Note: This text is intended to be a high-level introduction toaccounting/bookkeeping. The author will make his best effort to keep theinformation current and accurate; however, given the ever-changing nature ofindustry regulations, no guarantee can be made as to the accuracy of theinformationcontainedwithin.

AccountingMadeSimple:

AccountingExplainedin100PagesorLess

MikePiper

Copyright©2010MikePiperNo part of this publication may be reproduced or distributed without express permission of theauthor.SimpleSubjects,LLCChicago,Illinois60626ISBN:978-0-9814542-2-1www.ObliviousInvestor.com

Dedication

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Astheauthorofthisbook,I’mveryinterestedtohearyourthoughts.Ifyoufindthebookhelpful,pleaseletmeknow!Alternatively,ifyouhaveanysuggestionsofwaystomakethebookbetter,I’meagertohearthattoo.Finally,ifyou’reunsatisfiedwithyourpurchaseforanyreason,letmeknow,

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BestRegards,MikePiper

TableofContents1.AccountingEquation

Alwaystrue,noexceptionsOwners’EquityisjustaplugMyassetisyourliability

2.BalanceSheetIt’sasnapshotAssetsLiabilitiesEquityCurrentassetsandliabilitiesvs.long-termassetsandliabilitiesTwo-periodbalancesheets

3.IncomeStatementShowsperiodoftimeratherthanpointintimeGrossProfit&CostofGoodsSoldOperatingIncomevs.NetIncome

4.StatementofRetainedEarningsBridgebetweenfinancialstatementsDividendsarenotanexpense!RetainedEarnings:Notthesameascash

5.CashFlowStatementAsopposedtoincomestatementCashflowfromoperatingactivitiesCashflowfrominvestingactivitiesCashflowfromfinancingactivities

6.FinancialRatiosLiquidityratiosProfitabilityratios

FinancialleverageratiosAssetturnoverratiosPartTwoGenerallyAcceptedAccountingPrinciples(GAAP)

7.WhatisGAAP?WhohastofollowGAAP?

8.DebitsandCreditsDouble-entrysystemThegeneralledgerT-accountsThetrialbalance

9.Cashvs.AccrualCashmethodAccrualmethodPrepaidexpensesUnearnedrevenue

10.OtherGAAPConcepts&AssumptionsHistoricalcostMaterialityMoneyunitassumptionEntityassumptionMatchingprinciple

11.DepreciationofFixedAssetsStraight-linedepreciationAccumulatedDepreciationSalvagevalueGainorlossonsaleOtherdepreciationmethodsExpensingimmaterialpurchases

12.AmortizationofIntangibleAssetsWhatareintangibleassets?Straight-lineamortizationLegallifevs.expectedusefullife13.Inventory&CoGS

PerpetualmethodPeriodicmethodCalculatingCostofGoodsSoldFIFOvs.LIFOAveragecostmethod

Conclusion:TheHumbleLittleJournalEntry

Introduction

Like the other books in the “…in 100 Pages or Less” series, this book is

designed to give you a basic understanding of the topic (in this case,accounting),anddoitasquicklyaspossible.Theonlywaytopackatopicsuchasaccountingintojust100pagesistobeas

briefaspossible.Inotherwords,thegoalisnottoturnyouintoanexpert.With100 pages, it’s simply not possible to provide a comprehensive discussion ofeverytopicinthefieldofaccounting.(Soifthat’swhatyou’relookingfor,lookforadifferentbook.)Now,havingmadethatlittledisclaimer,IshouldstatethatIdothinkthisbook

willhelpyouachieveadecentunderstandingofthemostimportantaccountingconcepts.

SoWhatExactlyIsAccounting?

Someprofessorsliketosaythataccountingis“thelanguageofbusiness.”Thatdefinition has always been somewhat too abstract formy tastes.That said, allthoseprofessorsareright.At its most fundamental level, accounting is the system of tracking the

income,expenses,assets,anddebtsofabusiness.Whenlookedatwithatrainedeye, a business’s accounting records truly tell the storyof the business.Usingnothingbutabusiness’s“books”(accountingrecords),youcanlearnpracticallyanything about a business. You can learn simple things such as whether it’sgrowingordeclining,healthyorintrouble.Or,ifyoulookclosely,youcanseethings such as potential threats to the business’s health that might not beapparenteventopeoplewithinthecompany.

WhereWe’reGoing

Thisbookisbrokendownintotwomainparts:

1. Adiscussionofthemostimportantfinancialstatementsusedinaccounting:Howtoreadeachone,aswellaswhatlessonsyoucandrawfromeach.

2. A look at accounting using Generally Accepted Accounting Principals(GAAP),including:

Topicssuchasdouble-entrybookkeeping,debitsandcredits,and thecashvs.accrualmethods.How to account for some of the more complicated types oftransactions,suchasdepreciationexpense,gainsorlossesonsalesofproperty,inventoryandcostofgoodssold,andsoon.

Solet’sgetstarted.

PARTONE

FinancialStatements

CHAPTERONE

TheAccountingEquation

Before you can create financial statements, youneed to first understand the

singlemostfundamentalconceptofaccounting:TheAccountingEquation.TheAccountingEquationstatesthatatalltimes,andwithoutexceptions,the

followingwillbetrue:

Assets=Liabilities+Owners’EquitySowhatdoesthatmean?Let’stakealookattheequationpiecebypiece.

Assets:Allofthepropertyownedbythecompany.

Liabilities: All of the debts that the company currently has outstanding tolenders.

Owners’Equity(a.k.a.Shareholders’Equity):

Thecompany’sownershipinterestinitsassets,afteralldebtshavebeenrepaid.

Let’suseasimple,everydayexample:homeownership.

EXAMPLE:Lisaownsa$300,000home.Topayforthehome,shetookoutamortgage,onwhichshestillowes$230,000.Lisawouldbesaidtohave$70,000“equity in the home.” Applying the Accounting Equation to Lisa’s situationwouldgiveusthis:

Assets = Liabilities + Owners’Equity$300,000 = $230,000 + $70,000Inotherwords,owners’equity(thepartthatoftenconfusespeople)isjustaplugfigure. It’s simply the leftover amount after payingoff the liabilities/debts. SowhiletheAccountingEquationisconventionallywrittenas:Assets=Liabilities+Owners’Equity,…itmightbeeasiertothinkofitthisway:Assets–Liabilities=Owners’EquityIf,oneyearlater,Lisahadpaidoff$15,000ofhermortgage,heraccounting

equationwouldnowappearasfollows:

Assets = Liabilities + Owners’Equity$300,000 = $215,000 + $85,000Because her liabilities have gone down by $15,000—and her assets have notchanged—herowner’sequityhas,bydefault,increasedby$15,000.

MyAssetisYourLiability

Oneconceptthatcantripupaccountingnovicesistheideathataliabilityforonepersonis,infact,anassetforsomebodyelse.Forexample,ifyoutakeoutaloanwithyourbank, the loan is clearly a liability foryou.From theperspectiveofyourbank,however,theloanisanasset.Similarly, the balance in your savings or checking account is, of course, an

asset(toyou).Forthebank,however,thebalanceisaliability.It’smoneythattheyoweyou,asyou’reallowedtodemandfullorpartialpaymentofitatanytime.

Chapter1SimpleSummary1

Acompany’sassetsconsistofallthepropertythatthecompanyowns.Acompany’sliabilitiesconsistofallthedebtthatthecompanyowestolenders.Acompany’sowners’equityisequaltotheowners’interestinthecompany’sassets,afterpayingbackallthecompany’sdebts.TheAccountingEquationisalwayswrittenasfollows:Assets=Liabilities+Owners’EquityHowever,it’slikelyeasiertothinkoftheAccountingEquationthisway:Assets–Liabilities=Owners’Equity.

CHAPTERTWO

TheBalanceSheet

A company’s balance sheet shows its financial situation at a given point in

time. It is,quite simply,a formalpresentationof theAccountingEquation.Asyou’d expect, the three sections of a balance sheet are assets, liabilities, andowners’equity.Havea lookat the exampleof abasicbalance sheeton the followingpage.

Let’sgooverwhateachoftheaccountsrefersto.

Assets

Cash andCash Equivalents: Balances in checking and savings accounts, aswellasanyinvestmentsthatwillmaturewithin3monthsorless.

BalanceSheetAssets CashandCashEquivalents $50,000Inventory $110,000AccountsReceivable $20,000Property,Plant,andEquipment $300,000TotalAssets: $480,000 Liabilities AccountsPayable $20,000NotesPayable $270,000TotalLiabilities: $290,000 Owners’Equity CommonStock $50,000RetainedEarnings $140,000TotalOwners’Equity $190,000TotalLiabilities+Owners’Equity: $480,000Inventory:Goodskeptinstock,availableforsale.AccountsReceivable:Amountsduefromcustomersforgoodsorservicesthathavealreadybeendelivered.

Property,Plant,andEquipment:Assetsthatcannotreadilybeconvertedintocash—things such as computers,manufacturing equipment, vehicles, furniture,etc.

Liabilities

Accounts Payable:Amounts due to suppliers for goods or services that havealreadybeenreceived.NotesPayable:Contractualobligationsduetolenders(e.g.,bankloans).

Owners’Equity

CommonStock:Amountsinvestedbytheownersofthecompany.RetainedEarnings:Thesumofallnetincomeoverthelifeofthebusinessthathasnotbeendistributedtoownersintheformofadividend.(Ifthisisconfusingat themoment, don’tworry. Itwill be explained inmore detail inChapter 4,whichdiscussestheStatementofRetainedEarnings.)

Currentvs.Long-Term

Often, the assets and liabilities on a balance sheet will be broken down intocurrentassets (or liabilities)and long-termassets (or liabilities).Currentassetsare those thatareexpected tobeconverted intocashwithin12monthsor less.TypicalcurrentassetsincludeAccountsReceivable,Cash,andInventory.Everything that isn’t a current asset is, by default, a long-term asset.

Sometimes, long-term assets are referred to, understandably, as non-currentassets.Property,Plant,andEquipmentisalong-termassetaccount.Currentliabilitiesarethosethatwillneedtobepaidoffwithin12monthsor

less. The most common example of a current liability is Accounts Payable.NotesPayablethatarepaidoffoveraperiodoftimearesplituponthebalancesheet so that the next 12 months’ payments are shown as a current liability,whiletheremainderofthenoteisshownasalong-termliability.

Multiple-PeriodBalanceSheets

What you’ll often see when looking at published financial statements is abalance sheet—such as theoneon the followingpage—that has two columns.One column shows the balances as of the end of the most recent accountingperiod,andtheadjoiningcolumnshowsthebalancesasofthepriorperiod-end.Thisisdonesothatareadercanseehowthefinancialpositionofthecompanyhaschangedovertime.Forexample,lookingatthebalancesheetonthefollowingpagewecanlearn

afewthingsaboutthehealthofthecompany.Overall,itappearsthatthingsaregoing well. The company’s assets are increasing while its debt is being paiddown.The only thing that might be of concern is an increase in Accounts

Receivable.An increase inAccountsReceivablecouldbe indicativeof troublewithgetting clients to payon time.On theother hand, it’s alsoquite possiblethat it’s simply the result of an increase in sales, and there’snothing toworryabout.

BalanceSheetCurrentAssets 12/31/11 12/31/10CashandCashEquivalents $50,000 $30,000AccountsReceivable $20,000 $5,000TotalCurrentAssets $70,000 $35,000 Non-CurrentAssets Property,Plant,andEquipment $330,000 $330,000TotalNon-CurrentAssets: $330,000 $330,000 TotalAssets $400,000 $365,000 CurrentLiabilities AccountsPayable $20,000 $22,000

CurrentPortionofNotePayable $12,000 $12,000TotalCurrentLiabilities $32,000 $34,000 Long-TermLiabilities Non-CurrentPortionofNote $250,000 $262,000TotalLong-TermLiabilities $250,000 $262,000 TotalLiabilities: $282,000 $296,000 Owners’Equity CommonStock $30,000 $30,000RetainedEarnings $88,000 $39,000TotalOwners’Equity $118,000 $69,000 TotalLiabilities+Equity: $400,000 $365,000

Chapter2SimpleSummary2

Acompany’sbalancesheetshowsitsfinancialpositionatagivenpointintime.BalancesheetsareformattedinaccordancewiththeAccountingEquation:Assets=Liabilities+Owners’EquityCurrentassetsarethosethatareexpectedtobeconvertedintocashwithin12monthsorless.Anyassetthatisnotacurrentassetisanon-current(a.k.a.long-term)assetbydefault.Currentliabilitiesarethosethatwillneedtobepaidoffwithinthenext12months.Bydefault,anyliabilitythatisnotacurrentliabilityisalong-termliability.

CHAPTERTHREE

TheIncomeStatement

Acompany’s income statement shows the company’s financial performance

overaperiodoftime(usuallyoneyear).Thisisincontrasttothebalancesheet,whichshowsfinancialpositionatapoint intime.Afrequentlyusedanalogyisthatthebalancesheetislikeaphotograph,whiletheincomestatementismoreakintoavideo.The incomestatement—sometimes referred toas aprofit and loss (orP&L)

statement—isorganizedexactlyhowyou’dexpect.Thefirstsectiondetails thecompany’srevenues,whilethesecondsectiondetailsthecompany’sexpenses.

IncomeStatement Revenue Sales $300,000CostofGoodsSold (100,000)3

GrossProfit 200,000 Expenses Rent 30,000SalariesandWages 80,000Advertising 15,000Insurance 10,000TotalExpenses 135,000 NetIncome $65,000

GrossProfitandCostofGoodsSold

GrossProfit refers to the sumof a company’s revenues,minusCostofGoodsSold.CostofGoodsSold(CoGS)is theamount that thecompanypaidfor thegoodsthatitsoldoverthecourseoftheperiod.

EXAMPLE: Laura runs a small business selling t-shirts with band logos onthem.Atthebeginningofthemonth,Lauraordered100t-shirtsfor$3each.Bytheendofthemonth,shehadsoldallofthet-shirtsforatotalof$800.Forthemonth,Laura’sCostofGoodsSoldis$300,andherGrossProfitis$500.4EXAMPLE:Richrunsasmallbusinesspreparing taxreturns.Allofhiscostsareoverhead—thatis,eachadditionalreturnhepreparesaddsnothingtohistotalcosts—sohehasnoCostofGoodsSold.HisGrossProfitissimplyequaltohisrevenues.

OperatingIncomevs.NetIncome

Sometimes,you’llseeanincomestatement—liketheoneonthefollowingpage—that separates “Operating Expenses” from “Non-Operating Expenses.”Operating Expenses are the expenses related to the normal operation of thebusinessandarelikelytobeincurredinfutureperiodsaswell.Thingssuchasrent, insurance premiums, and employees’ wages are typical OperatingExpenses.Non-OperatingExpensesarethosethatareunrelatedtotheregularoperation

ofthebusinessand,asaresult,areunlikelytobeincurredagaininthefollowingyear.(AtypicalexampleofaNon-OperatingExpensewouldbealawsuit.)

IncomeStatement Revenue Sales $450,000CostofGoodsSold (75,000)GrossProfit 375,000 OperatingExpenses Rent 45,000SalariesandWages 120,000Advertising 25,000Insurance 10,000TotalOperatingExpenses 200,000 OperatingIncome 175,000 Non-OperatingExpenses LawsuitSettlement 120,000TotalNon-OperatingExpenses

TotalNon-OperatingExpenses120,000

NetIncome $55,000 The reasoning behind separating Operating Expenses from Non-OperatingExpenses is that it allows for the calculation of Operating Income. In theory,Operating Income isamoremeaningfulnumber thanNet Income,as it shouldoffer abetter indicatorofwhat the company’s income is going to look like infutureyears.Theeffectof this focusonOperatingIncomeasopposed toNet Incomehas

beentocausemanycompaniestomakeeffortstoclassifyasmanyexpensesaspossibleasNon-OperatingwiththeintentionofmakingtheirOperatingIncomelookmoreimpressivetoinvestors.Asaresultofthis“creativeaccounting,”it’sbecomeabitofadebatewhichincomefigureis,infact,thebetterindicatoroffuturesuccess.

Chapter3SimpleSummary

Theincomestatementshowsacompany’sfinancialperformanceoveraperiodoftime(usuallyayear).Acompany’sGrossisequaltoitsrevenuesminusitsCostofGoodsSold.Acompany’sOperatingIncomeisequaltoitsGrossProfitminusitsOperatingExpenses—theexpensesthathavetodowiththenormaloperationofthebusiness.Acompany’sNetIncomeisequaltoitsOperatingIncome,minusanyNon-OperatingExpenses.

CHAPTERFOUR

TheStatementofRetainedEarnings

The statement of retained earnings is a very brief financial statement. (See

example on following page.) It has only one purpose, which, as you wouldexpect,istodetailthechangesinacompany’sretainedearningsoveraperiodoftime.Again,retainedearningsisthesumofallofacompany’sundistributedprofits

over the entire existence of the company.We say “undistributed” in order todistinguish fromprofits thathave beendistributed to company shareholders intheformofdividendpayments.

EXAMPLE:ABCConstruction is formed on January 1, 2011.At its date offormation,itnaturallyhasaRetainedEarningsbalanceofzero(becauseithasn’thadanynetincomeyet).Over the course of 2011, ABC Construction’s net income is $50,000. In

December of the year, it pays a dividend of $20,000 to its shareholders. Itsretainedearningsstatementfortheyearwouldlookasfollows.

StatementofRetainedEarningsRetainedEarnings,1/1/2011 $0NetIncome 50,000DividendsPaidtoShareholders (20,000)RetainedEarnings,12/31/2011 $30,000If, in2012,ABCConstruction’snetincomewas$70,000anditagainpaida

$20,000dividend,its2012retainedearningsstatementwouldappearasfollows:

StatementofRetainedEarningsRetainedEarnings,1/1/2012 $30,000NetIncome 70,000DividendsPaidtoShareholders (20,000)RetainedEarnings,12/31/2012

RetainedEarnings,12/31/2012 $80,000

BridgeBetweenFinancialStatements

The statement of retained earnings functions much like a bridge between theincome statement and the balance sheet. It takes information from the incomestatement,anditprovidesinformationtothebalancesheet.Thefinalstepofpreparinganincomestatementiscalculatingthecompany’s

netincome:

IncomeStatement Revenue Sales $240,000GrossProfit 240,000 Expenses Rent 70,000SalariesandWages 80,000TotalExpenses 150,000 NetIncome $90,000Net income is then used in the statement of retained earnings to calculate theend-of-yearbalanceinRetainedEarnings:

StatementofRetainedEarningsRetainedEarnings,Beginning $40,000NetIncome 90,000DividendsPaidtoShareholders (50,000)RetainedEarnings,Ending $80,000The ending Retained Earnings balance is then used to prepare the company’s

end-of-yearbalancesheet:

BalanceSheetAssets CashandCashEquivalents $130,000Inventory 80,000TotalAssets: 210,000 Liabilities AccountsPayable 20,000TotalLiabilities: 20,000 Owners’Equity CommonStock 110,000RetainedEarnings 80,000TotalOwners’Equity 190,000 TotalLiabilities+Owners’Equity: $210,000

Dividends:NotanExpense!

When first learning accounting,many people are tempted to classify dividendpaymentsasanexpense.It’strue,theydolookalotlikeanexpenseinthattheyareacashpaymentmadefromthecompanytoanotherparty.Unlike many other cash payments, however, dividends are simply a

distribution ofprofits (asopposed toexpenses,which reduceprofits).Becausetheyarenotapartof thecalculationofnet income,dividendpaymentsdonotshow up on the income statement. Instead, they appear on the statement ofretainedearnings.

RetainedEarnings:It’sNottheSameasCash

The definition of retained earnings—the sum of a company’s undistributedprofits over the entire existence of the company—makes it sound as if acompany’sRetainedEarningsbalancemustbesittingaroundsomewhereascashinacheckingorsavingsaccount.Inalllikelihood,however,thatisn’tthecaseatall.Just because a company hasn’t distributed its profits to its owners doesn’t

mean it hasn’t already used them for something else. For instance, profits arefrequentlyreinvestedingrowingthecompanybypurchasingmoreinventoryforsaleorpurchasingmoreequipmentforproduction.

Chapter4SimpleSummary

Thestatementofretainedearningsdetailsthechangesinacompany’sretainedearningsoveraperiodoftime.Thestatementofretainedearningsactsasabridgebetweentheincomestatementandthebalancesheet.Ittakesinformationfromtheincomestatement,anditprovidesinformationtothebalancesheet.Dividendpaymentsarenotanexpense.Theyareadistributionofprofits.Retainedearningsisnotthesameascash.Often,asignificantportionofacompany’sretainedearningsisspentonattemptstogrowthecompany.

CHAPTERFIVE

TheCashFlowStatement

The cash flow statement does exactly what it sounds like: It reports a

company’scashinflowsandoutflowsoveranaccountingperiod.

CashFlowStatementvs.IncomeStatement

Atfirst,itmaysoundasifacashflowstatementfulfillsthesamepurposeasanincomestatement.Thereare,however,someimportantdifferencesbetweenthetwo.First, there are often differences in timing between when an income or

expense item is recordedandwhen thecashactuallycomes inorgoesout thedoor. We’ll discuss this topic much more thoroughly in Chapter 9: Cash vs.Accrual.Fornow,let’sjustconsiderabriefexample.

EXAMPLE:InSeptember,XYZConsultingperformsmarketingservicesforacustomerwhodoesnotpayuntil thebeginningofOctober. InSeptember, thissalewouldbe recordedas an increase inbothSales andAccountsReceivable.(AndthesalewouldshowuponaSeptemberincomestatement.)Thecash,however,isn’tactuallyreceiveduntilOctober,sotheactivitywould

notappearonSeptember’scashflowstatement.Thesecondmajordifferencebetweentheincomestatementandthecashflow

statement is that thecash flowstatement includes several typesof transactionsthatarenotincludedintheincomestatement.

EXAMPLE:XYZConsultingtakesoutaloanwithitsbank.Theloanwillnotappearontheincomestatement,asthetransactionisneitherarevenueitemnoranexpenseitem.Itissimplyanincreaseofanasset(Cash)andaliability(NotesPayable).However,becauseit’sacashinflow,theloanwillappearonthecashflowstatement.EXAMPLE: XYZ Consulting pays its shareholders a $30,000 dividend. Asdiscussed inChapter 4, dividends are not an expense. Therefore, the dividendwill not appear on the income statement. Itwill, however, appear on the cashflowstatementasacashoutflow.

CategoriesofCashFlow

Onacashflowstatement(suchastheexampleonpage39)allcashinflowsoroutflowsareseparatedintooneofthreecategories:

1. Cashflowfromoperatingactivities,2. Cashflowfrominvestingactivities,and3. Cashflowfromfinancingactivities.

CashFlowfromOperatingActivities

The concept of cash flow from operating activities is quite similar to that ofOperating Income. The goal is to measure the cash flow that is the result ofactivities directly related to normal business operations (i.e., things that willlikelyberepeatedyearafteryear).Common items that are categorized as cash flow from operating activities

include:

Receiptsfromthesaleofgoodsorservices,Paymentsmadetosuppliers,Paymentsmadetoemployees,andTaxpayments.

CashFlowfromInvestingActivities

Cashflowfrominvestingactivitiesincludescashspenton—orreceivedfrom—investmentsinfinancialsecurities(stocks,bonds,etc.)aswellascashspenton—orreceivedfrom—capitalassets(i.e.,assetsexpectedto last longer thanoneyear).Typicalitemsinthiscategoryinclude:

Purchaseorsaleofproperty,plant,orequipment,Purchaseorsaleofstocksorbonds,andInterestordividendsreceivedfrominvestments.

CashFlowfromFinancingActivities

Cashflowfromfinancingactivitiesincludescashinflowsandoutflowsrelatingto transactions with the company’s owners and creditors. Common items thatwouldfallinthiscategoryinclude:

Dividendspaidtoshareholders,Cashflowrelatedtotakingout—orpayingback—aloan,andCashreceivedfrominvestorswhennewsharesofstockareissued.

CashFlowStatement CashFlowfromOperatingActivities: Cashreceiptsfromcustomers $320,000Cashpaidtosuppliers (50,000)Cashpaidtoemployees (40,000)Incometaxespaid (55,000)NetCashFlowFromOperatingActivities 175,000 CashFlowfromInvestingActivities: Cashspentonpurchaseofequipment (210,000)NetCashFlowFromInvestingActivities (210,000) CashFlowfromFinancingActivities: Dividendspaidtoshareholders (25,000)Cashreceivedfromissuingnewshares 250,000NetCashFlowFromFinancingActivities 225,000 Netincreaseincash: $190,000

Chapter5SimpleSummary

Thecashflowstatementandtheincomestatementdifferinthattheyreporttransactionsatdifferenttimes.(We’lldiscussthismorethoroughlyinChapter9:Cashvs.Accrual.)Thecashflowstatementalsodiffersfromtheincomestatementinthatitshowsmanytransactionsthatwouldnotappearontheincomestatement.Cashflowfromoperatingactivitiesincludescashtransactionsthatoccurasaresultofnormalbusinessoperations.Cashflowfrominvestingactivitiesincludescashtransactionsrelatingtoacompany’sinvestmentsinfinancialsecuritiesandcashtransactionsrelatingtolong-termassetssuchasproperty,plant,andequipment.Cashflowfromfinancingactivitiesincludescashtransactionsbetweenthecompanyanditsownersorcreditors.

CHAPTERSIX

FinancialRatios

Ofcourse,nowthatyouknowhowtoreadfinancialstatements,alogicalnext

stepwouldbe to takea lookat thedifferentconclusionsyoucandrawfromacompany’s financials. For themost part, thiswork is done by calculating andcomparingseveraldifferentratios.

LiquidityRatios

Liquidityratiosareusedtodeterminehoweasilyacompanywillbeabletomeetits short-term financial obligations. Generally speaking, with liquidity ratios,higherisbetter.Themostfrequentlyusedliquidityratioisknownasthecurrentratio:

A company’s current ratio serves to provide an assessment of the company’sabilitytopayoffitscurrentliabilities(liabilitiesduewithinayearorless)usingitscurrentassets(cashandassetslikelytobeconvertedtocashwithinayearorless).Acompany’squickratioservesthesamepurposeasitscurrentratio:Itseeks

toassessthecompany’sabilitytopayoffitscurrentliabilities.

The difference between quick ratio and current ratio is that the calculation ofquickratioexcludesinventorybalances.Thisisdoneinordertoprovideaworst-case-scenario assessment: How well will the company be able to fulfill itscurrent liabilities if sales are slow (that is, if inventories are not converted tocash)?

EXAMPLE: ABC Toys (see balance sheet on page 43) would calculate itsliquidityratiosasfollows:

Acurrent ratioof1 tellsus thatABCToys’currentassetsmatch itscurrent

liabilities, meaning it shouldn’t have any trouble handling its financialobligationsoverthenext12months.However, a quick ratio of only 0.5 indicates that ABC Toys will need to

maintainatleastsomelevelofsalesinordertosatisfyitsliabilities.

BalanceSheet,ABCToysAssets CashandCashEquivalents $40,000Inventory 100,000AccountsReceivable 60,000Property,Plant,andEquipment 300,000TotalAssets: 500,000 Liabilities AccountsPayable 50,000IncomeTaxPayable 150,000TotalLiabilities: 200,000 Owners’Equity CommonStock 160,000RetainedEarnings 140,000TotalOwners’Equity 300,000 TotalLiabilities+Owners’Equity: $500,000

ProfitabilityRatios

While a company’s net income is certainly a valuable piece of information, itdoesn’ttellthewholestoryintermsofhowprofitableacompanyreallyis.Forexample,Google’s net income is going to absolutely dwarf the net income ofyourfavoritelocalItalianrestaurant.Butthetwobusinessesareofsuchdifferentsizes that the comparison is rathermeaningless, right?That’swhywe use thetwofollowingratios:

Acompany’sreturnonassetsshowsusacompany’sprofitabilityincomparisonto the company’s size (asmeasuredby total assets). In otherwords, return onassetsseeks toanswer thequestion,“Howefficiently is thiscompanyusing itsassetstogenerateprofits?”Returnonequityissimilarexceptthatshareholders’equityisusedinplaceof

total assets.Return on equity asks, “Howefficiently is this company using itsinvestors’moneytogenerateprofits?”By using return on assets or return on equity, you can actually make

meaningfulcomparisonsbetweentheprofitabilityoftwocompanies,evenifthecompaniesareofdrasticallydifferentsizes.

EXAMPLE:Using the balance sheet frompage 43 and the income statementbelow,wecancalculatethefollowingprofitabilityratiosforABCToys:

IncomeStatement,ABCToys Revenue Sales $300,000CostofGoodsSold (100,000)GrossProfit 200,000 Expenses Rent 30,000SalariesandWages 80,000TotalExpenses 110,000 NetIncome $90,000A company’s gross profit margin shows what percentage of sales remains

after covering the cost of the sold inventory. This gross profit is then used tocoveroverheadcosts,withtheremainderbeingthecompany’snetincome.

EXAMPLE:Virginiarunsabusinesssellingcosmetics.Overthecourseoftheyear, her total saleswere $80,000, and her Cost ofGoods Soldwas $20,000.Virginia’sgrossprofitmarginfortheyearis75%,calculatedasfollows:

Gross profit margin is often used to make comparisons between companieswithin an industry. For example, comparing the gross profit margin of twodifferentgrocerystorescangiveyouanideaofwhichonedoesabetter jobofkeepinginventorycostsdown.Gross profit margin comparisons across different industries can be rather

meaningless.Forinstance,agrocerystoreisgoingtohavealowerprofitmarginthana softwarecompany, regardlessofwhichcompany is run in amorecost-effectivemanner.

FinancialLeverageRatios

Financial leverage ratios attempt to show towhat extent a company has useddebt(asopposedtocapitalfrominvestors)tofinanceitsoperations.Acompany’sdebt ratio showswhatportionofacompany’sassetshasbeen

financedwithdebt.

A company’s debt-to-equity ratio shows the ratio of financing via debt tofinancingviacapitalfrominvestors.

TheProsandConsofFinancialLeverage

It’sobviouslyriskyforacompanytobeveryhighlyleveraged(thatis,financedlargely with debt). There is, however, something to be gained from usingleverage. The more highly leveraged a company is, the greater its return onequitywillbeforagivenamountofnetincome.Thatmaysoundconfusing;let’slookatanexample.EXAMPLE: XYZ Software has $200 million of assets, $100 million ofliabilities,and$100millionofowners’equity.XYZ’snetincomefortheyearis$15million, giving them a return on equity of 15% ($15million net incomedividedby$100millionowners’equity).If, however, XYZ Software’s capital structure was more debt-dependent—

such that theyhad$150millionof liabilitiesandonly$50millionofequity—

their return on equitywould now bemuch greater. In fact,with the same netincome,XYZwould have a return on equity of 30% ($15million net incomedividedby$50millionowners’equity),therebyofferingthecompany’sownerstwiceasgreatareturnontheirmoney.Inotherwords,whenthecompany’sdebt-to-equityratioincreased(from1in

the first example to3 in the secondexample), the company’s returnonequityincreasedaswell,eventhoughnetincomeremainedthesame.

In short, the question of leverage is a question of balance.Beingmore highlyleveraged (i.e., more debt, less investment from shareholders) allows for agreater return on the shareholders’ investment.On the other hand, financing acompanyprimarilywithloansisobviouslyariskywaytorunabusiness.

AssetTurnoverRatios

Assetturnoverratiosseektoshowhowefficientlyacompanyusesitsassets.Thetwomost commonly used turnover ratios are inventory turnover and accountsreceivablesturnover.

The calculation of inventory turnover shows how many times a company’sinventory is sold and replaced over the course of a period. The “averageinventory”partoftheequationistheaverageInventorybalanceovertheperiod,calculatedasfollows:

Inventoryperiodshowshowlong,onaverage,inventoryisonhandbeforeitissold.

Ahigherinventoryturnover(andthus,alowerinventoryperiod)showsthatthecompany’s inventory is selling quickly and is indicative that management isdoingagoodjobofstockingproductsthatareindemand.A company’s receivables turnover (calculated as credit sales over a period

dividedbyaverageAccountsReceivableovertheperiod)showshowquicklythecompanyiscollectinguponitsAccountsReceivable.

Averagecollectionperiod is exactlywhat it sounds like: theaverage lengthoftimethatareceivablefromacustomerisoutstandingpriortocollection.

Obviously, higher receivables turnover and lower average collection period isgenerally thegoal. If a company’s average collectionperiod steadily increasesfromoneyear to thenext, itcouldbean indication that thecompanyneeds toaddressitspoliciesintermsofwhenandtowhomitextendscreditwhenmakingasale.

Chapter6SimpleSummary

Liquidityratiosshowhoweasilyacompanywillbeabletomeetitsshort-termfinancialobligations.Thetwomostfrequentlyusedliquidityratiosarecurrentratioandquickratio.Profitabilityratiosseektoanalyzehowprofitableacompanyisinrelationtoitssize.Returnonassetsandreturnonequityarethemostimportantprofitabilityratios.Financialleverageratiosexpresstowhatextentacompanyisusingdebt(insteadofshareholderinvestment)tofinanceitsoperations.Themoreleveragedacompanyis,thehigherreturnonequityitwillbeabletoprovideitsshareholders.However,increasingdebtfinancingcandramaticallyincreasethebusiness’srisklevel.Assetturnoverratiosseektoshowhowefficientlyacompanyusesitsassets.Inventoryturnoverandreceivablesturnoverarethemostimportantturnoverratios.

PARTTWO

GenerallyAcceptedAccountingPrinciples(GAAP)

CHAPTERSEVEN

WhatisGAAP?

In theUnited States, GenerallyAcceptedAccounting Principles (GAAP) is

the name for the framework of accounting rules used in the preparation offinancial statements. GAAP is created by the Financial Accounting StandardsBoard(FASB).The goal of GAAP is to make it so that potential investors can compare

financial statements of various companies in order to determine which one(s)theywanttoinvestin,withouthavingtoworrythatonecompanyappearsmoreprofitableonpapersimplybecauseitisusingadifferentsetofaccountingrules.

WhoisRequiredtoFollowGAAP?

All publicly traded companies are required by the Securities and ExchangeCommission to follow GAAP procedures when preparing their financialstatements.Inaddition,becauseofGAAP’sprevalenceinthefieldofaccounting—and because of the resulting fact that accountants are trained according toGAAP when they go through school—many companies follow GAAP evenwhentheyarenotrequiredtodoso.GovernmentalentitiesarerequiredtofollowGAAPaswell.Thatsaid, there

areadifferentsetofGAAPguidelines(createdbyadifferentregulatorybody)for government organizations. So, while they are following GAAP, theirfinancialstatementsarequitedifferentfromthoseofpubliccompanies.

Chapter7SimpleSummary

GenerallyAcceptedAccountingPrinciples(GAAP)istheframeworkofaccountingrulesandguidelinesusedinthepreparationoffinancialstatements.TheSecuritiesandExchangeCommissionrequiresthatallpubliclytradedcompaniesadherebyGAAPwhenpreparingtheirfinancialstatement

CHAPTEREIGHT

DebitsandCredits

Most people (without knowing it) use a system of accounting known as

single-entryaccountingwhentheyrecordtransactionsrelatingtotheircheckingorsavingsaccounts.Foreachtransaction,oneentryismade(eitheranincreaseordecreaseinthebalanceofcashintheaccount).Likely thesinglemost importantaspectofGAAPis theuseofdouble-entry

accounting, and the accompanying system of debits and credits.With double-entryaccounting,eachtransactionresultsintwoentriesbeingmade.(Thesetwoentriescollectivelymakeupwhatisknownasa“journalentry.”)This is actually fairly intuitive when you think back to the accounting

equation:

Assets=Liabilities+Owners’Equity.If each transaction resulted in only one entry, the equation would no longerbalance. That’s why, with each transaction, entries will be recorded to twoaccounts.EXAMPLE: A company uses $40,000 cash to purchase a new piece ofequipment.Inthejournalentrytorecordthistransaction,Cashwilldecreaseby$40,000andEquipmentwillincreaseby$40,000.Asaresult,the“Assets”sideoftheequationwillhaveanetchangeofzero,andnothingchangesatallonthe“Liabilities+Owners’Equity”sideoftheequation.

Assets = Liabilities + Owners’Equity-40,000 nochange nochange+40,000 Alternatively, if the company had purchased the equipment with a loan, thejournalentrywouldbeanincreasetoEquipmentof$40,000andanincreasetoNotes Payable of $40,000. In this case, each side of the equationwould haveincreasedby$40,000.

Assets = Liabilities + Owners’Equity+40,000 +40,000 nochange

So,WhatareDebitsandCredits?

Debits and credits are simply the terms used for the two halves of eachtransaction.Thatis,eachofthesetwo-entrytransactionsinvolvesadebitandacredit.Now,ifyou’vebeenusingabankaccountforanyperiodoftime,youlikely

have an idea that debit means decrease while credit means increase. That is,however,not exactly true.Adebit (or credit) to anaccountmay increase it ordecreaseit,dependinguponwhattypeofaccountitis:

Adebitentrywillincreaseanassetaccount,anditwilldecreasealiabilityorowners’equityaccount.Acreditentrywilldecreaseanassetaccount,anditwillincreasealiabilityorowners’equityaccount.

Fromtheperspectiveofyourbank,yourcheckingaccountisaliability—thatis,it’s money that they owe you. Because it’s a liability, your bank credits theaccounttoincreasethebalanceanddebitstheaccounttodecreasethebalance.Let’sapplythissystemofdebitsandcreditstoourearlierexample.EXAMPLE: A company uses $40,000 cash to purchase a new piece ofequipment. Cash will decrease by $40,000 and Equipment will increase by$40,000.To record this decrease toCash (an asset account)weneed to creditCashfor$40,000.Torecord this increase toEquipment (anassetaccount),weneedtodebitEquipmentfor$40,000.Thistransactioncouldberecordedasajournalentryasfollows:

DR.Equipment 40,000 CR.Cash 40,000Asyou can see,when recording a journal entry, the account that is debited islistedfirst,andtheaccountthatiscreditedislistedsecond,withanindentationto the right. Also, debit is conventionally abbreviated as “DR” and credit isabbreviated as “CR.” (Often, these abbreviations are omitted, and credits are

signifiedentirelybythefactthattheyareindentedtotheright.)An easy way to keep everything straight is to think of “debit” as meaning

“left,”and“credit”asmeaning“right.”Inotherwords,debitsincreaseaccountsontheleftsideoftheaccountingequation,andcreditsincreaseaccountsontherightside.Also,thishelpsyoutorememberthatthedebithalfofajournalentryisontheleft,whilethecredithalfisindentedtotheright.Let’stakealookatafewmoreexampletransactionsandseehowtheywould

berecordedasjournalentries.

EXAMPLE: Chris’ Construction takes out a $50,000 loanwith a local bank.Cashwillincreaseby$50,000,andNotesPayablewillincreaseby$50,000.ToincreaseCash(anassetaccount),wewilldebitit.ToincreaseNotesPayable(aliabilityaccount),wewillcreditit.

DR.Cash 50,000 CR.NotesPayable 50,000EXAMPLE: Last month, Chris’ Construction purchased $10,000 worth ofbuildingsupplies,usingcredittodoso.BuildingSupplies(asset)andAccountsPayable(liability)eachneed tobe increasedby$10,000.Todoso,we’lldebitBuildingSupplies,andcreditAccountsPayable.

DR.BuildingSupplies 10,000 CR.AccountsPayable 10,000Eventually,Chris’sConstructionwillpaythevendorforthesupplies.Whentheydo, we’ll need to decrease Accounts Payable and Cash by $10,000 each. Todecreasealiability,wedebitit,andtodecreaseanasset,wecreditit.

DR.AccountsPayable 10,000 CR.Cash 10,000

RevenueandExpenseAccounts

So far,we’veonlydiscussed journal entries thatdeal exclusivelywithbalancesheetaccounts.Naturally,journalentriesneedtobemadeforincomestatementtransactionsaswell.Forthemostpart,whenmakingajournalentrytoarevenueaccount,weusea

credit, andwhenmakinganentry toanexpenseaccount,weuseadebit.Thismakessensewhenweconsiderthatrevenuesincreaseowners’equity(andthus,like owners’ equity, should be increased with a credit) and that expensesdecrease owners’ equity (and therefore, unlike owners’ equity, should beincreasedwithadebit).

EXAMPLE:Darla’sDresseswritesacheckfortheirmonthlyrent:$4,500.WeneedtodecreaseCashandincreaseRentExpense.

DR.RentExpense 4,500 CR.Cash 4,500EXAMPLE: Connie, a software consultant, makes a sale for $10,000 and ispaidincash.We’llneedtoincreasebothCashandSalesby$10,000each.

DR.Cash 10,000 CR.Sales 10,000Sometimesatransactionwillrequiretwojournalentries.EXAMPLE:Darla’sDressessellsaweddingdressfor$1,000cash.Darlahadoriginally purchased the dress from a supplier for $450.We have to increaseSalesandCashby$1,000each.Wealsohavetodecreaseinventoryby$450andincreaseCostofGoodsSold(anexpenseaccount)by$450.

DR.Cash 1,000 CR.Sales 1,000DR.CostofGoodsSold 450CR.Inventory 450

CR.Inventory

450

TheGeneralLedger

The general ledger is the place where all of a company’s journal entries getrecorded.Ofcourse,hardlyanybodyusesanactualpaperdocumentforageneralledger anymore. Instead, journal entries are entered into the company’saccounting software, whether it’s a high-end customized program, a moreaffordableprogramlikeQuickBooks,orevensomethingassimpleasaseriesofExcelspreadsheets.Thegeneralledgerisacompany’smostimportantfinancialdocument,asitis

fromthegeneralledger’sinformationthatacompany’sfinancialstatementsarecreated.

T-Accounts

Inmanysituations,itcanbeusefultolookatalltheactivitythathasoccurredina single account over a given time period. The tool most frequently used toprovide this one-account view of activity is known as the “T-Account.” OnelookatanexampleT-accountandyou’llknowwhereitgetsitsname:

TheaboveT-accountshowsusthat,overtheperiodinquestion,Cashhasbeendebitedfor$400,$550,and$300,aswellascreditedfor$200and$950. Often, a T-accountwill include the account’s beginning and ending

balances:

This T-account shows us that at the beginning of the period, Inventory had adebit balance of $600. It was then debited for a total of $750 (250+500) andcreditedforatotalof$500(200+300).Asaresult,Inventoryhadadebitbalanceof$850at the endof theperiod ($600beginningbalance,plus$250netdebitovertheperiod).

TheTrialBalance

A trial balance is simply a list indicating the balances of every single generalledgeraccountatagivenpointintime.Thetrialbalanceistypicallypreparedattheendofaperiod,priortopreparingtheprimaryfinancialstatements.Thepurposeofthetrialbalanceistocheckthatdebits—intotal—areequalto

the total amount of credits. If debits do not equal credits, you know that anerroneousjournalentrymusthavebeenposted.Whileatrialbalanceisahelpfulcheck, it’s far from perfect, as there are numerous types of errors that a trialbalance doesn’t catch. (For example, a trial balance wouldn’t alert you if thewrong asset account had been debited for a given transaction, as the errorwouldn’tthrowoffthetotalamountofdebits.)

Chapter8SimpleSummary

Foreverytransaction,ajournalentrymustberecordedthatincludesbothadebitandacredit.Debitsincreaseassetaccountsanddecreaseequityandliabilityaccounts.Creditsdecreaseassetaccountsandincreaseequityandliabilityaccounts.Debitsincreaseexpenseaccounts,whilecreditsincreaserevenueaccounts.Thegeneralledgeristhedocumentinwhichacompany’sjournalentriesarerecorded.AT-accountshowstheactivityinaparticularaccountoveragivenperiod.Atrialbalanceshowsthebalanceineachaccountatagivenpointintime.Thepurposeofatrialbalanceistocheckthattotaldebitsequaltotalcredits.

CHAPTERNINE

Cashvs.Accrual

Individualsandmostsmallbusinessesuseamethodofaccountingknownas

“cash accounting.” In order to be in accordance with GAAP, however,businessesmustuseamethodknownas“accrualaccounting.”

TheCashMethod

Underthecashmethodofaccounting,salesarerecordedwhencashisreceived,and expenses are recorded when cash is sent out. It’s straightforward andintuitive.Theproblemwiththecashmethod,however,isthatitdoesn’talwaysreflecttheeconomicrealityofasituation.

EXAMPLE:Pamrunsaretailicecreamstore.Herleaserequireshertoprepayherrentforthenext3monthsatthebeginningofeveryquarter.Forexample,inApril,sheisrequiredtopayherrentforApril,May,andJune.IfPamusesthecashmethodofaccounting,hernetincomeinAprilwill

besubstantiallylowerthanhernetincomeinMayorJune,evenifhersalesandotherexpensesareexactlythesamefrommonthtomonth.Ifapotentialcreditorwastolookatherfinancialstatementsonamonthlybasis,thelenderwouldgettheimpressionthatPam’sprofitabilityissubjecttowildfluctuations.Thisis,ofcourse,adistortionofthereality.

TheAccrualMethod

Undertheaccrualmethodofaccounting,revenueisrecordedassoonasservicesareprovidedorgoodsaredelivered,regardlessofwhencashisreceived.(Note:ThisiswhyweuseanAccountsReceivableaccount.)Similarly,undertheaccrualmethodofaccounting,expensesarerecognizedas

soonas thecompanyreceivesgoodsorservices, regardlessofwhenitactuallypays for them. (Accounts Payable is used to record these as-yet-unpaidobligations.)The goal of the accrualmethod is to fix themajor shortcoming of the cash

method:Distortionsofeconomicrealityduetothefrequenttimelagbetweenaservicebeingperformedandtheservicebeingpaidfor.

EXAMPLE:Mario runs an electronics store. On the 5th of everymonth, hepays his sales reps their commissions for sales made in the prior month. InAugust, his sales reps earned total commissions of $93,000. IfMario uses theaccrualmethodofaccounting,hemustmake the followingentryat theendofAugust:

CommissionsExpense 93,000 CommissionsPayable 93,000Whenever an expense is recorded prior to its being paid for—such as in theaboveentry—thejournalentryisreferredtoasan“accrual,”hence,the“accrualmethod.”Theneedfortheaboveentrycouldbestatedbysayingthat,attheendofAugust,“Mariohastoaccruefor$93,000ofCommissionsExpense.”Then, on the 5th of September,when he pays his reps forAugust, hemust

makethefollowingentry:

CommissionsPayable 93,000 Cash 93,000

A few points are worthy of specific mention. First, because Mario uses theaccrual method, the expense is recorded when the services are performed,regardlessofwhentheyarepaidfor.Thisensuresthatanyfinancialstatements

forthemonthofAugustreflecttheappropriateamountofCommissionsExpenseforsalesmadeduringthemonth.Second, after both entries have been made, the net effect is a debit to the

relevant expense account and a credit toCash. (Notehow this is exactlywhatyou’dexpectforanentryrecordinganexpense.)Lastpointofnote:CommissionsPayablewillhavenonetchangeafterboth

entries have been made. Its only purpose is to make sure that financialstatementsprepared at the endofAugustwould reflect that—at that particularmoment—anamountisowedtothesalesreps.Let’srunthroughafewmoreexamplessoyoucangetthehangofit.

EXAMPLE:Lindseyisafreelancewriter.DuringFebruaryshewritesaseriesofadsforalocalbusinessandsendsthemabillfortheagreed-uponfee:$600.Lindseymakesthefollowingjournalentry:

AccountsReceivable 600 Sales 600

WhenLindseyreceivespayment,shewillmakethefollowingentry:

Cash 600 AccountsReceivable 600EXAMPLE:OnJanuary1st,whenLindseystartedherbusiness,shetookouta6-month,$3,000loanwithalocalcreditunion.Thetermsoftheloanwerethat,ratherthanmakingpaymentsoverthecourseoftheloan,shewouldrepayitall(alongwith$180ofinterest)onJuly1st.Because Lindsey uses the accrual method, she must record the interest

expenseoverthelifeoftheloan,ratherthanrecordingitallattheendwhenshepaysitoff.WhenLindseyinitiallytakesouttheloan,shemakesthefollowingentry:

Cash 3,000 NotesPayable 3,000Then, at the end of every month, Lindsey records 1/6th of the total interestexpensebymakingthefollowingentry:

InterestExpense 30

InterestExpense 30 InterestPayable 30OnJuly1st,Lindseypaysofftheloan,makingthefollowingentry:

NotesPayable 3,000InterestPayable 180 Cash 3,180

PrepaidExpenses

Sofar,allofourexampleshavelookedatscenariosinwhichthecashexchangeoccurredafter thegoods/servicesweredelivered.Naturally,thereareoccasionsinwhichtheoppositesituationarises.Again,thegoaloftheaccrualmethodistorecordtherevenuesorexpensesin

theperiodduringwhichtherealeconomictransactionoccurs(asopposedtotheperiod in which cash is exchanged). Let’s revisit our earlier example of Pamwiththeicecreamstore.

EXAMPLE: Pam’smonthly rent is $1,500.However,Pam’s landlord—RetailRentals—requiresthatsheprepayherrentforthenext3monthsatthebeginningof every quarter.OnApril 1st, Pamwrites a check for $4,500 (rent forApril,May,andJune).Shemakesthefollowingentry:

PrepaidRent 4,500 Cash 4,500Intheaboveentry,PrepaidRentisanassetaccount.Overthecourseofthethreemonths,the$4,500willbeeliminatedastheexpenseisrecorded.Assetscausedby the prepayment of an expense are known, quite reasonably, as “prepaidexpenseaccounts.”Then, at the endof eachmonth (April,May, and June),Pamwillmake the

followingentrytorecordherrentexpensefortheperiod:

RentExpense 1,500 PrepaidRent 1,500Again,bytheendofthethreemonths,PrepaidRentwillbebacktozero,andshewillhaverecognizedtheproperamountofRentExpenseeachmonth($1,500).Ofcourse,theprocesswillstartalloveragainonJuly1stwhenPamprepaysherrentforthethirdquarteroftheyear.

UnearnedRevenue

From Pam’s perspective, the early rent payment created an asset account(Prepaid Rent). Naturally, from the perspective of her landlord, the earlypaymentmust have the opposite effect: It creates a liability balanceknown as“unearnedrevenue.”

EXAMPLE: On April 1st, when Retail Rentals receives Pam’s check for$4,500, theymust set up an Unearned Rent liability account. Then, they willrecordtherevenuemonthbymonth.OnApril1st,RetailRentalsreceivesthecheckandmakesthefollowingentry:

Cash 4,500 UnearnedRent 4,500Then, at the end of each month, Retail Rentals will record the revenue bymakingthefollowingentry:

UnearnedRent 1,500 RentalIncome 1,500

Chapter9SimpleSummary

InordertobeinaccordancewithGAAP,businessesmustusetheaccrualmethodofaccounting(asopposedtothecashmethod).Thegoaloftheaccrualmethodistorecognizerevenue(orexpense)intheperiodinwhichtheserviceisprovided,regardlessofwhenitispaidfor.

CHAPTERTEN

OtherGAAPConceptsandAssumptions

Again,thegoalofGAAPistoensurethatcompanies’financialstatementsare

prepared using a consistent set of rules and assumptions so that they can becompared to those of another company in a meaningful way. In this chapterwe’ll examine a fewof the assumptions that are usedwhenpreparingGAAP-compliantfinancialstatements.

HistoricalCost

UnderGAAP,assetsare recordedat theirhistorical cost (i.e., theamountpaidfor them). This seems obvious, but there are times in which it would appearreasonableforacompanytoreportanassetatavalueotherthantheamountpaidfor it. For example, if a companyhas owned a pieceof real estate for severaldecades,reportingthepieceoflandat itshistoricalcostmayverysignificantlyunderstatethevalueoftheland.However, ifGAAPallowedcompanies touseanyothervaluationmethod—

currentmarketvalueforinstance—itwouldintroduceagreatdealofsubjectivityintotheprocess.(Tousetheexampleofrealestateagain:Dependinguponwhatmethodyouuseorwhoyouask,youcouldfindseveraldifferentanswersforthefairmarketvalueofapieceofrealestate.)Instead,GAAPusuallyrequiresthatcompaniesreportassetsusingthemostobjectivevalue:thecostpaidforthem.

Materiality

Under GAAP, the materiality (or immateriality) of a transaction refers to theimpactthatthetransactionwillhaveonthecompany’sfinancialstatements.Ifamistakeinrecordingagiventransactioncouldcauseaviewerofthecompany’sfinancialstatements tomakeadifferentdecision thanheorshewouldmake ifthetransactionwerereportedcorrectly,thetransactionissaidtobe“material.”EXAMPLE:Martin’sbusinesscurrentlyhas$50,000ofcurrentassets,$20,000ofcurrentliabilities,andowes$75,000onaloanthatwillbeduein2years.Theloan isclearlymaterial, asamisstatementof theamount,oranexclusionof itfromthecompany’sbalancesheetwouldverylikelyleadapotentialinvestor(orcreditor) tomakeapoordecision regarding investing in (or lendingmoney to)thecompany.EXAMPLE: Carly runs a nicely profitable graphic design business. Hermonthly revenues are usually around $20,000, and her monthly expenses areapproximately$8,000.InAugust,Carlypurchases$80worthofofficesupplies,butsheforgetstorecordthepurchase.WhileCarlyshouldmakesuretorecordthepurchaseatsomepoint, the$80

expense is clearly immaterial. If creditors were looking at her financialstatementsat theendofAugust, the$80understatementofexpenseswouldbeunlikely to cause them to make a different decision than they would if theexpensehadbeenaccuratelyrecorded.

MonetaryUnitAssumption

GAAPmakestheassumptionthatthedollarisastablemeasureofvalue.It’snosecret that this is a faulty assumption due to inflation constantly changing therealvalueofthedollar.Thereasonforusingsuchaflawedassumptionisthatthebenefit gained from adjusting the value of assets on a regular basis to reflectinflation would be far outweighed by the cost in both time and money ofrequiringcompaniestodoso.

EntityAssumption

ForGAAPpurposes, it’sassumedthatacompanyisanentirelyseparateentityfrom its owners. This concept is known as the “entity assumption” or “entityconcept.”Themost important ramificationof theentityassumption is the requirement

fordocumentingtransactionsbetweenacompanyanditsowners.Forexample,ifyouwhollyownabusiness,anytransfersfromthebusiness’sbankaccounttoyourbankaccountneed tobe recorded, despite the fact that it doesn’t exactlyseem like a “transaction” in that you’re really just moving around your ownmoney.

MatchingPrinciple

According to GAAP, the matching principle dictates that expenses must bematchedtotherevenuesthattheyhelpgenerate,andrecordedinthesameperiodinwhich the revenues are recorded. This concept goes hand-in-handwith theconcept of accrual accounting. For example, it’s the matching principle thatdictates that a company’s utility expenses for the month of March must berecorded in March (rather than in April, when they are likely paid). Thereasoning is that March’s utility expenses contribute to the production ofMarch’srevenues,sotheymustberecordedinMarch.Similarly,itisthematchingprinciplethatdictatesthatifacompanypurchases

an asset that is expected to provide benefit to the company for multipleaccountingperiods(adesk,forinstance),thecostoftheassetmustbespreadoutover the period for which it is expected to provide benefits. This process isknownasdepreciation,andwe’lldiscussitmorethoroughlyinChapter11.

Chapter10SimpleSummary

Anasset’shistoricalcostisoftenquitedifferentfromitscurrentmarketvalue.However,duetoitsobjectivenature,historicalcostisgenerallyusedwhenreportingthevalueofassetsunderGAAP.Atransactionissaidtobeimmaterialifamistakeinrecordingthetransactionwouldnotresultinasignificantmisstatementofthecompany’sfinancialstatements.UnderGAAP,inordertosimplifyaccounting,currencyisgenerallyassumedtohaveastablevalue.Thisisknownasthemonetaryunitassumption.ForGAAPaccounting,abusinessisassumedtobeanentirelyseparateentityfromitsowners.Thisisknownastheentityconceptorentityassumption.AccordingtoGAAP’smatchingprinciple,expensesmustbereportedinthesameperiodastherevenueswhichtheyhelptoproduce.

CHAPTERELEVEN

DepreciationofFixedAssets

Asmentionedbrieflyinthepreviouschapter,whenacompanybuysanasset

that will probably last for greater than one year, the cost of that asset is notcounted as an immediate expense. Rather, the cost is spread out over severalyearsthroughaprocessknownasdepreciation.

Straight-LineDepreciation

The most basic form of depreciation is known as straight-line depreciation.Usingthismethod, thecostof theasset isspreadoutevenlyover theexpectedlifeoftheasset.EXAMPLE: Daniel spends $5,000 on a new piece of equipment for hiscarpentrybusiness.Heexpectstheequipmenttolastfor5years,bywhichpointitwill likely be of no substantial value.Each year, $1,000of the equipment’scostwillbecountedasanexpense.When Daniel first purchases the equipment, he would make the followingjournalentry:

DR.Equipment 5,000 CR.Cash 5,000Then,eachyear,DanielwouldmakethefollowingentrytorecordDepreciationExpensefortheequipment:

DepreciationExpense 1,000 AccumulatedDepreciation 1,000Accumulated Depreciation is what’s known as a “contra account,” or morespecifically, a “contra-asset account.”Contra accounts are used to offset otheraccounts.Inthiscase,AccumulatedDepreciationisusedtooffsetEquipment.Atanygivenpoint,thenetofthedebitbalanceinEquipment,andthecredit

balance in Accumulated Depreciation gives us the net Equipment balance—sometimesreferredtoas“netbookvalue.”Intheexampleabove,afterthefirstyearofdepreciationexpense,wewouldsaythatEquipmenthasanetbookvalueof$4,000.($5,000originalcost,minus$1,000AccumulatedDepreciation.)Wemakethecreditentries toAccumulatedDepreciationrather thandirectly

toEquipmentsothatwe:

1. Havearecordofhowmuchtheassetoriginallycost,and

2. Havearecordofhowmuchdepreciationhasbeenchargedagainsttheassetalready.

EXAMPLE (CONTINUED): Eventually, after 5 years, AccumulatedDepreciationwillhaveacreditbalanceof5,000(theoriginalcostoftheasset),and theassetwillhaveanetbookvalueofzero.WhenDanieldisposesof theasset,hewillmakethefollowingentry:

AccumulatedDepreciation 5,000 Equipment 5,000

Aftermaking this entry, therewill no longer be any balance in Equipment orAccumulatedDepreciation.

SalvageValue

Whatifabusinessplanstouseanassetforafewyears,andthensellitbeforeitbecomes entirely worthless? In these cases, we use what is called “salvagevalue.”Salvagevalue(sometimesreferredtoasresidualvalue)isthevaluethattheassetisexpectedtohaveaftertheplannednumberofyearsofuse.EXAMPLE:Lydiaspends$11,000onofficefurniture,whichsheplans tousefor the next ten years, after which she believes it will have a value ofapproximately$2,000.Thefurniture’soriginalcost,minusitsexpectedsalvagevalueisknownasitsdepreciablecost—inthiscase,$9,000.Eachyear,Lydiawillrecord$900ofdepreciationasfollows:

DepreciationExpense 900 AccumulatedDepreciation 900Aftertenyears,AccumulatedDepreciationwillhavea$9,000creditbalance.If,atthatpoint,Lydiadoesinfactsellthefurniturefor$2,000,she’llneedtorecordthe inflow of cash, and write off the Office Furniture and AccumulatedDepreciationbalances:

Cash 2,000AccumulatedDepreciation 9,000 OfficeFurniture 11,000

GainorLossonSale

Ofcourse,it’sprettyunlikelythatsomebodycanpredictexactlywhatanasset’ssalvagevaluewillbeseveralyearsfromthedatesheboughttheasset.Whenanassetissold,iftheamountofcashreceivedisgreaterthantheasset’snetbookvalue,againmustberecordedonthesale.(Gainsworklikerevenueinthattheyhavecreditbalances,andincreaseowners’equity.)If,however,theassetissoldfor less than its net book value, a loss must be recorded. (Losses work likeexpenses:Theyhavedebitbalances,andtheydecreaseowners’equity.)Determiningwhethertomakeagainentryoralossentryisnevertoodifficult:

Justfigureoutwhetheranadditionaldebitorcreditisneededtomakethejournalentrybalance.EXAMPLE (CONTINUED): If, after ten years, Lydia had sold the furniturefor$3,000ratherthan$2,000,shewouldrecordthetransactionasfollows:

Cash 3,000AccumulatedDepreciation 9,000 OfficeFurniture 11,000 GainonSaleofFurniture 1,000EXAMPLE(CONTINUED):If,however,Lydiahadsoldthefurnitureforonly$500,shewouldmakethefollowingentry:

Cash 500AccumulatedDepreciation 9,000LossonSaleofFurniture 1,500 OfficeFurniture 11,000

OtherDepreciationMethods

In addition to straight-line, there are a handful of other (more complicated)methodsofdepreciationthatarealsoGAAP-approved.Forexample,thedoubledecliningbalancemethodconsistsofmultiplyingtheremainingnetbookvalueby a given percentage every year. The percentage used is equal to double thepercentagethatwouldbeusedinthefirstyearofstraight-linedepreciation.

EXAMPLE: Randy purchases $10,000 of equipment, which he plans todepreciate over five years. Using straight-line, Randy would be depreciating20% of the value (100%÷ five years) in the first year. Therefore, the doubledecliningbalancemethodwilluse40%depreciationeveryyear(2x20%).Thedepreciationforeachofthefirstfouryearswouldbeasfollows:

EXAMPLE(CONTINUED):Becausetheequipmentisbeingdepreciatedoverfive years, Randy would record $1,296 (that is, 2,160 – 864) of depreciationexpenseinthefifthyearinordertoreducetheasset’snetbookvaluetozero.Another GAAP-accepted method of depreciation is the units of production

method. Under the units of production method, the rate at which an asset isdepreciatedisnotafunctionoftime,butratherafunctionofhowmuchtheassetisused.

EXAMPLE:Brucerunsabusinessmakingleatherjackets.Hespends$50,000onapieceofequipmentthatisexpectedtolastthroughtheproductionof5,000jackets. Using the units of production method of depreciation, Bruce woulddepreciate the equipment each period based upon how many jackets wereproduced(atarateof$10depreciationperjacket).If, in a given month, Bruce’s business used the equipment to produce 150

jackets,thefollowingentrywouldbeusedtorecorddepreciation:

DepreciationExpense 1,500 AccumulatedDepreciation 1,500

ImmaterialAssetPurchases

Theconceptofmaterialityplaysabigroleinhowsomeassetsareaccountedfor.For example, consider the case of a $15 wastebasket. Given the fact that awastebasket is almost certain to last for greater than one year, it should,theoretically,bedepreciatedoveritsexpectedusefullife.However—intermsoftheimpactonthecompany’sfinancialstatements—the

difference between depreciating thewastebasket and expensing the entire costright away is clearly negligible. The benefit of the additional accountingaccuracy is far outweighed by the hassle involved in making insignificantdepreciationjournalentriesyearafteryear.Asaresult,assetsofthisnaturearegenerally expensed immediately upon purchase rather than depreciated overmultipleyears.Suchapurchasewouldordinarilyberecordedasfollows:

OfficeAdministrativeExpense 15.00 Cash(orAccountsPayable) 15.00

Chapter11SimpleSummary

Straight-linedepreciationisthesimplestdepreciationmethod.Usingstraight-line,anasset’scostisdepreciatedoveritsexpectedusefullife,withanequalamountofdepreciationbeingrecordedeachmonth.Accumulateddepreciation—acontra-assetaccount—isusedtokeeptrackofhowmuchdepreciationhasbeenrecordedagainstanassetsofar.Anasset’snetbookvalueisequaltoitsoriginalcost,lesstheamountofaccumulateddepreciationthathasbeenrecordedagainsttheasset.Ifanassetissoldformorethanitsnetbookvalue,againmustberecorded.Ifit’ssoldforlessthannetbookvalue,alossisrecorded.Immaterialassetpurchasestendtobeexpensedimmediatelyratherthanbeingdepreciated.

CHAPTERTWELVE

AmortizationofIntangibleAssets

Intangible assets are real, identifiable assets that are not physical objects.

Commonintangibleassetsincludepatents,copyrights,andtrademarks.

Amortization

Amortization is the process—very analogous to depreciation—in which anintangible asset’s cost is spread out over the asset’s life.Generally, intangibleassetsareamortizedusingthestraight-linemethodovertheshorterof:

Theasset’sexpectedusefullife,orTheasset’slegallife.

EXAMPLE: Kurtrunsabusinessmakingcomponentsforwirelessrouters.In2011,hespends$60,000obtainingapatentforanewmethodofproductionthathehasrecentlydeveloped.Thepatentwillexpirein2031.Even though thepatent’s legal life is 20years, its useful life is likely tobe

much shorter, as it’s anear certainty that thismethodwill becomeobsolete inwell under 20 years, given the rapid rate of innovation in the technologyindustry.Assuch,Kurtwillamortizethepatentoverwhatheprojects tobeitsusefullife:fouryears.Eachyear,thefollowingentrywillbemade:

AmortizationExpense 15,000 AccumulatedAmortization 15,000

Chapter12SimpleSummary

Amortizationistheprocessinwhichanintangibleasset’scostisspreadoutovertheasset’slife.Thetimeperiodusedforamortizinganintangibleassetisgenerallytheshorteroftheasset’slegallifeorexpectedusefullife.

CHAPTERTHIRTEEN

InventoryandCostofGoodsSold

UnderGAAP, thereare twoprimarymethodsofkeeping trackof inventory:

theperpetualmethodandtheperiodicmethod.

PerpetualMethodofInventory

Anybusinessthatkeepsreal-timeinformationoninventorylevelsandthattracksinventoryonanitem-by-itembasisisusingtheperpetualmethod.Forexample,retail locations that use barcodes and point-of-sale scanners are utilizing theperpetualinventorymethod.Therearetwomainadvantagestousingtheperpetualinventorysystem.First,

itallowsabusinesstoseeexactlyhowmuchinventorytheyhaveonhandatanygivenmoment,therebymakingiteasiertoknowwhentoordermore.Second,itimproves theaccuracyof thecompany’s financialstatementsbecause itallowsveryaccuraterecordkeepingas to theCostofGoodsSoldoveragivenperiod.(CoGSwill be calculated, quite simply, as the sum of the costs of all of theparticularitemssoldovertheperiod.)The primary disadvantage to using the perpetual method is the cost of

implementation.

PeriodicMethodofInventory

Theperiodicmethodof inventory isasysteminwhich inventory iscountedatregularintervals(atmonth-end,forinstance).Usingthismethod,abusinesswillknowhowmuchinventoryithasatthebeginningandendofeveryperiod,butitwon’t know precisely how much inventory is on hand in the middle of anaccountingperiod.Aseconddrawbackoftheperiodicmethodisthatthebusinesswon’tbeable

totrackinventoryonanitem-by-itembasis,therebyrequiringassumptionstobemade as to which particular items of inventory were sold. (More on theseassumptionslater.)

CalculatingCoGSunderthePeriodicMethodofInventory

When using the periodicmethod, Cost of Goods Sold is calculated using thefollowingequation:

BeginningInventory + InventoryPurchases -

EndingInventory =

CostofGoodsSold

Thisequationmakesperfectsensewhenyoulookatitpiecebypiece.Beginninginventory,plustheamountofinventorypurchasedovertheperiodgivesyouthetotal amount of inventory that could have been sold (sometimes known,understandably,asCostofGoodsAvailableforSale).Wethenassumethat,ifanitem isn’t in inventory at the end of the period, itmust have been sold. (Andconversely,ifanitemisinendinginventory,itobviouslywasn’tsold,hencethesubtractionoftheendinginventorybalancewhencalculatingCoGS).EXAMPLE:CorinahasabusinesssellingbooksoneBay.Aninventorycountat thebeginningofNovember shows that shehas$800worthof inventoryonhand. Over the month, she purchases another $2,400 worth of books. HerinventorycountattheendofNovembershowsthatshehas$600ofinventoryonhand.Using the equation above, we learn that Corina’s Cost of Goods Sold for

Novemberis$2,600,calculatedasfollows:

BeginningInventory + Purchases - EndingInventory =

CostofGoodsSold

800 + 2,400 - 600 = 2,600Granted,thisequationisn’tperfect.Forinstance,itdoesn’tkeeptrackofthecostofinventorytheft.AnystolenitemswillaccidentallygetbundledupintoCoGS,because:

1. Theyaren’tininventoryattheendoftheperiod,and2. There is no way to know which items were stolen as opposed to sold,

becauseinventoryisn’tbeingtrackeditem-by-item.

AssumptionsUsedinCalculatingCoGSunderthePeriodicMethod

Ofcourse,thecalculationofCoGSisabitmorecomplexoutintherealworld.For example, if a business is dealing with changing per-unit inventory costs,assumptionshave tobemadeas towhichonesweresold(thecheaperunitsorthemoreexpensiveunits).

EXAMPLE:Maggie has a business selling t-shirts online. She gets all of herinventory from a single vendor. In the middle of April, the vendor raises itspricesfrom$3pershirtto$3.50pershirt.IfMaggiesells100shirtsduringApril—andshehasnowayofknowingwhichofthoseshirtswerepurchasedatwhichprice—shouldherCoGSbe$300,$350,orsomewhereinbetween?The answer depends upon which inventory-valuation method is used. The

threemostusedmethodsareknownasFIFO,LIFO,andAverageCost.UnderGAAP,abusinesscanuseanyofthethree.

First-In,First-Out(FIFO)

Underthe“First-In,First-Out”methodofcalculatingCoGS,weassumethattheoldest units of inventory are always sold first. So in the above example,we’dassume that Maggie sold all of her $3 shirts before selling any of her $3.50shirts.

Last-In,First-Out(LIFO)

Underthe“Last-In,First-Out”method,theoppositeassumptionismade.Thatis,we assume that all of the newest inventory is sold before any older units ofinventoryaresold.So,intheaboveexample,we’dassumethatMaggiesoldallofher$3.50shirtsbeforesellinganyofher$3shirts.EXAMPLE (CONTINUED): At the beginning of April,Maggie’s inventoryconsistedof50shirts—allofwhichhadbeenpurchasedat$3pershirt.Overthemonth,shepurchased100shirts,60at$3pershirt,and40at$3.50pershirt.Intotal,Maggie’sGoodsAvailable forSale forAprilconsistsof110shirtsat$3pershirt,and40shirtsat$3.50pershirt.IfMaggieweretousetheFIFOmethodofcalculatingherCoGSforthe100

shirtsshesoldinApril,herCoGSwouldbe$300.(Shehad110shirtsthatcost$3,andFIFOassumesthatalloftheolderunitsaresoldbeforeanynewerunitsaresold.)

100x3=300IfMaggieweretousetheLIFOmethodofcalculatingherCoGSforthe100

shirtsshesoldinApril,herCoGSwouldbe$320.(LIFOassumesthatall40ofthenewer,$3.50shirtswouldhavebeensold,andtheother60musthavebeen$3shirts.)

(40x3.5)+(60x3)=320 It’simportanttonotethatthetwomethodsresultnotonlyindifferent

CostofGoodsSoldfortheperiod,butindifferentendinginventorybalancesaswell.Under FIFO—because we assumed that all 100 of the sold shirts were the

older,$3,shirts—itwouldbeassumedthat,attheendofApril,her50remainingshirtswouldbemadeupof10shirtsthatwerepurchasedat$3each,and40thatwerepurchasedat$3.50each.Grandtotalendinginventorybalance:$170.In contrast, theLIFOmethodwould assume that—because all of the newer

shirts were sold—the remaining shirts must be the older, $3 shirts. As such,

Maggie’sendinginventorybalanceunderLIFOis$150.

AverageCost

The average cost method is just what it sounds like. It uses the beginninginventorybalanceandthepurchasesovertheperiodtodetermineanaveragecostperunit.ThataveragecostperunitisthenusedtodetermineboththeCoGSandtheendinginventorybalance.

Avg.Cost/UnitxUnitsSold=CostofGoodsSoldAvg.Cost/UnitxUnitsinEnd.Inv.=End.Inv.BalanceEXAMPLE (CONTINUED): Under the average cost method, Maggie’saveragecostpershirtforApriliscalculatedasfollows:BeginningInventory:50shirts($3/shirt)Purchases:100shirts(60at$3/shirtand40at$3.50/shirt)Hertotalunitsavailableforsaleovertheperiodis150shirts.HertotalCostofGoodsAvailableforSaleis$470(110shirtsat$3eachand40at$3.50each).Maggie’saveragecostpershirt=$470/150=$3.13Usinganaveragecost/shirtof$3.13,wecancalculatethefollowing:CoGSinApril=$313(100shirtsx$3.13/shirt)EndingInventory=$157(50shirtsx$3.13/shirt)

Chapter13SimpleSummary

Theperiodicmethodofinventoryinvolvesdoinganinventorycountatthe

Theperiodicmethodofinventoryinvolvesdoinganinventorycountatthe

endofeachperiod,thenmathematicallycalculatingCostofGoodsSold.Theperpetualmethodofinventoryinvolvestrackingeachindividualitemofinventoryonaminute-to-minutebasis.Itcanbeexpensivetoimplement,butitimprovesandsimplifiesaccounting.FIFO(first-in,first-out)istheassumptionthattheoldestunitsofinventoryaresoldbeforethenewerunits.LIFO(last-in,first-out)istheoppositeassumption:Thenewestunitsofinventoryaresoldbeforeolderunitsaresold.TheaveragecostmethodisaformulaforcalculatingCoGSandendinginventorybasedupontheaveragecostperunitofinventoryavailableforsaleoveragivenperiod.

CONCLUSION

TheHumbleLittleJournalEntry

Thegoalofaccounting is toprovidepeople—both internalusers (managers,

owners) and external users (creditors, investors)—with information about acompany’s finances. This information is provided in the form of financialstatements.Thesefinancialstatementsarecompiledusinginformationfoundinthe general ledger, which is, essentially, the collection of all of a business’sjournalentries.In this way, we can see that it’s the humble little journal entry (and its

respective components: debits and credits) that provides the information uponwhichdecisions aremade in theworldofbusiness.Tensofbillionsofdollarschangehands everydaybasedultimatelyupon the journal entries recordedbyaccountants—andaccountingsoftware—aroundtheworld.Thesejournalentriesarebased,inturn,upontheframeworkprovidedbythe

Accounting Equation and the double-entry accounting system that goes alongwithit.Meanwhile, it’s the guidelines provided by GAAP that make these journal

entries (and the financial statements they eventually make up) meaningful.BecausewithouttheconsistencyofaccountingprovidedforbyGAAP,makingaworthwhile comparison between two companies’ financial statements wouldproveimpossible.

EndNotes

1 Sample accounting problems for each chapter of this book are available at:www.obliviousinvestor.com/example-accounting-problems.Isuggesttakingadvantageofthemifyoufeelthatyourunderstandingofatopiccouldusesomehelp.

2 Just a reminder: Sample accounting problems for each chapter of this book are available at:www.obliviousinvestor.com/example-accounting-problems.

3Inaccounting,negativenumbersareindicatedusingparentheses.4Ifacompanydoesn’tsellallofitsinventoryoverthecourseoftheperiod,theCostofGoodsSold

calculationbecomesalittlemoreinvolved.We’llbecoveringsuchcalculationsinChapter13.

APPENDIX

HelpfulOnlineResources

www.ObliviousInvestor.com

The author’s blog. Includes a wide variety of articles regarding personalfinance,accounting,andtaxation.

www.quickbooks.com

RunbyIntuit,thisprogramisanexcellentbookkeepingresource.

www.nolo.comThe most well-known (and deservedly so) publisher of legal self-helpbooks.

www.fasb.org

ThewebsiteoftheFinancialAccountingStandardsBoard,theorganizationresponsibleforcreatingandupdatingGAAP.

RecommendedReading

QuickBooksforDummies,byStephenL.NelsonQuickBooks:TheMissingManual,byBonnieBiafore

AlsobyMikePiper

InvestingMade Simple: Investing in Index Funds Explained in 100 Pages orLessObliviousInvesting:BuildingWealthbyIgnoringtheNoiseSurprisingly Simple: IndependentContractor, SoleProprietor, andLLCTaxesExplainedin100PagesorLess,byMikePiperSurprisingly Simple: LLC vs. S-Corp vs. C-Corp Explained in 100 Pages orLess,byMikePiperTaxesMade Simple: Income Taxes Explained in 100 Pages or Less, byMikePiper