Though it may seem unlikely that some companies still use entirely paper-based systems to conduct their accounts payable processes, this is still the case for some smaller businesses. The flowchart in Exhibit 1 shows the basic process flow for these organizations, with the minimum set of con­trols needed to ensure that it operates properly. The small black diamonds on the flowchart indicate the location of key control points in the process, with descriptions next to the diamonds.

The controls noted in the flowchart are described at greater length next, in sequence from the top of the flowchart to the bottom.

• Manually review for duplicate invoices. A noncomputerized accounting system has no way to utomatically verify a supplier’s invoice number of invoices previously paid. Consequently, the payables staff must compare each newly received supplier invoice against invoices in two files: both those in the unpaid invoices file and those in the paid invoices file.
  Exhibit 1 System of Controls for Paper-Based Accounts Payable
  
• Conduct three-way match. The payables staff must compare the pricing and quantities listed on the supplier invoice to the quantities actually received, as per receiving documents, and the price originally agreed to, as noted in the company’s purchase order. Read the rest of this entry »

The preceding sections of this chapter have shown you the gears and wires behind the scenes that make everything work. Now, we are ready for the show: this is how accounting answers the three big questions we introduced at the beginning of the book:
• How much money came in?—revenue or gross income
• Where did the money go?—expenses
• How much money is left?—net income
The Income Equation

We find the direct answer to these three questions on the income and expense statement. The income statement equation— revenue – expenses = net income—is the key to the income statement. The result here is simple arithmetic: revenue (the gozinta) minus expenses (the gozouta) yields net income.
The Balance Sheet Equation

The balance sheet answers another set of crucial questions for a company. Today, what is my company worth? What’s in my bank account? How much money do other companies or people owe me? How much money do I owe other people or companies?

The fundamental equation of accounting underlies the balance sheet. It looks like this:
assets = liabilities + equity
assets – liabilities = equity
assets – equity = liabilities

The physical layout of the balance sheet matches the first equation:
assets = liabilities + equity

This makes logical sense: the value of what the company owns (assets) minus the value of what the company owes (liabilities) leaves you with what the company is worth (equity).

The Equations and the Normal Accounts

This table illustrates how the income equation balances if we enter our transactions properly on the normal side of each account

This table illustrates how the balance sheet equation—that is, the fundamental equation of accounting—balances properly if we enter our transactions on the normal side of each account.

Every transaction we enter follows the basic accounting equations. In fact, the T accounts are designed to make sure that we follow the equations. That is why some accounts are
credit accounts and others are debit accounts.

If each entry is balanced, then all of the entries are balanced and our balance sheet and income statement will come out right. If there is an error in one transaction, it will show up because our financial statements will be out of balance.

The Lemonade Stand

Load, Wash, Rinse, Spin, Dry

Past as Prologue

The Income Statement

Statement of Cash Flows

The Balance Sheet

A Delicate Balance: The Adjusting Entries

The Three Questions

Visualize to Understand

The Accounting System

Double Entry

Bookkeeping and Accounting

Financial Statements

Accounting Principles

The Fundamental Equations of Accounting

The Advantages of an Accounting System

A Few Important Details

The GAAP revenue recognition and matching principles require that the revenue from a particular accounting period be matched with expenses that help cause that revenue. That way, external users will have a more accurate picture of profitability.

Table 3-5. Balance sheet

The accrual accounting setup provides for accounts to carry amounts into the future and then peel off as they enter the applicable period.

Figure 3-5 Balance sheet

Let’s look at the simple example of paying the insurance bill. The annual bill is $7,200 if paid in advance, $8,400 in two equal installments, or $800 on a monthly basis. Being prudent managers, we take the time value of money into account. We pay the $7,200 in June to cover the insurance bill for the entire 12 months. Our fiscal year ends December 31, so we’ll have to carry the insurance over.

When we’ve paid for the insurance, it’s an asset. When the month comes around, the portion of the asset covering the month converts to an expense. On the books, it will look like Table 3-6.

By the end of the year, the accumulated accounts will show the ledger entries in Table 3-7.

You can set some accounting systems do this automatically. With others, you have to remember to post the transaction monthly. At the start of the next year, the balance in the asset account must be carried forward while the expense account is cleared (Table 3-8).

Common adjusting entries involve carrying over payrollrelated data to the next accounting period. Thus, employee wages and taxes earned in the last period but not payable until the new period, along with the associated employer share of FICA and other taxes due, need an adjusting entry. Other adjustments include the need to accrue revenues and expenses related to interest, depreciation, inventory changes, dividends, or income tax payable. Finally, if your day-to-day books are

Table 3-6. Insurance: general journal and ledger accounts

Table 3-7. Insurance: ledger accounts

maintained on a cash basis, set up an accounts receivable and accounts payable balance.

Table 3-8. Insurance: ledger accounts

The balance sheet is the accounting equation. It lists the firm’s assets, liabilities, and equity as of a specific date. In this respect it’s a position statement rather than flow statement. The balance sheet is the company’s solvency report card. Typically, the date is the end of the firm’s reporting fiscal year. However, computer software has made generating reports vastly easier. It’s not uncommon for a manager to run off last night’s balance sheet to read with coffee in the morning.

The balance sheet always balances because of the doubleentry system and debit-credit recording rule correctly applied. Each asset increase in the equation must have one or more of the following:
• asset decrease
• liability increase
• equity increase
• revenue increase
• gain increase
• expense decrease
• loss decrease

It’s all contained algebraically within the equation. There are no other options. Recall that the balance sheets for Enron and WorldCom were mathematically correct.

The balance sheet reports the resources and obligations of the firm. Because it’s a mixture of many different assets and liabilities with varying cost structures, it can be a bit confusing. Remember the consistency aspect of GAAP quality? That’s the one that said land bought for $100,000 20 years ago is still carried on the books at $100,000, even though it may be worth $10,000,000. Similarly, that new $1,000,000 machine that you bought a year ago may have been overtaken by such superior technology that you can’t even give it away. Still, it’s on the books for $1,000,000, less accumulated depreciation.

There are some other accounts that have some inherent risk. The accounts receivable may not all collect. If the inventory is particularly high, that could be a sign that the product is not moving. The balance sheet consists of many accounts that are actually estimates that may or may not come true. Understanding the potential limitations helps when considering the balance sheet in conjunction with other financial statements.

For many years, the accounting profession worked to get a grip on how to report the information contained in the statement of cash flows. In the 1960s, a funds statement was developed to meet the need for public companies to report this information. It languished from lack of attention. It wasn’t until late 1987 that the Accounting Principles Board established the format for the statement of cash flows.

I had a business school professor who liked to claim, “No one went broke making a profit.” Well, the statement of cash flows shows you how it can be done. If your collections don’t keep up with your payment obligations, you’ll run out of cash and be forced into bankruptcy. All those accounts receivable propping up the balance sheet lose cash value if they can’t be collected. Creditors prefer steak to paper, but will take potatoes if that’s all you have left.

The information in the income statement and the balance sheet comes from end-state accounts. The statement of cash flows (Table 3-3) is the only report that uses “flow” information. Changes in the cash flow can often explain why balance sheet accounts changed. The statement is also useful in projecting the liquidity of a business over time. One clear thing it will show is how a business uses the profits that it generates.

The first section of the statement is for operating activities. Operating activities are those things that generate cash income. These include sales receipts as well as inventory or manufacturer purchase. Cash from operations can be negative, and often is, especially in growing companies. At the start, operating losses rise as cash is spent for expenses. As you add business, you start to book some revenue. A lot of that revenue is in the form of accounts receivable, so your cash collection rate is a bit slow. Not for nothing is it called cash burn. Without loans or personal capital coming in to feed the fire, a company can be reduced to cinders.

A lot of that cash is going to investing activities. Investments are the power tools, shop buildings, and office equipment needed to get things started. It doesn’t matter if you are buying them outright or financing them, you’ll have to account for them. How you chose to pay for your assets will affect your cash flow. Which path you choose will depend on several variables—amount, interest rate, expected payback time, and forecast of future cash flows.

If you chose to use debt financing, the financing activities section is where you’ll record the loan proceeds. This section also shows the gozintas and gozoutas of cash to the owners through stock purchases, dividend payments, or shareholder loans.

Many companies are woefully undercapitalized, sometimes by owner intent, often through ignorance of the need. To be competitive, business owners and managers must continually plan to keep the cash flowing into the company. The U. S. Small Business Administration names ineffective cash flow management as one of the top reasons why firms fail.

There are two methods used to present statement of cash flows information, the indirect method (as in Table 3-3) and the direct method. The methods are different in their treatment of operating activities only. Most companies use the indirect method, because it’s easier. Most banks prefer the direct method, as it provides more information.

The indirect method does not report the operating cash flows. Instead, the operating activities section reconciles net income and net operating cash flows. You start with the net income from your income statement. You then adjust this accrual amount for items that do not affect cash flows. There are three basic types of adjustments in the operating activities section. The first involves non-cash outlays, such as depreciation or amortization. Then, adjust for gains and loses on transactions reported in other sections of the statement of cash flows. Finally, convert all current operating assets and liabilities from the accrual to the cash basis.

Table 3-3. Statement of cash flows

A way to visualize the cash coming in is with a corollary of the accounting equation (Table 3-4).

In the direct method, the net cash flow from operations is computed directly as the net sum of the operating cash flows. Your firm will do one or the other. Ask about why the particular

Table 3-4. Accounting equation

statement form was chosen and just learn it

The generic income statement below contains most of the elements found in a comprehensive income statement for a corporation. There’s certainly enough flexibility in the format to permit additions and subtractions based on the need to communicate business activity. In Chapter 1, we took a simplified approach to the income statement. The full income statement formula is an expanded accounting equation.

assets = liabilities + equity + revenues – expenses + gains – losses

Solving algebraically and then reducing it to the normal balance of each account yields the following:

assets + expenses + losses = liabilities + equity + revenue + gain or debits = credits

The income statement (Table 3-2) shows the profitability of the company.

The income statement is formatted with combinations of bold highlighting, indentation, preliminary account sums, and

Table 3-2. Income statement

aggregated category sums so the information is presented as clearly as possible. One of the few constants is that it will always show the company name, the type of statement, and the period being reported.

In this example, perhaps a small set design company, the Sales Revenue, the top line, is the money received from customers for the product. There are direct manufacturing costs involved and company records expenses for the raw material, the labor of the people who build the sets, and the overhead associated with manufacture. This overhead might be the shop where construction takes place as well as utility, insurance, and other costs associated with the defined work. Subtract these costs from Revenue to yield the Gross Margin.

Since this income statement calculates a Cost of Sales, General Widget (GW) provides a product. If GW were a service company, these costs would not appear. There are
variations in the income statement format depending on industry, company size, and disclosure needs. They will still follow the general sequence resolving debits and credits. Note also that this example classifies the income as it related first to production, the Gross Margin, also called “income from continuing operations.” Many consider this number the most important predictor of future business health. If it’s high, your business generates enough cash to support the activity that’s actually making money.

From the Gross Margin, subtract all the expenses incurred in “keeping the doors open” to yield Operating Income. This subdivision of the income statement is not a GAAP requirement, but it gives an idea of the strength and profitability of the core business operation. Then both expenses and income not related to operations are calculated. Often these are single-event items that will not recur—the tornado that took the roof or the obscure patent sold for big bucks. That brings us to Income Before Tax. We subtract the income tax and finally reach the bottom line, Net Income. This is how much we made. To know how well GW did as a company, you would have to compare this 7% return with others in the widget industry. It could be great, fair, or downright anemic.

Financial statements are historical documents. They report the past. Since there’s no way to directly know the future, we use financial statements—past performance—to forecast the future. If the accounting system operates under GAAP and the financial statements are prepared according to GAAP, we can use a variety of forecasting and analysis tools to predict the future performance of the business. This approach has many flaws, but it’s the most reliable of a shaky lot. (Shamans reading chicken guts and monkeys throwing darts are two discarded forecasting tools, although the monkeys still have a few adherents.)

From recording information in the general journal through the accounting cycle, the raw accounting information has three main purposes—financial data for external users and management, management cost results to guide decision making, and tax information for governmental authorities. Management can prepare several reports from this data. For present purposes, we will focus on three reports: the balance sheet, the income statement, and the statement of cash flows. Each of these statements highlights a particular portion of the accounting equation and its corollaries, to help you determine meaningful things about the activity of the enterprise. Recall The Three Questions. How much money came in? Where did the money go? How much money is left?

The income statement answers the first question. The revenue and expense accounts are added up for a given period of time, typically a year. The statement of cash flows solves the second question. It tracks where cash came from what it was used for. It also tracks activity for a given time period. Finally, the balance sheet polishes off the third of the three questions. It shows what’s left in the company. It’s the only one that uses a point in time, typically the end of the fiscal year.

All the gozinta and gozouta transactions of the business can be assigned to one of three categories of activities—operating, investing, and financing. Operating activities are what make the profits for the enterprise. Investing activities support operations through buying and selling the long-term assets needed to carry out operations. Those assets are paid for through the financing activities that come up with the cash and repay borrowed money.

Table 3-1. Financial statements and categories of activities

As we step through the financial statements, we can see where each category of activity fits.

Financial statements are a chief end product of sequential steps generally called the accounting cycle. The accounting cycle details a series of repeated procedures on different kinds of data. This stable repetition helps meet the calls for reliability, relevance, and consistency, to tick off just a few of the GAAP mandates.

We’ve already met most of the elements of the accounting transaction cycle. The cycle outlines the steps to be followed for receiving, entering, and presenting the transaction data that comes into the firm. The cycle ends with preparing for the next cycle. While different authors may assign different names and condense or expand certain areas, the accounting cycle will include the following steps:

1. Analyze business transactions.
2. Journalize transactions.
3. Post transactions to the ledger accounts.
4. Prepare a trial balance of the general ledger.
5. Analyze, prepare, and post the adjusting entries.
6. Prepare an adjusted trial balance.
7. Prepare the financial statements: income statement, balance sheet, and statement of cash flows.
8. Journalize and post the closing entries.
9. Prepare a post-closing trial balance.

There would be a flow of gozintas and gozoutas that we would visualize and fit into the accounting equation, or its corollary, the revenue proposition. Once the transaction is analyzed, the whole is recorded in the general journal. Then, the accounting system, either a computer or a Cratchit, groups each relevant piece of that transaction into individual account ledgers. These individual ledgers are then summed in the general ledger.

The process has been to record the compound elements of the transaction in the general journal. That entry is then broken down into account elements, like separating whites and colors, to push the laundry metaphor. Getting to the general ledger requires a first test of the accounting equation. All the accounts that normally carry a debit balance are summed against all the accounts that normally carry a credit balance. Remember how assets normally carry a debit balance and liabilities/ equities have a credit balance? Are the results in balance?

In a manual environment, the trial balance is often not in balance. Then, the problems must be exposed. Adjusting entries generally are made to meet the requirements of accrual accounting. The revenues are recorded when earned and expenses reported when incurred. We test the accounting equation again. There’ll be more on adjusting entries later. Look on this as the rinse phase.

When the adjusted trial balance is in balance, it’s used to prepare the financial statement(s). This might be considered the spin cycle. Then, any entries needed to close out this period and prepare for the next are posted. Closing involves zeroing out the revenue and expense accounts, while leaving the asset, liability, and equity accounts intact. A final balancing vindication of the accounting equation confirms that we’re set to face the next cycle in getting and spending.