Accounting All In One For Dummies

Table of Contents Introduction................................................................. 1 About This Book ..............................................................................................1 Foolish Assumptions.......................................................................................2 Icons Used in This Book .................................................................................2 Beyond the Book .............................................................................................3 Where to Go from Here...................................................................................3 Book I: Setting Up Your Accounting System ................... 5 Chapter 1: Grasping Bookkeeping and Accounting Basics 7 Knowing What Bookkeeping and Accounting Are All About .....................8 Distinguishing between bookkeeping and accounting......................8 Taking a panoramic view of bookkeeping and accounting ..............9 Wrapping Your Brain around the Accounting Cycle ................................10 Working the Fundamental Accounting Equation.......................................14 Chapter 2: Outlining Your Financial Road Map with a Chart of Accounts 17 Getting to Know the Chart of Accounts......................................................17 Connecting the chart of accounts to financial statements.............18 Organizing the accounts .....................................................................18 Balancing transactions........................................................................19 Setting Up Your Chart of Accounts .............................................................20 Mulling Over Debits versus Credits ............................................................21 Understanding Double-Entry Accounting...................................................22 Revisiting the balance sheet equation ..............................................22 Recording journal entries ...................................................................22 Figuring out a complex journal entry................................................24 Chapter 3: Using Journal Entries and Ledgers 27 Keeping a Journal ..........................................................................................27 Using journals to record cash transactions .....................................28 Recording accrual transactions.........................................................31 Exploring other journals .....................................................................33 Checking out examples of common journal entries........................35 Bringing It All Together in the Ledger ........................................................37 Realizing what a ledger is ...................................................................37 Posting to the ledgers .........................................................................38viii Accounting All-In-One For Dummies Viewing an example of a general ledger............................................38 Recognizing the purpose of the trial balance ..................................39 Putting Accounting Software to Work for You...........................................40 Chapter 4: Choosing an Accounting Method 43 Distinguishing between Cash and Accrual Basis.......................................43 The cash basis......................................................................................44 The accrual basis.................................................................................45 Sorting through Standards for Other Types of Accounting.....................46 Managerial accounting........................................................................47 Not-for-profit accounting ....................................................................47 Governmental accounting...................................................................48 International accounting.....................................................................49 Considering the Conceptual Framework of Financial Accounting..........49 The objective of financial reporting ..................................................50 Characteristics of accounting information.......................................50 Elements of the financial statements ................................................51 Financial statement measurements...................................................52 Book II: Recording Accounting Transactions ................. 53 Chapter 1: Keeping the Books 55 Analyzing the Effect of Business Transactions..........................................55 Revisiting the fundamental accounting equation............................56 Getting familiar with accounts ...........................................................56 Defining debits and credits.................................................................57 Knowing more about the transaction methodology .......................57 Managing Your Bookkeeping and Accounting System .............................58 Categorizing your financial information: The chart of accounts........................................................................................58 Standardizing source document forms and processing procedures ............................................................59 Hiring competent personnel...............................................................60 Enforcing strong internal controls ....................................................62 Wrapping Up with End-of-Period Procedures............................................63 Tidying up the books...........................................................................63 Leaving good audit trails ....................................................................64 Staying alert for unusual events and developments .......................64 Designing truly useful reports for managers....................................65 Chapter 2: Tracking Purchases 67 Keeping Track of Inventory..........................................................................68 Entering initial cost..............................................................................69 Managing inventory and its value......................................................71Table of Contents ix Buying and Monitoring Supplies..................................................................75 Staying on Top of Your Bills.........................................................................76 Segregating duties to prevent theft ...................................................76 Taking advantage of discounts ..........................................................77 Chapter 3: Counting Your Sales 79 Collecting on Cash Sales...............................................................................79 Discovering the value of sales receipts ............................................80 Recording cash transactions in the books .......................................81 Selling on Credit.............................................................................................82 Deciding whether to offer store credit..............................................82 Recording store credit transactions in the books...........................83 Proving Out the Cash Register.....................................................................85 Tracking Sales Discounts..............................................................................86 Recording Sales Returns and Allowances ..................................................87 Monitoring Accounts Receivable.................................................................89 Accepting Your Losses .................................................................................89 Chapter 4: Processing Employee Payroll and Benefits 91 Staffing Your Business ..................................................................................91 Completing government forms ..........................................................92 Picking pay periods .............................................................................96 Determining wage and salary types ..................................................97 Collecting Employee Taxes ..........................................................................98 Sorting out Social Security tax ...........................................................98 Making sense of Medicare tax ............................................................98 Figuring out federal withholding tax .................................................99 Settling up state and local withholding taxes ................................100 Determining Net Pay ...................................................................................100 Surveying Your Benefits Options ..............................................................101 Tax-exempt benefits ..........................................................................101 Taxable benefits.................................................................................102 Dealing with cafeteria plans .............................................................102 Preparing Payroll and Posting It in the Books.........................................103 Calculating payroll for hourly employees ......................................103 Doling out funds to salaried employees .........................................104 Totaling up for commission checks ................................................104 Putting it together to prepare payroll.............................................106 Depositing Employee Taxes .......................................................................107 Chapter 5: Computing and Reporting Payroll Taxes 111 Paying Employer Taxes on Social Security and Medicare .....................111 Filing Form 941 ...................................................................................112 Knowing how often to file .................................................................113x Accounting All-In-One For Dummies Completing Unemployment Reports and Paying Unemployment Taxes..............................................................................113 How states calculate the FUTA tax rate..........................................114 Calculating FUTA tax .........................................................................114 Filing and paying unemployment taxes to state governments ....118 Carrying Workers’ Compensation Insurance...........................................118 Maintaining Employee Records .................................................................120 Book III: Adjusting and Closing Entries...................... 123 Chapter 1: Depreciating Your Assets 125 Defining Depreciation..................................................................................125 Knowing what you can and can’t depreciate .................................126 Figuring out the useful life of a fixed asset .....................................127 Delving into cost basis ......................................................................128 Evaluating Your Depreciation Options.....................................................128 Walking through the straight-line method .....................................130 Accelerating by using declining balance ........................................130 Calculating sum-of-the-years’-digits ................................................132 Using the units-of-production method............................................133 Seeing how the methods compare ..................................................133 Figuring partial year depreciation ...................................................135 Tackling Taxes and Depreciation ..............................................................135 Section 179..........................................................................................136 MACRS.................................................................................................136 Chapter 2: Paying and Collecting Interest 137 Deciphering Types of Interest....................................................................137 Simple interest ...................................................................................138 Compound interest............................................................................138 Handling Interest Income ...........................................................................139 Delving into Loans and Interest Expenses ...............................................140 Short-term debt..................................................................................140 Long-term debt...................................................................................143 Chapter 3: Proving Out the Cash 147 Why Prove Out the Cash?...........................................................................147 Making Sure Ending Cash Is Right .............................................................148 Closing the Cash Journals ..........................................................................150 Finalizing cash receipts.....................................................................150 Finalizing cash outlays ......................................................................154 Using a Temporary Posting Journal..........................................................155 Chapter 4: Reconciling Accounts and Closing Journal Entries 157 Reconciling Bank Accounts........................................................................157 Tracking down reconciling items ....................................................159 Using a computerized system ..........................................................160Table of Contents xi Posting Adjustments and Corrections......................................................161 Prepping to Close: Checking for Accuracy and Tallying Things Up..................................................................................................162 Paying attention to initial transaction details................................162 Summarizing journal entries ............................................................163 Analyzing summary results ..............................................................167 Planning for cash flow .......................................................................168 Posting to the General Ledger ...................................................................168 Checking Out Computerized Journal Records.........................................169 Chapter 5: Checking Your Accuracy 175 Working with a Trial Balance.....................................................................175 Conducting your trial balance..........................................................176 Dealing with trial balance errors .....................................................178 Testing Your Balance by Using Computerized Accounting Systems....179 Developing a Financial Statement Worksheet .........................................181 Replacing Worksheets with Computerized Reports ...............................183 Chapter 6: Adjusting the Books 185 Adjusting All the Right Areas .....................................................................185 Depreciating assets ...........................................................................187 Allocating prepaid expenses ............................................................188 Counting inventory............................................................................189 Allowing for bad debts ......................................................................190 Recognizing unpaid salaries and wages..........................................193 Testing an Adjusted Trial Balance ............................................................194 Book IV: Preparing Income Statements and Balance Sheets .................................................. 195 Chapter 1: Brushing Up on Accounting Standards 197 Exploring the Origins of Accounting Standards ......................................198 Recognizing the Role of the American Institute of Certified Public Accountants (AICPA)...............................................................................199 Tying together regulators for audits of publicly traded companies ..........................................................................199 ASB audit and attestation standards...............................................200 AICPA Code of Professional Conduct..............................................201 Checking Out the U.S. Securities and Exchange Commission (SEC).....202 Getting to Know the Financial Accounting Standards Board (FASB) .......203 Understanding generally accepted accounting principles (GAAP) ..........................................................................204 Looking online for FASB standards .................................................205 Pick a standard: Domestic or international....................................205xii Accounting All-In-One For Dummies Chapter 2: Preparing an Income Statement and Considering Profit 207 Understanding the Nature of Profit...........................................................207 Choosing the Income Statement Format ..................................................208 Deciding What to Disclose in the Income Statement..............................210 Considering expense disclosure......................................................210 Presenting the right amount of expense information ...................210 Examining How Sales and Expenses Change Assets and Liabilities ...........................................................................................211 Sizing up a business’s financial condition ......................................211 Noting how accounting transactions affect the income statement and balance sheet........................................................212 Considering the Diverse Financial Effects of Making a Profit ................214 Introducing T-accounts.....................................................................214 Combining activity into one journal entry......................................215 Explaining additional transactions related to profit .....................216 Reporting Extraordinary Gains and Losses .............................................217 Segregating the income statement ..................................................217 Considering business disruptions ...................................................217 Questioning whether activity is truly unusual...............................219 Correcting Common Misconceptions about Profit .................................220 Clearing up profit misconceptions ..................................................220 Comparing to industry standards....................................................221 Waving the red flag when you see revenue and credit sales increase .................................................................................221 Chapter 3: Assessing the Balance Sheet’s Asset Section 223 Homing in on Historic Cost ........................................................................224 Discovering What Makes an Asset Current..............................................224 Cash .....................................................................................................224 Short-term investments ....................................................................226 Accounts receivable ..........................................................................227 Notes receivable ................................................................................230 Inventory.............................................................................................230 Prepaid expenses...............................................................................232 Keeping Track of Noncurrent (Long-Term) Assets.................................232 Meeting the tangibles: Property, plant, and equipment (PP&E)..................................................................233 Investigating intangible assets.........................................................235 Exploring the Asset Section of the Balance Sheet...................................237 Chapter 4: Digging for Debt in the Balance Sheet’s Liabilities Section 239 Seeing How Businesses Account for Liabilities .......................................239 Keeping Current Liabilities under Control...............................................241 Accounts payable ..............................................................................242 Payroll and taxes................................................................................243Table of Contents xiii Unearned revenue..............................................................................244 Other short-term liabilities...............................................................244 Planning for Long-Term Obligations .........................................................246 Financing asset purchases with debt versus equity .....................247 Managing long-term debt..................................................................247 Anticipating contingent liabilities....................................................248 Accounting for Bond Issuances .................................................................249 Mulling over bond basics..................................................................249 Examining sample bond transactions .............................................250 Journaling bond transactions ..........................................................251 Chapter 5: Explaining Ownership in the Equity Section of the Balance Sheet 253 Understanding How Owner Equity Varies among Business Entities......................................................................................253 Sole proprietorship ...........................................................................253 Partnership.........................................................................................254 Corporation ........................................................................................255 Distinguishing between Two Types of Capital Stock..............................255 Preferred stock...................................................................................255 Common stock ...................................................................................256 Recording stock transactions on the balance sheet .....................256 Defining Paid-In Capital...............................................................................257 Recording Retained Earnings.....................................................................258 Spotting Reductions to Stockholders’ Equity ..........................................258 Paying dividends................................................................................259 Buying back shares: Treasury stock ...............................................261 Exploring Stock Splits .................................................................................261 Computing Earnings per Share ..................................................................262 Simple capital structure....................................................................262 Complex capital structure ................................................................263 Chapter 6: Coupling the Income Statement and Balance Sheet 265 Rejoining the Income Statement and Balance Sheet...............................266 Seeing connections between accounts ...........................................266 Using transactions to explain the connections..............................267 Introducing Operating Ratios.....................................................................269 Comparing expected with actual operating ratios ........................269 Generating balance sheet amounts by using ratios ......................270 Adding Fixed Assets, Depreciation, and Owners’ Equity .......................273 Dealing with fixed assets and depreciation....................................273 Tacking on owners’ equity................................................................275 Completing the Balance Sheet with Debt .................................................276 Going over the debt section of the balance sheet.........................276 Tying in the new equity section.......................................................277xiv Accounting All-In-One For Dummies Book V: Reporting on Your Financial Statements......... 279 Chapter 1: Presenting Financial Condition and Business Valuation 281 Clarifying the Values of Assets in Balance Sheets...................................281 Considering options for balance sheet valuation..........................282 Comparing two balance sheet valuations.......................................283 Introducing Business Valuation.................................................................285 Grasping the practical applications of business valuations ........285 Considering a CVA designation........................................................286 Comparing Business Valuation Methods .................................................287 Replacing assets: Replacement value .............................................287 Using future earnings and cash flow ...............................................288 Chapter 2: Laying Out Cash Flows and Changes in Equity 291 Understanding the Difference between Cash and Profit ........................291 Seeing how noncash transactions affect profit..............................292 Distinguishing costs from expenses................................................292 Realizing the Purpose of the Statement of Cash Flows...........................293 Walking through the Cash Flow Sections .................................................294 Figuring cash operating results .......................................................295 Showing cash investing transactions..............................................297 Accounting for financing activities..................................................298 Recognizing Methods for Preparing the Statement of Cash Flows .......299 Using the direct method ...................................................................301 Starting indirectly with net income.................................................302 Interpreting the Statement of Cash Flows................................................303 Looking Quickly at the Statement of Changes in Stockholders Equity ............................................................................304 Chapter 3: Analyzing Financial Statements 305 Judging Solvency and Liquidity.................................................................305 Understanding the risks of late payments......................................306 Recognizing current assets and liabilities......................................306 Brushing up on current and quick ratios........................................308 Understanding That Transactions Drive the Balance Sheet..................310 Analyzing three types of balance sheet transactions ...................310 Reviewing changes in balance sheet accounts ..............................311 Measuring Profitability ...............................................................................312 Understanding trend analysis ..........................................................313 Focusing on return on investment...................................................314 Homing in on return on equity.........................................................315 Exploring Activity Measures ......................................................................315 Accounts receivable turnover..........................................................316 Inventory turnover ............................................................................317Table of Contents xv Comparing Horizontal and Vertical Analysis...........................................317 Using horizontal analysis..................................................................318 Implementing vertical analysis ........................................................319 Using Common Size Financial Statements................................................320 Chapter 4: Reading Explanatory Notes and Disclosures 321 Realizing How Corporations Should Govern Themselves......................321 Identifying Corporate Characteristics ......................................................322 Reviewing Common Explanatory Notes ...................................................324 Leveling the playing field among financial statements .................324 Explaining significant accounting policies .....................................325 Looking for important event disclosures .......................................328 Putting the Onus on the Preparer .............................................................332 Chapter 5: Studying the Report to the Shareholders 335 Why Private and Public Companies Treat Annual Reports Differently .................................................................................................336 Fulfilling Three Purposes............................................................................337 Serving a marketing and PR function ..............................................337 Stating financial performance and goals.........................................337 Meeting regulatory requirements....................................................338 Reading the Annual Report to Shareholders ...........................................338 Meeting the chair of the board of directors...................................339 Highlighting key financial data.........................................................339 Touting company achievements......................................................341 Looking into the future......................................................................341 Getting to know key management and board members ...............342 Walking through Form 10-K........................................................................342 Facing page: Identifying the affected company..............................343 Part I: Finding out more about the registrant ................................343 Part II: Revealing the company’s financial performance ..............343 Part III: Identifying management and corporate governance.......345 Part IV: Exhibits, financial statement schedules, and signature..........................................................................................346 Book VI: Planning and Budgeting for Your Business.... 347 Chapter 1: Incorporating Your Business 349 Securing Capital: Starting with Owners ....................................................349 Contrasting two sources of equity ..................................................350 Leveraging equity capital with debt................................................352 Recognizing the Legal Roots of Business Entities...................................353 Incorporating a Business............................................................................354 Issuing stock shares ..........................................................................355 Offering different classes of stock shares.......................................355xvi Accounting All-In-One For Dummies Determining market value of stock shares.....................................357 Keeping alert for dilution of share value ........................................358 Recognizing conflicts between stockholders and managers .......360 Chapter 2: Choosing a Legal Structure for a Business 361 Differentiating between Partnerships and Limited Liability Companies .................................................................................361 Partnerships .......................................................................................362 Limited liability company (LLC) ......................................................363 Limiting liability: Professional corporations and LLPs.................363 Understanding how partnerships and LLCs distribute profits....364 Going It Alone: Sole Proprietorships.........................................................365 Describing a sole proprietorship.....................................................365 Understanding liability and financial reporting.............................365 Choosing the Right Legal Structure for Income Tax ...............................366 C corporations ...................................................................................366 S corporations....................................................................................368 Partnerships and LLCs......................................................................369 Summing up the legal structure issue.............................................370 Chapter 3: Drawing Up a Business Plan to Secure Cash 371 Outlining the Basic Business Plan.............................................................371 The executive summary....................................................................372 The market assessment ....................................................................373 The operational overview.................................................................374 The financial summary: Performance and required capital.........374 Developing a Business Plan........................................................................375 Recognizing the evolution of business plans: BOTE, WAG, and SWAG........................................................................................375 Getting the process going.................................................................377 Analyzing and streamlining information with SWOT and KISS....378 Incorporating Third-Party Information into Your Plan...........................380 Gathering the info ..............................................................................381 Riding the CART concept: Complete, accurate, reliable, and timely ........................................................................381 Chapter 4: Budgeting for a Better Bottom Line 383 Brushing Up on Budgeting Basics .............................................................383 Meeting the master budget...............................................................384 Understanding key budgeting concepts .........................................384 Planning strategically........................................................................385 Recognizing Factors That Impact Your Budgeting Process...................385 Experience counts .............................................................................386 Timing is everything..........................................................................386 People get you headed in the right direction.................................387 Sales projections pay off...................................................................387 The Nuts and Bolts of Budgeting...............................................................388 Understanding the budgeting financials.........................................389 Reviewing revenue and production budgets .................................392Table of Contents xvii Chapter 5: Mastering and Flexing Your Budgeting 395 Budgeting with Cash or Accrual Accounting ...........................................395 Cash basis accounting: Using your checkbook to budget............396 I accrue, you accrue, we all accrue with accrual accounting ......398 Budgeting to Produce the Income Statement and Balance Sheet .........398 The well-balanced balance sheet.....................................................399 The incredible income statement....................................................399 Flexing Your Budget: When Plans Change ...............................................400 Controlling your business.................................................................400 Dealing with budget variances.........................................................401 Implementing a flexible budget........................................................402 Chapter 6: Planning for Long-Term Obligations 407 Managing Long-Term Debt .........................................................................407 The many faces of notes payable ....................................................408 Treasury bonds defined....................................................................413 The dark side of debt-free.................................................................414 Accounting for Bonds .................................................................................415 Valuing bonds payable......................................................................415 Figuring out the present value of a bond........................................416 Issuing at face value ..........................................................................417 Book VII: Making Savvy Business Decisions ............... 419 Chapter 1: Estimating Costs with Job Costing 421 Understanding How Job Costing Works ...................................................421 Cost objects: The sponges that absorb money .............................422 Charging customers for direct and indirect costs.........................423 Implementing job costing in manufacturing: An example................425 Taking a Closer Look at Indirect Costs by Using Normal Costing.........428 Budgeting for indirect costs.............................................................429 Following a normal job costing system...........................................430 Following the Flow of Costs through a Manufacturing System .............432 Control starts with control accounts..............................................432 Walking through a manufacturing cost example ...........................433 Applying the methodology to other control accounts .................435 Chapter 2: Performing Activity-Based Costing 437 Avoiding the Slippery Slope of Peanut Butter Costing ...........................437 Recognizing a single indirect cost allocation.................................438 A fly in the peanut butter: Dealing with different levels of client activity..............................................................................439 Undercosting and overcosting.........................................................440 Designing an Activity-Based Costing System...........................................442 Refining your approach.....................................................................442 Grouping costs by using a cost hierarchy......................................443 Testing your ABC design...................................................................444xviii Accounting All-In-One For Dummies Using Activity-Based Costing to Compute Total Cost, Profit, and Sale Price ...........................................................................................448 Allocating indirect costs evenly by product ..................................449 Analyzing and reallocating cost activities......................................449 Changing allocations to cost pools .................................................450 Changing prices after ABC................................................................451 Chapter 3: Examining Contribution Margin 453 Computing Contribution Margin ...............................................................454 Figuring total contribution margin ..................................................454 Calculating contribution margin per unit .......................................456 Working out contribution margin ratio...........................................456 Preparing a Cost-Volume-Profit Analysis..................................................457 Drafting a cost-volume-profit graph ................................................457 Trying out the total contribution margin formula.........................459 Practicing the contribution margin per unit formula....................460 Eyeing the contribution margin ratio formula ...............................460 Generating a Break-Even Analysis.............................................................461 Plotting the break-even point...........................................................461 Using the formula approach.............................................................462 Shooting for Target Profit...........................................................................463 Observing Margin of Safety ........................................................................465 Using a graph to depict margin of safety........................................465 Calculating the margin of safety ......................................................465 Taking Advantage of Operating Leverage ................................................466 Graphing operating leverage............................................................466 Looking at the operating leverage formula ....................................467 Chapter 4: Accounting for Change with Variance Analysis 469 Setting Up Standard Costs..........................................................................469 Establishing direct materials standards .........................................470 Determining direct labor standards................................................472 Calculating the overhead rate..........................................................473 Adding up standard cost per unit....................................................474 Understanding Variances ...........................................................................474 Computing direct materials variances............................................475 Calculating direct labor variances...................................................478 Computing overhead variances .......................................................481 Looking past the favorable/unfavorable label ...............................482 Teasing Out Variances................................................................................483 Interpreting variances in action.......................................................483 Focusing on the big numbers...........................................................484 Tracing little numbers back to big problems.................................485 Chapter 5: Making Smart Pricing Decisions 487 Differentiating Products .............................................................................487 Taking All Costs into Account with Absorption Costing........................488Table of Contents xix Pricing at Cost-Plus .....................................................................................489 Computing fixed markups.................................................................489 Setting a cost-plus percentage .........................................................490 Considering problems with cost-plus pricing................................490 Extreme Accounting: Trying Variable-Cost Pricing.................................491 Working out variable-cost pricing ...................................................492 Spotting the hazards of variable-cost pricing ................................493 Bull’s-Eye: Hitting Your Target Cost..........................................................493 Calculating your target cost .............................................................494 Knowing when to use target costing ...............................................495 Book VIII: Handling Cash and Making Purchase Decisions................................................... 497 Chapter 1: Identifying Costs and Matching Costs with Revenue 499 Defining Costs and Expenses in the Business World..............................500 Satisfying the Matching Principle..............................................................500 Identifying Product and Period Costs.......................................................501 Discovering Which Costs Are Depreciated ..............................................501 Handling real property depreciation...............................................502 Allocating costs between land and buildings.................................502 Expensing repairs and maintenance ...............................................503 Preparing a Depreciation Schedule...........................................................503 Deciding When to Recognize Revenue......................................................505 Going over the revenue recognition principle...............................505 Recognizing revenue and cash flow ................................................506 Chapter 2: Exploring Inventory Cost Flow Assumptions 507 Discovering How Inventory Valuation Affects the Financial Statements.........................................................................507 Comparing merchandising and manufacturing companies .........508 Connecting inventory to revenue ....................................................508 Logging Inventory for Service Companies................................................509 Classifying Inventory Types.......................................................................509 Accounting for merchandising company inventory......................509 Accounting for manufacturing company inventory ......................512 Getting to Know Inventory Valuation Methods .......................................513 Understanding guidelines used for all methods ............................513 Specific identification........................................................................514 Weighted average ..............................................................................514 First-in, first-out (FIFO)......................................................................515 Last-in, first-out (LIFO)......................................................................515 Comparing inventory cost-flow assumptions ................................515 Preparing an Inventory Worksheet ...........................................................518xx Accounting All-In-One For Dummies Chapter 3: Answering the Question: Should I Buy That? 519 Identifying Incremental and Opportunity Costs......................................520 Keeping It Simple: The Cash Payback Method ........................................520 Using the cash payback method with equal annual net cash flows .................................................................................521 Applying the cash payback method when annual net cash flows change each year .................................................................522 It’s All in the Timing: The Net Present Value (NPV) Method.................523 Calculating time value of money with one payment for one year.....................................................................................524 Finding time value of money with one payment held for two periods or more .......................................................525 Calculating NPV with a series of future cash flows .......................526 Measuring Internal Rate of Return (IRR) ..................................................529 Considering Qualitative Factors ................................................................530 Chapter 4: Knowing When to Use Debt to Finance Your Business 533 Understanding the Basics of Debt Capital................................................534 Debt maturity .....................................................................................534 Debt security ......................................................................................535 Other debt attributes ........................................................................536 Determining When Debt Is Most Appropriate .........................................537 When you can offer security or collateral ......................................537 When business is stable....................................................................538 When you have financial strength ...................................................538 Using Loans, Leases, and Other Sources of Debt....................................539 Borrowing from banks.......................................................................539 Making friends with asset-based lenders........................................541 Leasing as a source of capital ..........................................................542 Tapping government programs and the SBA .................................543 Using other sources of debt-based capital.....................................544 Getting Creative with Capital .....................................................................545 Generating internal cash flow ..........................................................545 Leveraging unsecured creditors......................................................545 Going after government aid, gifts, and grants................................546 Partnering up......................................................................................546 Chapter 5: Interpreting Your Financial Results as a Manager 547 Gauging the Relative Importance of Information ....................................548 Reviewing Profit and Earnings ...................................................................548 Judging profit performance ..............................................................548 Testing earnings per share (EPS) against change in bottom line .................................................................................549 Judging the Company’s Cash Position......................................................551 Tackling Extraordinary Gains and Losses................................................552 Recognizing the Risks of Restatement......................................................553 Remembering the Limits of Financial Reports.........................................554Table of Contents xxi Book IX: Auditing and Detecting Financial Fraud ....... 555 Chapter 1: Mulling Over Sarbanes-Oxley Regulation 557 Pre-SOX Securities Laws.............................................................................558 The Securities Act of 1933: Arming investors with information.............................................................................558 The Securities Exchange Act of 1934: Establishing the SEC.........559 Other securities laws.........................................................................563 The Scope of SOX: Securities and Issuers ................................................563 Determining what a security is ........................................................564 Defining an issuer...............................................................................565 Figuring out how stock exchanges work.........................................566 Unveiling the SOX surprise...............................................................567 The Post-SOX Paper Trail ...........................................................................569 Form10-K ............................................................................................569 Form10-Q ............................................................................................570 Form 8-K..............................................................................................570 Chapter 2: Preventing Cash Losses from Embezzlement and Fraud 571 Setting the Stage for Protection.................................................................571 Preventing loss with internal controls............................................572 Recognizing the dual purpose of internal accounting controls ...........................................................................................573 Struggling with fraud committed by the business.........................574 Putting Internal Controls to Work .............................................................575 Going down the internal controls checklist ...................................576 Considering some important details of internal control ..............580 Recognizing Limitations of Internal Controls ..........................................582 Keeping internal controls under control ........................................583 Finding fraud that slips through the net.........................................583 Chapter 3: Assessing Audit Risk 585 Using the Audit Risk Model ........................................................................585 Listing the financial statements .......................................................586 Introducing audit risk........................................................................586 Inherent risk: Recognizing the nature of a client’s business........587 Control risk: Assessing a client’s ability to detect and correct problems ...........................................................................589 Detection risk: Figuring out your chances of overlooking inaccuracies..........................................................590 Following Risk Assessment Procedures ...................................................592 Recognizing the nature of the company .........................................593 Examining the quality of company management...........................593 Asking employees for information...................................................594 Analyzing processes and paperwork ..............................................595 Observing the client at work ............................................................596xxii Accounting All-In-One For Dummies Figuring Out What’s Material and What Isn’t...........................................597 Distinguishing errors from fraud .....................................................598 Explaining the triangle of fraud........................................................600 Evaluating Your Audit Risk Results...........................................................604 Tailoring the audit to a low-risk situation ......................................604 Responding to a high-risk assessment............................................605 Documenting audit risk results........................................................606 Chapter 4: Collecting and Documenting Audit Evidence 607 Management Assertions: Assessing the Information a Client Gives You....................................................................................608 Defining financial statement presentation and disclosure...........608 Monitoring classes of transactions .................................................609 Analyzing account balances .............................................................611 Eyeing the Four Concepts of Audit Evidence...........................................612 The nature of the audit evidence.....................................................612 The competence of the audit evidence...........................................613 The sufficiency of the audit evidence .............................................614 The evaluation of the audit evidence..............................................615 Applying Professional Judgment ...............................................................617 Exercising skepticism........................................................................617 Brainstorming with audit team members.......................................618 Using Your Audit Program to Request the Right Evidence....................620 Documenting the Audit Evidence..............................................................621 Types of documentation...................................................................621 Ownership and retention of the audit documentation .................624 Chapter 5: Auditing a Client’s Internal Controls 625 Defining Internal Controls ..........................................................................626 Identifying the Five Components of Internal Controls............................627 Determining When You Need to Audit Internal Controls.......................629 Defining substantive strategy and control testing strategy .........629 Figuring out which strategy is best .................................................630 Testing a Client’s Reliability: Assessing Internal Control Procedures .................................................................................631 Considering external factors ............................................................631 Evaluating how management assesses its controls ......................632 Using questionnaires to evaluate internal controls ......................634 Designing your tests of controls......................................................635 Using sampling to test internal controls.........................................636 Knowing when internal controls are sound or flawed ..................639 Documenting your conclusion .........................................................641 Limiting Audit Procedures When Controls Are Strong...........................641 Tailoring Tests to Internal Control Weaknesses .....................................642 Timing a Client’s Control Procedures.......................................................643 Setting a timeline for the client........................................................644 Conducting interim versus year-end audits ...................................644Table of Contents xxiii Chapter 6: Getting to Know the Most Common Fraud Schemes 647 Frauds Committed by Businesses .............................................................647 Preying on vulnerable populations .................................................648 Picking investors’ pockets................................................................648 Doing business with bribes ..............................................................649 Laundering money.............................................................................649 Perpetrating construction fraud......................................................650 Dealing in subprime and predatory lending...................................651 Taking advantage of employees.......................................................651 Frauds Committed against Businesses.....................................................652 Employee theft ...................................................................................653 Vendor and customer fraud .............................................................653 Insurance fraud ..................................................................................653 Real estate and mortgage fraud .......................................................654 Bilking the Government ..............................................................................655 Tax fraud.............................................................................................655 Contract fraud ....................................................................................658 Medicare and Medicaid fraud ..........................................................659 Social Security fraud..........................................................................660 Introducing the Ponzi Scheme...................................................................661 Chapter 7: Cooked Books: Finding Financial Statement Fraud 663 Exploring the Financial Statement Fraud Triangle..................................664 Understanding the incentive behind financial statement fraud ..............................................................................664 Seeing the fraud opportunity ...........................................................665 Coming up with a rationalization for the fraud..............................665 Spotting the Common Methods of Fraud .................................................666 Hidden liabilities ................................................................................666 Cookie jar reserves............................................................................667 Off–balance sheet transactions........................................................667 Notes no one can comprehend ........................................................668 Uncovering Financial Statement Fraud.....................................................669 Comparative techniques...................................................................669 Ratio analysis .....................................................................................670 Beneish model....................................................................................671 Data mining.........................................................................................672 Index....................................................................... 673