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5 Star Reviews from Amazon.com Readers
The Best Book on Financial Statements, Period! Wow, what
a great book! I’m a technical professional and now no longer in the
financially confused majority.
—Robert I. Hedges (Burnsville, MN)
Simply the Best! Clearly the first introductory book one should
read. This book—a must on every managers shelf—adds value by
providing clear and concise definitions and relates them visually
to the changing financial statements. A tremendous bang for buck.
Simply go get it and read it.
—ClimbHigh
A very useful book. While the book gets only skin deep on ac-
counting concepts, it does an excellent job in deconstructing how
the Income Statement, Statement of Cash Flows, and Balance
Sheet are changed. Very few accounting related books make ex-
plicit what happens the way this book does.
—R. Chonchol (Florida)
Financial
Statements
A Step-by-Step Guide
to Understanding
and Creating
Financial Reports
Pompton Plains NJ
Revised and Expanded Edition
Financial
Statements
A Step-by-Step Guide
to Understanding
and Creating
Financial Reports
by Thomas R. Ittelson
Copyright © 2009 by Thomas R. Ittelson
To order this title, please call toll-free 1-800-CAREER-1 (NJ and Canada:
201-848-0310) to order using VISA or MasterCard, or for further informa-
tion on books from Career Press.
Introduction ................................................................................................... 3
Preface
If the first edition of this book was an Knowing a little accounting and financial
entrepreneurial business, it would be a reporting can be very, very satisfying.
huge success. Now over 100,000 copies of Yes, it does all come out right at the end,
Financial Statements: A Step-by-Step and there is real beauty and poetry in its
Guide to Understanding and Creating structure.
Financial Reports are in-press and helping
non-financial managers and students of
But let’s discuss perhaps the real rea-
accounting and finance cope with the
son you’ve bought and are now reading
“numbers of business.”
this book. My bet is that it has to do with
With this new revised second edition, we
power. You want the power you see associ-
have expanded the book into five sections
ated with knowing how numbers flow in
from the original three. Many readers of
business.
the first edition wanted to better under-
Be it poetry or power, this accounting
stand capital investment decision-making,
and financial reporting stuff is not rocket
which is the focus of our two new sections.
science. You’ve learned all the math re-
Capital is often a company’s scarcest
quired to master accounting by the end of
resource, and using capital wisely is essen-
the fourth grade—mostly addition and
tial for success. The chief determinant of
subtraction with a bit of multiplication
what a company will become is the capital
and division thrown in to keep it lively.
investments it makes today. So in this new
The specialized vocabulary, on the
edition, we will use the financial analysis
other hand, can be confusing. You will
techniques of net present value (NPV) and
need to learn the accounting definitions of
internal rate of return (IRR) as capital in-
revenue, income, cost and expense. You’ll
vestment decision-making tools
also need to understand the structure and
appreciate the purpose of the three major
Preface to the First Edition: numeric statements that describe a com-
We needed to hire an accountant to pany’s financial condition.
keep the books at a venture-capital Here’s a hint: Watch where the money
backed, high-technology startup of which I flows; watch where goods and services
was a founder and CEO. I interviewed a flow. Documenting these movements of
young woman—just out of school—for the cash and product is all that financial
job and asked her why she wanted to be- statements do. It is no more complicated
come an accountant. Her answer was a than that. Everything else is details.
surprise to all of us, But why is it all so boring, you ask?
“Because accounting is so symmetrical, Well, it’s only boring if you do not under-
so logical, so beautiful and it always comes stand it. Yes, the day-to-day repetitive ac-
out right,” she said. counting tasks are boring. However, how
We hired her on the spot, thinking it to finance and extract cash from the ac-
would be fun to have almost-a-poet keep- tions of the enterprise is not boring at all.
ing our books. She worked out fine. It is the essence of business and the gen-
I hope you take away from this book a eration of wealth.
part of what my young accountant saw. Not boring at all.
—1—
Introduction
Many non-financial managers have an We will not get bogged down in details
accounting phobia …a financial vertigo that get in the way of conceptual under-
that limits their effectiveness. If you think standing. Just as it is not necessary to
“inventory turn” means rotating stock know how the microchips in your computer
on the shelf, and that “accrual” has some- work to multiply a few numbers, it’s not
thing to do with the Wicked Witch of the necessary to be a Certified Public Account-
West, then this book’s for you. ant (CPA) to have a working knowledge of
Financial Statements: A Step-by-Step the “accounting model of the enterprise.”
Guide to Understanding and Creating
Financial Reports is designed for those
business professionals (1) who know very Transactions. This book describes a
little about accounting and financial sequence of “transactions” of our sample
statements, but feel they should, and those company, AppleSeed Enterprises, Inc., as
(2) who need to know a little more, but for it goes about making and selling delicious
whom the normal accounting and financial applesauce. We will sell stock to raise
reporting texts are mysterious and un- money, buy machinery to make our prod-
enlightening. In fact, the above two cate- uct, and then satisfy our customers by
gories make up the majority of all people shipping wholesome applesauce. We’ll get
in business. You are not alone. paid and we will hope to make a profit.
Financial Statements: A Step-by-Step Then we will expand the business.
Guide to Understanding and Creating Fi- Each step along the way will generate
nancial Reports is a transaction-based, account “postings” on AppleSeed’s books.
business training tool with clarifying, We’ll discuss each transaction to get a
straightforward, real-life examples of how hands-on feel for how a company’s finan-
financial statements are built and how cial statements are constructed. We’ll
they interact to present a true financial learn how to report using the three main
picture of the enterprise. financial statements of a business—the
—3—
Financial Statements
Balance Sheet, Income Statement and ing. This book is especially directed at
Cash Flow Statement—for these common those managers, scientists and salespeople
business dealings: who should know how a Balance Sheet,
Income Statement and Cash Flow State-
1. selling stock
ment work…but don’t.
2. borrowing money Your goal is to gain knowledge of ac-
3. receiving orders counting and finance to assist you in your
4. shipping goods business dealings. You want the power
that comes from understanding financial
5. invoicing customers
manipulations. You must know how the
6. receiving payments score is kept in business. You recognize, as
7. paying sales commissions Gordon Baty says, you must “feel intui-
8. writing off bad debts tively comfortable with the accounting
model” to succeed in business.
9. prepaying expenses
10. ordering equipment
11. paying deposits
This book is divided into five main sec-
12. receiving raw materials tions, each with a specific teaching objec-
13. scrapping damaged product tive:
14. paying suppliers Section A. Financial Statements:
Structure & Vocabulary will introduce
15. booking manufacturing variances
the three main financial statements of the
16. depreciating fixed assets enterprise and define the special vocabu-
17. valuing inventory lary that is necessary to understand the
18. hiring staff and paying salary, books and to converse with accountants.
wages and payroll taxes Section B. Transactions: Exploits of
AppleSeed Enterprises, Inc. will take us
19. computing profit
through 31 business transactions, showing
20. paying income taxes how to report financial impact of each on
21. issuing dividends the Balance Sheet, Income Statement and
22. acquiring a business Cash Flow Statement of AppleSeed Enter-
prises.
23. and more
Section C. Financial Statements:
By the end of this book, you’ll know Construction & Analysis will subject the
your way around the finances of our apple- financial statement of our sample company
sauce-making company, AppleSeed Enter- to a rigorous analysis using common ratio
prises, Inc. analysis techniques. Then finally we will
Goals. My goal in writing this book is touch on how to “cook the books,” why
to help people in business master the someone would want to, and how to detect
basics of accounting and financial report- financial fraud.
—4—
Introduction
—5—
Section A. Financial Statements:
Structure & Vocabulary
—7—
About This Section
This book is written for people who need to The box below shows some of this confus-
use financial statements in their work but ing vocabulary. It is absolutely essential to
have no formal training in accounting and use these words correctly when discussing
financial reporting. Don’t feel bad if you financial statements. You’ll just have to
fall into this category. My guess is that 95 learn them. It’s really not that much, but
percent of all non-financial managers are it is important. Look at these examples:
financially illiterate when it comes to un- 1. Sales and revenue are synonymous
derstanding the company’s books. Let’s and mean the “top line” of the Income
proceed toward some enlightenment. Statement, the money that comes in from
customers.
2. Profits, earnings and income are all
This section is about financial state- synonymous and mean the “bottom line,”
ment structure and about the specialized or what is left over from revenue after all
vocabulary of financial reporting. We will the costs and expenses spent in generating
learn both together. It’s easier that way. that revenue are subtracted.
Much of what passes as complexity in ac- Note that revenue and income have
counting and financial reporting is just different meanings. Revenue is the “top
specialized (and sometimes counterintui- line” and income is the “bottom line” of the
tive) vocabulary and basically simple re- Income Statement. Got that?
porting structure that gets confusing only 3. Costs are money (mostly for materi-
in the details. als and labor) spent making a product.
Vocabulary. In accounting, some im- Expenses are money spent to develop it,
portant words may have meanings that sell it, account for it and manage this
are different from what you would think. whole making and selling process.
—9—
Financial Statements
4. Both costs and expenses become and the Cash Flow Statement. To end the
expenditures when money is actually sent section, we will discuss how these three
to vendors to pay for them. statements interact and when changing a
5. Orders are placed by customers and number in one necessitates changing a
signify a request for the future delivery of number in another.
products. Orders do not have an impact on
any of the financial statements in any way
until the products are actually shipped. At Chapter 1 will lay some ground rules
this point these shipments become sales. for financial reporting—starting points
Shipments and sales are synonymous. and assumptions that accounting profes-
6. Solvency means having enough sionals require to let them make sense of a
money in the bank to pay your bills. company’s books. In Chapter 2, we will
Profitability means that your sales are discuss the Balance Sheet—what you own
greater than your costs and expenses. You and what you owe. Then in Chapter 3
can be profitable and insolvent at the same comes the Income Statement reporting on
time. You are making money but still do the enterprise’s product selling activities
not have enough cash to pay your bills. and whether there is any money left over
Financial Statements. Once you un- after all these operations are done and ac-
derstand the specialized accounting vo- counted for.
cabulary, you can appreciate financial The last statement, but often the most
statement structure. For example, there important in the short term, is the Cash
will be no confusion when we say that Flow Statement discussed in Chapter 4.
revenue is at the top of an Income State- Look at this statement as a simple check
ment and income is at the bottom. register with deposits being cash in and
In this section, we will learn vocabulary any payments cash out.
and financial statement structure simul- Chapter 5 puts all three financial
taneously. Then follows a chapter on each statements together and shows how they
one of the three main financial statements: work in concert to give a true picture of
the Balance Sheet, the Income Statement the enterprise’s financial health.
— 10 —
Chapter 1. Twelve Basic Principles
Accountants have some basic rules and If during the review of a corporation’s
assumptions upon which rest all their books, the accountant has reason to be-
work in preparing financial statements. lieve that the company may go bankrupt,
These accounting rules and assumptions he must issue a “qualified opinion” stating
dictate what financial items to measure the potential of the company’s demise.
and when and how to measure them. By More on this concept later.
the end of this discussion, you will see how 3. Measurement. Accounting deals
necessary these rules and assumptions are with things that can be quantified—
to accounting and financial reporting. resources and obligations upon which there
So, here are the 12 very important is an agreed-upon value. Accounting only
accounting principles: deals with things that can be measured.
This assumption leaves out many very
1. accounting entity
valuable company “assets.” For example,
2. going concern
loyal customers, while necessary for com-
3. measurement
pany success, still cannot be quantified
4. units of measure
and assigned a value and thus are not
5. historical cost
stated in the books.
6. materiality
Financial statements contain only the
7. estimates and judgments
quantifiable estimates of assets (what the
8. consistency
business owns) and liabilities (what the
9. conservatism
business owes). The difference between the
10. periodicity
two equals owner’s equity.
11. substance over form
4. Units of Measure. U.S. dollars are
12. accrual basis of presentation
the units of value reported in the financial
These rules and assumptions define statements of U.S. companies. Results of
and qualify all that accountants do and all any foreign subsidiaries are translated
that financial reporting reports. We will into dollars for consolidated reporting of
deal with each in turn. results. As exchange rates vary, so do the
1. Accounting Entity. The accounting values of any foreign currency denomi-
entity is the business unit (regardless of nated assets and liabilities.
the legal business form) for which the 5. Historical Cost. What a company
financial statements are being prepared. owns and what it owes are recorded at
The accounting entity principle states that their original (historical) cost with no ad-
there is a “business entity” separate from justment for inflation.
its owners…a fictional “person” called a A company can own a building valued
company for which the books are written. at $50 million yet carry it on the books at
2. Going Concern. Unless there is its $5 million original purchase price (less
evidence to the contrary, accountants as- accumulated depreciation), a gross under-
sume that the life of the business entity is statement of value.
infinitely long. Obviously this assumption This assumption can greatly understate
can not be verified and is hardly ever true. the value of some assets purchased in the
But this assumption does greatly simplify past and depreciated to a very low amount
the presentation of the financial position of on the books. Why, you ask, do account-
the firm and aids in the preparation of ants demand that we obviously understate
financial statements. assets? Basically, it is the easiest thing to
— 11 —
Financial Statements
do. You do not have to appraise and reap- forth. Measurement techniques must be
praise all the time. consistent from any one fiscal period to
6. Materiality. Materiality refers to another.
the relative importance of different 9. Conservatism. Accountants have a
financial information. Accountants don’t downward measurement bias, preferring
sweat the small stuff. But all transactions understatement to overvaluation. For ex-
must be reported if they would materially ample, losses are recorded when you feel
affect the financial condition of the com- that they have a great probability of occur-
pany. ring, not later, when they actually do oc-
Remember, what is material for a cor- cur. Conversely, the recording of a gain is
ner drug store is not material for IBM (lost postponed until it actually occurs, not
in the rounding errors). Materiality is a when it is only anticipated.
straightforward judgment call. 10. Periodicity. Accountants assume
7. Estimates and Judgments. Com- that the life of a corporation can be divided
plexity and uncertainty make any meas- into periods of time for which profits and
urement less than exact. Estimates and losses can be reported, usually a month,
judgments must often be made for finan- quarter or year.
cial reporting. It is okay to guess if: (1) What is so special about a month, quar-
that is the best you can do and (2) the ex- ter or year? They are just convenient peri-
pected error would not matter much any- ods; short enough so that management can
way. But accountants should use the same remember what has happened, long
guessing method for each period. Be con- enough to have meaning and not just be
sistent in your guesses and do the best you random fluctuations. These periods are
can. called “fiscal” periods. For example, a
8. Consistency. Sometimes identical “fiscal year” could extend from October 1
transactions can be accounted for differ- in one year till September 30 in the next
ently. You could do it this way or that way, year. Or a company’s fiscal year could be
depending upon some preference. The the same as the calendar year starting on
principle of consistency states that each January 1 and ending on December 31.
individual enterprise must choose a single 11. Substance Over Form. Account-
method of reporting and use it consistently ants report the economic “substance” of a
over time. You cannot switch back and transaction rather than just its form. For
“Lines” are perhaps not as important as Note that while all the numbers in
principles, but they can be confusing if the statement represent currency, only
you don’t know how accountants use the top line and the bottom line nor-
them in financial statements. Financial mally show a dollar sign.
statements often have two types of lines a SALES [$]
to indicate types of numeric computa- b COST OF GOODS SOLD
tions.
a–b=c GROSS MARGIN
Single lines on a financial statement
indicate that a calculation (addition or d SALES & MARKETING
subtraction) has been made on the num- e R&D
bers just preceding in the column. f G&A
The double underline is saved for the d+e+f=g TOTAL EXPENSES
last. That is, use of a double underline h INTEREST INCOME
signifies the very last amount in the i INCOME TAXES
statement. c–g+h–i=j NET INCOME [$]
— 12 —
Twelve Basic Principals
example, an equipment lease that is really products (Cost of Goods Sold) are recorded
a purchase dressed in a costume, is booked at the same time the matching revenue is
as a purchase and not as a lease on recorded.
financial statements. This substance over Allocation. Many costs are not speci-
form rule states that if it’s a duck…then fically associated with a product. These
you must report it as a duck. costs must be allocated to fiscal periods in
12. Accrual Basis of Presentation. a reasonable fashion. For example, each
This concept is very important to under- month can be charged with one-twelfth of
stand. Accountants translate into dollars the general business insurance policy even
of profit or loss all the money-making (or though the policy was paid in full at the
losing) activities that take place during a beginning of the year. Other expenses are
fiscal period. In accrual accounting, if a recorded when they arise (period ex-
business action in a period makes money, penses).
then all its product costs and its business Note that all businesses with inventory
expenses should be reported in that period. must use the accrual basis of accounting.
Otherwise, profits and losses could flop Other businesses may use a “cash basis” if
around depending on which period entries they desire. Cash basis financial state-
were made. ments are just like the Cash Flow State-
In accrual accounting, this documenta- ment or a simple checkbook. We’ll describe
tion is accomplished by matching for pres- features of accrual accounting in the chap-
entation: (1) the revenue received in sell- ters that follow.
ing product and (2) the costs to make that
specific product sold. Fiscal period ex-
penses such as selling, legal, administra- Who makes all these rules? The sim-
tive and so forth are then subtracted. ple answer is that “FASB” makes the rules
Key to accrual accounting is determin- and they are called “GAAP.” Note also that
ing: (1) when you may report a sale on the FASB is made up of “CPAs.” Got that?
financial statements, (2) matching and Financial statements in the United
then reporting the appropriate costs of States must be prepared according to the
products sold and (3) using a systematic accounting profession’s set of rules and
and rational method allocating all the guiding principles called the Generally Ac-
other costs of being in business for the pe- cepted Accounting Principles, GAAP for
riod. We will deal with each point sepa- short. Other countries use different rules.
rately: GAAP is a series of conventions, rules
Revenue recognition. In accrual ac- and procedures for preparing and report-
counting, a sale is recorded when all the ing financial statements. The Financial
necessary activities to provide the good or Accounting Standards Board, FASB for
service have been completed regardless of short, lays out the GAAP conventions,
when cash changes hands. A customer just rules and procedures.
ordering a product has not yet generated The FASB’s mission is “to establish and
any revenue. Revenue is recorded when improve standards of financial accounting
the product is shipped. and reporting for guidance and education
Matching principle. In accrual ac- of the public, including issuers, auditors,
counting, the costs associated with making and users of financial information.” The
— 13 —
Financial Statements
Securities and Exchange Commission (SEC) a number of years. In addition, they have
designates FASB as the organization passed a series of exams testing their clear
responsible for setting accounting stan- understanding of both accounting princi-
dards for all U.S. public companies. ples and auditing procedures. Note that
CPAs CPAs are, of course, Certified FASB is made up mostly of CPAs and that
Public Accountants. These very exalted CPAs both develop, interpret and apply
individuals are specially trained in college, GAAP when they audit a company. All this
and have practiced auditing companies for is fairly incestuous.
— 14 —
The Balance Sheet
— 15 —
Financial Statements
• So, if you add an asset to the left side of the equation, you
must also increase the right side by adding a liability or
increasing worth. Two entries are required to keep the
equation in balance.
— 16 —
The Balance Sheet
— 17 —
Financial Statements
ASSETS
CASH A
ACCOUNTS RECEIVABLE B
INVENTORY C
PREPAID EXPENSES D
CURRENT ASSETS A+B+C+D=E
OTHER ASSETS F
— 18 —
The Balance Sheet
ASSETS most
liquid
CASH A
ACCOUNTS RECEIVABLE B
INVENTORY C
PREPAID EXPENSES D
CURRENT ASSETS A+B+C+D=E
OTHER ASSETS F
— 19 —
Financial Statements
ASSETS
CASH A
ACCOUNTS RECEIVABLE B
INVENTORY C
§ PREPAID EXPENSES
CURRENT ASSETS
OTHER ASSETS
D
A+B+C+D=E
F
Current Assets
By definition, current assets are those assets that are
expected to be converted into cash in less than 12 months.
1. Cash
2. Accounts receivable
3. Inventory
• The money the company will use to pay its bills in the
near term (within the year) will come when its current
assets are converted into cash (that is, inventory is sold
and accounts receivable are then paid to the company by
customers).
— 20 —
The Balance Sheet
§ ASSETS
CASH
ACCOUNTS RECEIVABLE
A
B
INVENTORY C
PREPAID EXPENSES D
CURRENT ASSETS A+B+C+D=E
OTHER ASSETS F
• When you write a check to pay a bill, you are taking money
out of cash assets.
— 21 —
Financial Statements
ASSETS
§ CASH
ACCOUNTS RECEIVABLE
INVENTORY
A
B
C
PREPAID EXPENSES D
CURRENT ASSETS A+B+C+D=E
OTHER ASSETS F
— 22 —
The Balance Sheet
ASSETS
CASH A
§ ACCOUNTS RECEIVABLE
INVENTORY
PREPAID EXPENSES
B
C
D
CURRENT ASSETS A+B+C+D=E
OTHER ASSETS F
— 23 —
Financial Statements
ASSETS
CASH A
ACCOUNTS RECEIVABLE B
§ INVENTORY
PREPAID EXPENSES
CURRENT ASSETS
C
D
A+B+C+D=E
OTHER ASSETS F
— 24 —
Index
— 285 —