Lita Epstein - Reading Financial Reports For Dummies

A similar process , amortization, is used for intangible assets, such as patents. Just as with depreciation, a company must write down the value of a patent as it nears expiration. Amortization expenses appear on the income statement, and the balance sheet shows the value of the asset. The line item Patent is shown first on the balance sheet, with another line item called Accumulated amortization below it. The Accumulated amortization line shows how much has been written down against the asset in the current year and any past years. The financial report reader thus has a way to quickly calculate how much value is left in a company's patents.

A company groups the accounts it uses to develop the financial statements in the Chart of Accounts, which is a listing of all open accounts that the accounting department can use to record transactions, according to the role of the accounts in the statements. All businesses have a Chart of Accounts, even if it's so small that they don't even realize they do and have never formally gone about designing it.

The Chart of Accounts for a business sort of builds itself as the company buys and sells assets for its use and records revenue earned and expenses incurred in its day-to-day operations.

If you work for a company and have responsibility for its transactions, you'll have a copy of the Chart of Accounts so that you know which account you want to use for each transaction. If you're a financial report reader with no internal company responsibilities, you won't get to see this Chart of Accounts — but you still need to understand what goes into these different accounts to understand what you're seeing in the financial statements.

Each account in a Chart of Accounts is assigned a number. This clearly defined structure helps accountants move from job to job and still quickly get a handle on the Chart of Accounts. Also, because most companies use computerized accounting, the software is developed with these numerical definitions. Some companies make up an alphabetical listing of their Chart of Accounts with numbers in parentheses to make finding accounts easier for managers who are unfamiliar with the structure.

The accounts in the Chart of Accounts appear in the following order:

Balance sheet asset accounts (usually in the number range of 1,000 to 1,999)

Liability accounts (with numbers ranging from 2,000 to 2,999)

Equity accounts (3,000 to 3,999)

Income statement accounts/revenue accounts (4,000 to 4,999)

Expense accounts (5,000 to 6,999)

In the old days, these accounts were recorded on paper, and finding a specific transaction on the dozens or even hundreds of pages was a nightmare. Today, because most companies use computerized accounting, you can easily design a report to find most types of transactions electronically by grouping them according to account type, customer, salesperson, product, or almost any other configuration that helps you decipher the entries.

Every transaction a company makes during the year eventually finds its way into the general ledger. Although companies often use the general ledger just for a summary of what happens in each of their accounts, some companies include details about specific transactions in their subledgers. For example, accounts receivable is likely summarized in the general ledger by just using the end-of-month totals for outstanding customer accounts. The actual detail of the transactions that take place during the month involving accounts receivable are in an accounts receivable subledger. In addition, accounting records show details for each customer, including what the customers bought and how much they still owe.

To help you become familiar with the types of accounts in the Chart of Accounts and the types of transactions in those accounts, I review the most common accounts in this section in the order in which you're most likely to read them in a financial report, but keep in mind your company may use a different numbering system.

Asset accounts come first in the Chart of Accounts, with the most current accounts (ones that the company will use in less than 12 months) listed before the long-term accounts (ones that the company will use in more than 12 months).

Assets that you can hold in your hand are tangible assets, and they include current assets and long-term assets. Current assets are assets that the company will use up in the next 12 months. The following are examples of current-asset accounts:

Cash in checking: This account is always the first one listed. Businesses use this account most often. They deposit their cash received as revenue and their cash paid out to cover bills and debt.

Cash in savings: This account is where firms keep cash they don't need for daily operations. It usually earns interest until the company decides how it wants to use this surplus cash.

Cash on hand: This account tracks the actual cash the company keeps at its business locations. Cash on hand includes money in the cash registers, as well as petty cash. Most companies have several different cash-on-hand accounts. For example, a store may have its own account for tracking cash in the registers, and each department may have its own petty cash account. How these accounts are structured depends on the company and the security controls it has in place to manage the cash on hand. Companies always leave plenty of room for additions in this account category.

Accounts receivable: In this account, businesses record transactions in which customers bought products on store or company credit. Only companies that use the accrual method of accounting need this account.

Inventory: This account tracks the cost of products the company has available for sale, whether it purchases the products from other companies or produces them in-house. Businesses adjust this account periodically throughout the year to reflect the changes in inventory affected by sales or other factors, such as breakage or theft. Although some firms use a computerized inventory system that adjusts the account almost instantaneously, others adjust the account only at the end of an accounting period.

Long-term assets are assets that a company will hold for more than 12 months. The following are common long-term asset accounts:

Land: This account records any purchases of land as a company asset. Companies list land separately because it doesn't depreciate in value like the building or buildings sitting on it do.

Buildings: This account lists the value of any buildings the company owns. This value is always a positive number.

Accumulated depreciation: This account tracks the depreciation of company-owned buildings. Each year, the firm deducts a portion of the building's value based on the building's costs and the number of years the building will have a productive life.

Leasehold improvements: This account tracks improvements to buildings that the company leases rather than buys. In most cases, when a company leases retail or warehouse space, it must pay the costs of improving the property for its unique business use. These improvements are also depreciated, so the company uses a companion depreciation account called Accumulated depreciation — Leasehold improvements .

Vehicles: This account tracks the cars, trucks, and other vehicles that a business owns. The initial value added to this account is the value of the vehicles when put into service. Vehicles are also depreciated, and the depreciation account is Accumulated depreciation — Vehicles .

Furniture and fixtures: This account tracks all the desks, chairs, and other fixtures a company buys for its offices, warehouses, and retail stores. Yes, these items, too, are depreciated, and the depreciation account is named Accumulated depreciation — Furniture and fixtures .