICE OR OTHER EXPERT ASSISTANCE IS REQUIRED, THE SERVICES OF A COMPETENT PROFESSIONAL SHOULD BE SOUGHT.
For general information on our other products and services, please contact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at 317-572-3993, or fax 317-572-4002. For technical support, please visit https://hub.wiley.com/community/support/dummies
.
Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com
. For more information about Wiley products, visit www.wiley.com
.
A catalogue record for this book is available from the British Library.
Library of Congress Control Number: 2017952292
ISBN 978-1-119-41353-0 (pbk); ISBN 978-1-119-41361-5 (ebk); ISBN 978-1-119-41366-0 (ebk)
Welcome to Understanding Business Accounting For Dummies, 4th Edition. We’ve written this book for people who need to understand accounting information and financial reports, quickly. Unsurprisingly, the business climate at the end of the first decade of the 21st Century has made this a hot topic – not quite in the Brexit/Donald Trump league, but every bit as daunting in its own way. While it’s not for accountants and bookkeepers, they should find this book very interesting and a good refresher course. It may also be a valuable learning resource for accountants and bookkeepers to use with their non-accountant fellow managers to help bring them up to speed.
This book is for people who need to use and understand accounting information – business managers and entrepreneurs, for example, who need to raise money, make profit, turn profit into cash flow, and control the assets and liabilities of their venture. If you’re running a business or you’re a business unit manager, we’re probably preaching to the converted when we say that you need a basic familiarity with accounting and financial statements in order to make good business decisions.
Business investors, lawyers and business consultants – pretty much anyone who is affected by the financial performance of the business they work for or trade with – can also benefit from a solid understanding of how to read financial reports and how accounting works.
Understanding Business Accounting For Dummies lifts the veil of obscure terminology and lays bare the methods of accounting. This book takes you behind the scenes and explains the language and methods of accounting in a down-to-earth and light-hearted manner – and in plain English.
Each chapter in this book is designed to stand on its own. Each chapter is self-contained, and you can jump from chapter to chapter as you please (although we encourage you to take a quick tour through the chapters in the order that we present them). We bet you’ll discover some points that you may not have expected to find in a book about accounting.
Much of this book focuses on profit and how a business makes profit. Because profit and other financial aspects of a business are reported in financial statements, understanding some basic notations and conventions used in these financial reports is important.
We use the following condensed profit and loss account to illustrate some conventions that you can expect to see when reading financial reports. (The actual format of a profit and loss account includes more information about expenses and profit.) These conventions are the common ways of showing figures in financial reports just as saying hello and shaking hands are common conventions that you can expect when you greet someone.
Abbreviated Profit and Loss Account (£s) |
||
Sales revenue |
25,000,000 |
|
Cost of goods sold expense |
15,000,000 |
|
Gross margin |
10,000,000 |
|
Marketing expenses |
£4,000,000 |
|
Other expenses |
2,000,000 |
6,000,000 |
Profit |
4,000,000 |
When we present an accounting formula that shows how financial numbers are computed, we show the formula indented, like this:
Assets = Liabilities + Owners’ Equity
Terminology in financial reporting is reasonably uniform, thank goodness, although you may see a fair amount of jargon. When we introduce a new term in this book, we show the term in italics and flag it with an icon (see the section ‘Icons Used in This Book’ later in this Introduction). You can also turn to Appendix A to look up a term that you’re unfamiliar with.
While this book is designed for all of you who have that nagging feeling that you really should know more about accounting, we have made a few assumptions about you.
You don’t want to be an accountant, nor do you have any aspirations of ever sitting for the FCA (Fellow of the Institute of Chartered Accountants) exam. But you worry that ignorance of accounting may hamper your decision-making, and you know deep down that learning more about accounting would help.
We assume that you have a basic familiarity with the business world, but we take nothing for granted in this book regarding how much accounting you know. Even if you have some experience with accounting and financial statements, we think that you’ll find this book useful – especially for improving your communication with accountants.
We assume that you need to use accounting information. Many different types of people (business managers, investors and solicitors, to name but three) need to understand accounting basics – not all the technical stuff, just the fundamentals.
We assume that you want to know something about accounting because it’s an excellent gateway for understanding how business works, and it gives you an indispensable vocabulary for moving up in the business and investment worlds. Finding out more about accounting helps you understand company reports, mergers and takeovers, frauds and pyramid schemes, and business restructurings.
For Dummies books always include little icons in the margins to draw your attention to paragraphs of particular significance:
In addition to the material in the print or ebook you’re reading right now, you can also find some access-anywhere goodies on the web. Check out the free Cheat Sheet at www.dummies.com
by searching for ‘Understanding Business Accounting For Dummies UK Edition Cheat Sheet’ in the Search box.
If you’re new to the accounting game, by all means start with Part 1. However, if you already have a good background in business and know something about bookkeeping and financial statements, you may want to jump right into Part 2 of this book, starting with Chapter 5. Part 3 is on accounting tools and techniques for managers, and it assumes that you have a handle on the financial statements material in Part 2. Part 4 stands on its own; if your main interest in accounting is to make sense of and interpret financial statements, you can read through Part 2 on financial statements and then jump to Part 4 on reading financial reports. If you have questions about specific accounting terms, you can go directly to the glossary in the appendix.
We’ve had a lot of fun writing all the editions of this book. We sincerely hope that it helps you become a better business manager and investor, and that it aids you in your personal financial affairs. We also hope that you enjoy the book. We’ve tried to make accounting as much fun as possible, even though it’s a fairly serious subject. Just remember that accountants never die; they just lose their balance. (Hey, accountants have a sense of humour, too – though you may have to wait until you reach Chapter 6 to get the joke.)
Part 1
IN THIS PART …
Discover the ways that an understanding of business accounting can help your business.
Understand the differences between bookkeeping and accounting.
Work out how to pay taxes as an employer and a property owner.
Make sense of your financial position as an individual who is also a taxpayer, an investor, a borrower and a retirement planner.
Chapter 1
IN THIS CHAPTER
Understanding the different needs for accounting
Making and enforcing accounting rules
Peering into the back office: The accounting department in action
Transactions: The heartbeat of a business
Taking a closer look at the key financial statements
Should you let your toddler grow up to be an accountant?
Most medium to large businesses employ one or more accountants. Even a very small business could find value in having at least a part-time accountant. Have you ever wondered why? Probably what you think of first is that accountants keep the books and the records of the financial activities of the business. This is true, of course. But accountants perform other very critical but less well-known functions in a business:
www.gov.uk/government/organisations/companies-house
).In short, accountants are much more than bookkeepers – they provide the numbers that are so critical in helping business managers make the informed decisions that keep a business on course toward its strategic objectives.
Business managers, investors and others who depend on financial statements should be willing to meet accountants halfway. People who use accounting information, like spectators at a football game, should know the basic rules of play and how the score is kept. The purpose of this book is to make you a knowledgeable spectator of the accounting game and – who knows – perhaps even an amateur player.
Accounting extends into virtually every walk of life. You’re doing accounting when you make entries in your cheque book and fill out your income tax return. When you sign a mortgage on your home, you should understand the accounting method the lender uses to calculate the interest amount charged on your loan each period. Individual investors need to understand some accounting in order to figure the return on capital invested. And every organisation, profit-motivated or not, needs to know how it stands financially. Accounting supplies all that information.
Many different kinds of accounting are done by many different kinds of persons or entities for many different purposes:
Accounting is necessary in any economic system. The more developed the economic system, the more the system depends on information. Much of the information comes from the accounting systems used by the businesses, individuals and other institutions in the economic system.
Accounting involves bookkeeping, which refers to the painstaking and detailed recording of economic activity and business transactions. But accounting is a much broader term than bookkeeping because accounting refers to the design of the bookkeeping system. It addresses the many problems in measuring the financial effects of economic activity. Furthermore, accounting includes the financial reporting of these values and performance measures to non-accountants in a clear and concise manner.
An accountant rarely prepares a complete listing of all the details of the activities that took place during a period. Instead, he or she prepares a summary financial statement, which shows totals, not a complete listing of all the individual activities making up the total. Mostly, managers just want summary financial statements for the period – if they want to drill down into the details making up a total amount for the period, they ask the accountant for this more detailed backup information. Also, outside investors usually only see summary-level financial statements. For example, they see the total amount of sales revenue for the period but not how much was sold to each and every customer. Because a company’s accounts are available to the public at Companies House, businesses only reveal what they absolutely have to by law.
One aspect is the assets, or economic resources, of the business. The other aspect of the balance sheet is a breakdown of where the assets came from, or the sources of the assets. The asset values reported in the balance sheet are the amounts recorded when the assets were originally acquired. For many assets, these values are recent – only a few weeks or a few months old. For some assets, the values as reported in the balance sheet are the costs of the assets when they were acquired many years ago.
Assets are not like manna from heaven. They come from borrowing money in the form of loans that have to be paid back at a later date and from owners’ investment of capital (usually money) in the business. Also, making profit increases the assets of the business; profit retained in the business is the third basic source of assets. If a business has, say, £2.5 million in total assets (without knowing which particular assets the business holds), you know that the total of its liabilities, plus the capital invested by its owners, plus its retained profit, adds up to £2.5 million.
In this particular example, suppose that the total amount of the liabilities of the business is £1.0 million. This means that the total amount of owners’ equity in the business is £1.5 million, which equals total assets less total liabilities. Without more information, we don’t know how much of total owners’ equity is traceable to capital invested by the owners in the business and how much is the result of profit retained in the business. But we do know that the total of these two sources of owners’ equity is £1.5 million. The financial condition of the business in this example is summarised in the following accounting equation (in millions):
£2.5 Assets = £1.0 Liabilities + £1.5 Owners’ Equity
Looking at this accounting equation, you can see why the statement of financial condition is also called the balance sheet; the equal sign means the two sides have to balance.
Double-entry bookkeeping is based on this accounting equation – the total of assets on the one side is counter-balanced by the total of liabilities, invested capital and retained profit on the other side. Double-entry bookkeeping is discussed in Chapter 2.
Other financial statements are different from the balance sheet in one important respect: they summarise the significant flows of activities and operations over the period. Accountants prepare two types of summary flow reports for businesses:
The balance sheet, profit and loss account, and cash flow statement constitute the hard core of a financial report to those persons outside a business who need to stay informed about the business’s financial affairs. These individuals have invested capital in the business, or the business owes them money and therefore they have a financial interest in how well the business is doing. These three key financial statements are also used by the managers of a business to keep themselves informed about what’s going on and the financial position of the business. They are absolutely essential to helping managers control the performance of a business, identify problems as they come up, and plan the future course of a business. Managers also need other information that is not reported in the three basic financial statements. (Part 3 of this book explains these additional reports.)
Experience and common sense have taught business and financial professionals that uniform financial reporting standards and methods are critical in a free-enterprise, private, capital-based economic system. A common vocabulary, uniform accounting methods and full disclosure in financial reports are the goals. How well the accounting profession performs in achieving these goals is an open question, but few disagree that they are worthy goals to strive for.
The accounting professional bodies, with a little prodding from governments, are responsible for ensuring that accounting reports conform to what are known as Generally Accepted Accounting Practices (GAAP). A newish entrant, International Accounting Standards, is challenging that term itself as GAAP rules have been interpreted differently on different continents and indeed largely ignored on others.
The rule book has to be adapted to accommodate changes in the way that business is done. For example, international business across frontiers is now the norm, so rules on handling currency and reporting taxable profits in different countries have to be accommodated within a company’s accounts in a consistent manner.
Although you aren’t usually expected to know all the rules – unless you’re the accountant responsible for preparing your organisation’s figures – try to get up-to-date before any meetings where the subject is likely to come up. You can keep track of changes in company reporting rules on the Institute of Chartered Accountants in England and Wales’ website (www.icaew.com/en/technical/financial-reporting
).
In the UK, there’s a large degree of conformity between domestic and international standards, and the Accounting Standards Board (ASB) considers each new international standard carefully before deciding whether or not to include it in the domestic standard. Topics that have been the cause of disagreement in the recent past are the treatment of goodwill, deferred tax and pension costs.
Business managers should know the basic features of the accounting rules that apply in their area – though certainly not all the technical details – so that they understand how profit is measured. Managers get paid to make profit, and they should be very clear on how profit is measured and what profit consists of. The amount of profit a business makes depends on how profit is defined and measured.
For example, a business records the purchase of products at cost, which is the amount it paid for the products. Stock is the name given to products being held for sale to customers. Examples include clothes in a department store, fuel in the tanks in a petrol station, food on the shelves in a supermarket, books in a bookstore, and so on. The cost of products is put in the stock asset account and kept there until the products are sold to customers. When the products are eventually sold, the cost of the products is recorded as the cost of goods sold expense, at which time a decrease is recorded in the stock asset account. The cost of products sold is deducted from the sales revenue received from the customers, which gives a first-step measure of profit. (A business has many other expenses that need to be factored in, which you can read about in later chapters.)
Now, assume that before the business sells the products to its customers the replacement cost of many of the products being held in stock awaiting sale increases. The replacement cost value of the products is now higher than the original, actual purchase cost of the products. The company’s stock is worth more, is it not? Perhaps the business could raise the sales prices that it charges its customers because of the cost increase, or perhaps not. In any case, should the increase in the replacement cost of the products be recorded as profit? The manager may think that this holding gain should be recorded as profit. But the accepted accounting standards say that no profit is earned until the products are sold to the customers.
What about the opposite movement in replacement costs of products – when replacement costs fall below the original purchase costs? Should this development be recorded as a loss, or should the business wait until the products are sold? As you’ll see, the accounting rule that applies here is called lower of cost or market, and the loss is recorded. So the rule requires one method on the upside but another method on the downside. See why business managers and investors need to know something about the rules of the game? We should add that accounting rules are not all crystal-clear, which leaves a lot of wriggle room in the interpretation and application of these accounting standards. But first, a quick word about accounting rules and income tax accounting.
Generally speaking (and we’re being very general when we say the following), HM Revenue & Customs’ income tax accounting rules for determining the annual taxable income of a business are in agreement with the accounting rules applied in most other developed economies. In other words, the accounting methods used for figuring taxable income and for figuring business profit before income tax are in general agreement. Having said this, we should point out that several differences do exist. A business may use one accounting method for filing its annual income tax returns and a different method for measuring its profit, both for management reporting purposes and for preparing its external financial statements to outsiders.
An often-repeated accounting story concerns three accountants being interviewed for an important position. The accountants are asked one key question: ‘What’s 2 plus 2?’ The first candidate answers, ‘It’s 4,’ and is told, ‘Don’t call us, we’ll call you.’ The second candidate answers, ‘Well, most of the time the answer is 4, but sometimes it’s 3 and sometimes it’s 5.’ The third candidate answers: ‘What do you want the answer to be?’ Guess who got the job?
The point is that accounting rules are not entirely airtight or cut-and-dried, and they’re often being updated. Many accounting standards leave a lot of room for interpretation. Guidelines would be a better word to describe some accounting rules. Deciding how to account for certain transactions and situations requires flexibility, seasoned judgement and careful interpretation of the rules. Furthermore, many estimates have to be made.
Sometimes, businesses use what’s called creative accounting to make profit for the period look better. Like lawyers who know where to find legal loopholes, accountants sometimes come up with inventive solutions but still stay within the guidelines. We warn you about these creative accounting techniques – also called massaging the numbers – at various points in this book. Articles in financial newspapers and magazines regularly focus on such accounting abuses.
As we mentioned in the preceding sections, when preparing financial statements a business must follow generally accepted accounting principles – the authoritative ground rules for measuring profit and for reporting values of assets and liabilities. Everyone reading a financial report is entitled to assume that the country’s accepted accounting standards have been followed (unless the business clearly discloses that it is using another so-called comprehensive basis of accounting).
The basic idea behind sticking closely to the accepted accounting standards is to measure profit and to value assets and liabilities consistently from business to business – to establish broad-scale uniformity in accounting methods for all businesses. The idea is to make sure that all accountants are singing the same tune from the same hymnbook. The purpose is also to establish realistic and objective methods for measuring profit and putting values on assets and liabilities. The authoritative bodies write the tunes that accountants have to sing.
All systems of accounting standards include minimum requirements for disclosure, which refers to how information is classified and presented in financial statements and to the types of information that have to be added to the financial statements in the form of footnotes. The professional accounting bodies provide details on these requirements.
How do you know if a business has actually followed the rules faithfully? We think it boils down to two factors. First is the competency and ethics of the accountants who prepared the financial reports. No substitute exists for expertise and integrity. But accountants often come under intense pressure to massage the numbers from the higher-level executives that they work for.
Which leads to the second factor that allows you to know whether a business has obeyed the dictates of accounting standards. Businesses have their financial statements audited by independent chartered or management accountants. In fact, limited companies are required by law to have annual audits and many private businesses hire accountants to do an annual audit, even if not legally required.
A series of high profile financial frauds in US-based businesses such as Enron and WorldCom in the mid to late 1990s badly shook people’s confidence in US businesses. In response, the US government introduced the Sarbanes-Oxley Act, known less commonly but better understood as the Public Company Accounting Reforms and Investor Protection Act – 2002.
The central tenet of the Sarbanes-Oxley Act is to ensure truthfulness in financial reporting – a quest the accounting profession has been pursuing since Pacioli set out the rules of double-entry bookkeeping five centuries ago. The act closes the loopholes that creative accountants opened up, which made it difficult (and sometimes impossible) for shareholders to see how a business was performing until after the baddies had made off with the loot. The act applies to any business with shares listed on an American stock market that does business in the US – not just to US companies.
The British version – the Companies (Audit, Investigations and Community Enterprise) Act 2004 – is causing the accounting profession to clutch its collective head. This knock-on effect from Sarbanes-Oxley means that all companies selling shares to the public have to make changes to their accounts and accounting standards. You can read up on the UK rules at www.legislation.gov.uk/ukpga/2004/27/contents
.
As we discussed earlier in this chapter, bookkeeping (also called record-keeping) and financial reporting to managers and investors are the core functions of accounting. In this section, we explain another basic function of a business’s accounting department: the back-office functions that keep the business running smoothly.
Most people don’t realise the importance of the accounting department. That’s probably because accountants cover many of the back-office operating functions in a business – as opposed to sales, for example, which is front-line activity, out in the open, and in the line of fire.
Typically, the accounting department is responsible for:
The accounting department may be assigned other functions as well, but we think that this list gives you a pretty clear idea of the back-office functions that the accounting department performs. Quite literally, a business could not operate if the accounting department did not do these functions efficiently and on time.