Lita Epstein - Reading Financial Reports For Dummies

Equipment: This account tracks any equipment a company purchases that's expected to have a useful life of more than one year. This equipment includes computers, copiers, cash registers, and any other equipment needs. The depreciation account is Accumulated depreciation — Equipment .

Companies also hold intangible assets, which have value but are often difficult to measure. The following are the most common intangible assets in the Chart of Accounts:

Goodwill: A company needs this account only when it has bought another company. Frequently, a business that purchases another business pays more than the actual value of its assets minus its liabilities. The premium paid, which may account for factors such as customer loyalty, an exceptional workforce, and a great location, is listed on the books as goodwill.

Intellectual property: This category includes copyrights, patents, and written work or products for which the company has been granted exclusive rights. For example, the government grants patents to a company or individual that invents a new product or process. These assets are amortized, which is similar to depreciation, because intellectual property has a limited life span. The amortization account is Accumulated amortization — Intellectual property . Having exclusive rights to a product allows a company to hold off competition, which can mean a lot of extra profits. Patented products can often command a much higher price than products that aren't patented.

Money a company owes to creditors, vendors, suppliers, contractors, employees, government entities, and anyone else who provides products or services to the company is called a liability.

Current liabilities include money owed in the next 12 months. The following accounts record current liability transactions:

Accounts payable: This account includes all the payments to suppliers, vendors, contractors, and consultants that are due in less than one year. Most of the payments made on these accounts are for invoices due in less than two months.

Sales tax collected: This account tracks taxes collected for the state, local, or federal government on merchandise the company has sold. Firms record daily transactions in this account as they collect cash and make payments (usually monthly) to government agencies.

Accrued payroll taxes: This account includes any taxes that the company must pay to the state or federal government, based on taxes withheld from employees’ checks. These payments are usually made monthly or quarterly.

Credit card payable: This account tracks the payments to corporate credit cards. Some companies use these accounts as management tools for tracking employee activities and set them up by employee name, department name, or whatever method the company finds useful for monitoring credit card use.

Long-term liabilities include money due beyond the next 12 months. Companies use the following accounts to record long-term liability transactions:

Loans payable: This account tracks debts, such as mortgages or loans on vehicles, that are incurred for longer than one year.

Bonds payable: This account tracks corporate bonds that have been issued for a term longer than one year. Bonds are a type of debt sold on the market that must be repaid in full with interest.

Equity accounts reflect the portion of the assets that isn't subject to liabilities and is therefore owned by a company's shareholders. If the company isn't incorporated, the ownership of the partners or sole proprietors is represented in this part of the balance sheet in an account called Owner's equity or Shareholders’ equity. The following is a list of the most common equity accounts:

Common stock: This account reflects the value of the outstanding shares of common stock. Each share of common stock represents a portion of ownership, and this portion is calculated by multiplying the number of outstanding shares by the value of each share. Even companies that haven't sold stock in the public marketplace, but have incorporated, list shareholders on the incorporation documents and list the value of their shares on the balance sheet. Each common stock shareholder has a vote in the company's operations.

Preferred stock: This account reflects the value of outstanding shares of preferred stock, which falls somewhere between bonds and shares of stock. Although a company has no obligation to repay the preferred shareholders for their investment, it does promise these shareholders dividends. If the company can't pay the dividends for some reason, they're accrued for payment in later years. Any unpaid preferred stock dividends must be paid before a company pays dividends to common stock shareholders. Preferred shareholders don't vote in the firm's operations. If the business is liquidated, preferred shareholders receive their share of the assets before common shareholders.

Retained earnings: This account tracks the profits or losses for a company each year. These numbers reflect earnings retained instead of being paid out as dividends to shareholders. They show a company's long-term success or failure.

At the top of every income statement is the revenue the company brings in. This revenue is offset by any costs directly related to it. The top section of the income statement includes sales, cost of goods sold, and gross margin. Below this section, and before the profit and loss section, are the expenses. In this section, I review the key accounts in the Chart of Accounts that make up the income statement (see Chapter 7).

A company records all sales of products or services in revenue accounts. The following accounts record revenue transactions:

Sales of goods or services: This account tracks the company's revenues for the sale of its products or services.

Sales discounts: This account tracks any discounts the company offers to increase its sales. If a company is heavily discounting its products, either it may be competing intensely or interest in the product may be falling. A company outsider probably doesn't see these numbers, but if you're reading the reports prepared for internal management, this account gives you a view of how discounting is used.

Sales returns and allowances: This account tracks problem sales from unhappy customers. A large number here may reflect customer dissatisfaction, which could be the result of a quality-control problem. A company outsider probably doesn't see these numbers, but internal management financial reports show this information. A dramatic increase in this number is usually a red flag for company management.

A company tracks the costs directly related to the sale of goods or services in cost of goods sold accounts. The details usually appear only on internally distributed income statements and aren't distributed to company outsiders. Cost of goods sold is usually shown as a single line item, but it includes the transactions from all these accounts:

Purchases: This account tracks the cost of merchandise a company buys. A manufacturing company has an extensive tracking system for its cost of goods that includes accounts for items like raw materials, components, and labor to produce the final product.

Purchase discounts: This account tracks any cost savings a company is able to negotiate because of accelerated payment plans or volume buying. For example, if a vendor offers a 2 percent discount when a customer pays an invoice within 10 days rather than the normal 30 days, the vendor tracks this cost saving in purchase discounts.