Maire Loughran - Financial Accounting For Dummies

Earlier in this chapter in the “ Managing Cash” section, I emphasize the need to keep a handle on cash because having inadequate cash flow is the No. 1 reason why new businesses fail. You walked through Izzie Tees and Jeans Cash Budget and found that Izzie had a $10,872 cash shortfall as of the end of February.

Some quick suggestions were for Izzie to put off unnecessary purchases and try to extend terms for purchases she had made on account. On account simply means the vendor has shipped inventory to Izzie with a promise from Izzie to pay for it within a certain time frame. I want to delve into the topic of short-term debt (see Chapter 8).

It’s quite common in the business world to occasionally have a situation where you have to make payroll, and there just isn’t enough money in the business checking account to cover it. This sounds bad at face value, but there are some less than dire reasons for this to happen.

Accounts receivable is a biggie. Maybe you have a substantial customer that buys on credit. Based on your business relationship going back years, you know they will honor their commitment to send payment in the next 15 days. The cash implications are not a big deal.

Or the company may be in the business of manufacturing a seasonal item, such as patio furniture. Past performance has shown that 75 percent of sales take place in April through August. However, it is more efficient to manufacture the patio furniture year-round.

To finance the increase in patio furniture inventory, the company decides to take on short-term debt. The two most prevalent types of short-term debt (well, besides a loan from Mom!) are working capital loans and revolving lines of credit.

Working capital loans: This type of loan is made with the expectation that it will be paid back in the short term from sales and collections of accounts receivable. Short term means within 12 months. My students are usually surprised by the effect that working capital loans have on ratio analysis (see Chapter 14). Because cash and working capital loans are both current there is no effect on the current ratio. The addition to cash, a current asset, is cancelled out by the increase in working capital loans, which is a current liability.

Revolving line of credit: This source of cash is a maximum amount set by the lending institution, which the business uses at its discretion. Based on the terms, there is usually a requirement to make periodic payments once the funds are accessed.

Finally, keep in mind that there is no free lunch! Interest expense is a cost associated with the use of short-term debt —unless of course, the company lucks into an interest-free loan. Even those loans have a cost as the origination fee is generally anywhere from 3 to 5 percent of the loan amount.

Chapter 4

IN THIS CHAPTER

Taking a quick glimpse at accounting history

Introducing the accountant’s code of conduct (set by the AICPA)

Meeting the public accounting oversight agencies (such as the PCAOB)

Reviewing recent changes (made by the FASB)

Finding out about generally accepted accounting principles (GAAP)

If you’re not into following rules, financial accounting may not be the best career choice for you. You may want to consider the performing arts instead, or perhaps politics.

But if you’re the kind of person who thrives in a structured work environment, you’ve come to the right profession. The work of an accountant is carefully guided by standards, rules, and regulations that I introduce in this chapter.

After a whirlwind tour through the history of accounting, I present an overview of the financial accounting code of professional conduct, which is set by the American Institute of Certified Public Accountants (AICPA). These standards give you a roadmap to follow when you’re trying to figure out how to interact with your clients or employer and how to handle various accounting transactions taking place during day-to-day business operations.

Next, you meet the financial accounting standard-setting bodies and find out why publicly owned companies (those whose shares are freely traded on a public stock exchange) abide by different standards than privately owned companies.

Throughout this book, I refer to the acronym GAAP, which stands for generally accepted accounting principles. In this chapter, I explain that GAAP define for financial accountants the acceptable practices in the preparation of financial statements in the United States. Finally, I explain how GAAP have been restructured by the Financial Accounting Standards Board (FASB) into a more user-friendly format.

I hope you’re hungry, because in this chapter, you get out your spoon and dive into your alphabet soup!

I’d bet money that your financial accounting textbook takes a walk down memory lane in its first chapter, introducing you to the history of accounting. So I want to touch on a few major points to round out your textbook discussion before I explain current financial accounting standard setting.

If you’ve already taken an accounting history course, you know that accounting dates back to prehistoric times. If not, here are just a few number-crunching historic facts that place accounting in the context of world history:

Cavemen traded beads and other trinkets to acquire food and other basic necessities. These trades required some equitable method of measuring what trinkets were exchanged for how much food, for example, thus originating the concept of keeping track of — or accounting for — items.

Later in history, formal accounting records were kept to make sure subjects were paying the required amount of taxes to the Holy Roman and other empires.

The Industrial Revolution in the 18th and 19th centuries ushered in the mass production of goods through the use of machinery rather than craftsmen working with their hands. Mass production required a more sophisticated approach to recording the movement of goods, services, and money, ramping up the activities and professionalism of the accounting field. It also resulted in the separation of ownership from management.

Accountants plied their trade in a mostly unmonitored environment until the stock market crash of 1929. After this horrific event, the American Institute of Accountants, which is now the American Institute of Certified Public Accountants, partnered with the New York Stock Exchange to agree upon five principles of accounting.

Fast-forwarding to the present, these five principles have expanded into hundreds of principles covering every accounting topic imaginable, from how financial statements are prepared to accounting for different types of businesses.

If the financial accounting class you’re taking now is your first accounting or business class, you may be wondering why you have to record accounting events in such a nit-picky fashion. You may also wonder who the head nit-pickers are and from whence they get their authority. This chapter answers both questions and gives you a good foundation to tie into the information given in your financial accounting textbook.