Table of Contents
Preface 1
Introduction 3
Section A Financial Statements: Structure & Vocabulary
About This Section 9
Much of what passes for complexity in accounting and financial reporting is just specialized vocabulary and simple numeric structures. This section will introduce the words, the basic accounting principles and the structure of the main financial statements.
Chapter 1 Twelve Basic Principles 11
Accountants have some basic rules upon which all their work in preparing financial statements is based. Who makes these rules? The simple answer is that the "FASB" makes the rules and they are called "GAAP." Got that?
Chapter 2 The Balance Sheet 15
The Balance Sheet is one of the two main business financial statements… the other is the Income Statement. The Balance Sheet states the basic equation of accounting at an instant in time: What you have minus what you owe is what you're worth.
Chapter 3 The Income Statement 43
One of the two main financial statements of a business…the other is the Balance Sheet. The Income Statement gives a significant perspective on the health of the enterprise by showing its profitability.
Chapter 4 The Cash Flow Statement 61
Where the company gets cash, and where that cash goes. The Cash Flow Statement tracks the movement of cash through the business over a defined period of time.
Chapter 5 Connections 75
The financial statements are connected; an entry in one may well affect each of the others. This interlocking flow of numbers allows the three statements together to form a cohesive picture of the company's financial position.
A Balance Sheet Connections
B Sales Cycle
C Expense Cycle
D Investment Cycle
E Asset Purchase and the Depreciation Cycle
Section B Transactions: Exploits of AppleSeed Enterprises, Inc.
About This Section 91
With our knowledge of the three main financial statements, we will now draft the books of a hypothetical company, AppleSeed Enterprises, Inc. We will report the common and everyday actions that AppleSeed takes as it goes about its business of making and selling applesauce. Accounting for these "transactions" (T1 through T33 below) is the subject of much of this book. We will describe the Balance Sheet, Income Statement and Cash Flow Statement entries for common and ordinary business actions from selling stock, to shipping product, to paying the owners a dividend.
Chapter 6 Startup Financing and Staffing 95
Welcome to our little business, AppleSeed Enterprises, Inc. Imagine that you are AppleSeed's entrepreneurial chief executive officer (CEO). You also double as treasurer and chief financial officer (CFO).
T1 Sell 150,000 shares of AppleSeed's common stock ($1 par value) for $10 per share.
T2 Pay yourself your first month's salary. Book all payroll-associated fringe benefits and taxes.
T3 Borrow $1 million to buy a building. Terms of this 10 year mortgage are 10% per annum.
T4 Pay $1.5 million for a building to be used for office, manufacturing and warehouse space. Set up a depreciation schedule.
T5 Hire administrative and sales staff. Pay first month's salaries and book fringe benefits and taxes.
T6 Pay employee health, life and disability insurance premiums plus FICA, unemployment and withholding taxes.
Chapter 7 Staffing and Equipping Facility; Planning for Manufacturing Startup 109
Now begins the fun stuff. In a few short weeks we will be producing thousands of cases of the best applesauce the world has ever tasted.
T7 Order $250,000 worth of manufacturing machinery. Pay one-half down.
T8 Receive and install manufacturing machinery. Pay the remaining $125,000 due.
T9 Hire production workers; expense first month's salary and wages.
Prepare bill of materials and establish labor requirements.
Set up plant and machinery depreciation schedules.
Plan monthly production schedule and set standard costs.
T10 Place standing orders for raw materials with suppliers; receive 1 million jar labels.
Chapter 8 Startup of Manufacturing Operations 125
We're ready to start producing applesauce. The machinery is up and running, the workers are hired and we are about to receive a supply of raw materials.
T11 Receive two months' supply of raw materials.
T12 Start up production. Pay workers and supervisor for the month.
T13 Book depreciation and other manufacturing overhead costs for the month.
T14 Pay for the labels received in Transaction 10 in Chapter 7.
T15 Finish manufacturing 19,500 cases of applesauce and move them into finished goods inventory.
T16 Scrap 500 cases' worth of work-in-process inventory.
Manufacturing variances: what can go wrong, what can go right and how to account for both.
T17 Pay for the two months' supply of raw materials received in Transaction 11 above.
T18 Manufacture another month's supply of applesauce.
Chapter 9 Marketing and Selling 145
A wise old consultant once said to me, "Really, all you need to be in business is a customer."
T19 Produce product advertising fliers and T-shirt giveaways.
Product pricing; break-even analysis
T20 A new customer orders 1,000 cases of applesauce. Ship 1,000 cases at $15.90 per case.
T21 Take an order (on credit) for 15,000 cases of applesauce at a discounted price of $15.66 per case.
T22 Ship and invoice customer for 15,000 cases of applesauce ordered in Transaction 21 above.
T23 Receive payment of $234,900 for the shipment made in Transaction 22 above and pay the broker's commission.
T24 OOPS! Customer goes bankrupt. Write off cost of 1,000 cases as bad debt.
Chapter 10 Administrative Tasks 163
We've been busy making and selling our delicious applesauce. But having been in business for three months, it is time to attend to some important administrative tasks.
T25 Pay this year's general liability insurance.
T26 Make principal and interest payments on three months' worth of building debts.
T27 Pay payroll-associated taxes and insurance benefit premiums.
T28 Pay some suppliers…especially the mean and hungry ones.
Chapter 11 Growth, Profit & Return 173
We've had a very good first year of operations. We will determine our profit for the year, compute the taxes we owe, declare a dividend and issue our first Annual Report to Shareholders.
T29 Fast-forward through the rest of the year. Record summary transitions.
T30 Book income taxes payable.
T31 Declare a $0.375 per share dividend and pay to common shareholders.
Cash Flow Statement vs. Changes in Financial Position
AppleSeed Enterprises, Inc. Annual Report to Shareholders.
What is AppleSeed worth? How to value a business.
Section C Financial Statements: Construction & Analysis
About This Section 187
Here are some of the details of constructing and analyzing a company's financial statements, and also some of they ways of fudging them.
Chapter 12 Keeping Track with Journals and Ledgers 189
Journals and ledgers are where accountants scribble transaction entries. A journal is a book (or computer memory) in which all financial events are recorded in chronological order. A ledger is a book of accounts. An account is simply any grouping of like-items that we want to keep track of.
Cash, Accounts Payable, Accrued Expenses and Accounts Receivable Ledger
Chapter 13 Ratio Analysis 193
Often in judging the financial condition of an enterprise, it is not so much the absolute amount of sales, costs, expenses and assets that are important, but rather the relationships between them.
Common Size Statements: Income Statement, Balance Sheet
Liquidity Ratios: Current Ratio, Quick Ratio
Asset Management Ratios: Inventory Turn, Asset Turn, Receivable Days
Profitability Ratios: Return on Assets, Return on Equity, Return on Sales, Gross Margin
Leverage Ratios: Debt-to-Equity, Debt Ratio
Industry and Company Comparisons
Chapter 14 Alternative Accounting Policies and Procedures 207
Various alternative accounting policies and procedures are completely legal and widely used, but may result in significant differences in the values reported on a company's financial statements. Conservative? Aggressive? Some people would call this chapter's topic "creative accounting."
Chapter 15 Cooking the Books 211
"Cooking the books" means intentionally hiding or distorting the real financial performance or financial condition of a company. Cooking is most often accomplished by incorrectly and fraudulently moving Balance Sheet items onto the Income Statements and vise versa. Outright lying is also a favorite technique.
Section D Business Expansion: Strategy, Risk & Capital
About This Section 219
"The numbers" are just a single tool-albeit a very useful one-to use with other management tools (and common sense) in deciding how to invest capital for expansion. But remember: A strategically unsound business expansion is very seldom financially sound…regardless of what the numbers say. Think strategy first. This section is all about planning the future and raising capital.
Chapter 16 Mission, Vision, Goals, Strategies, Actions and Tactics. 221
How to expand? Why expand? Why stick our necks out? What strategies should we employ to help us meet our goals? What are our goals anyway? Think through AppleSeed's mission, vision, goals, strategies, actions and tactics. The Board of Directors want to see our strategic plan!
Mission, Vision & Goals…a hierarchy of destinations
Strategies, Actions & Tactics…a hierarchy of ways to get there
Chapter 17 Risk and Uncertainty 225
Every action (or even inaction) carries a risk of failure and an uncertainty of outcome. Understanding risk and uncertainty help minimize the chance of "negative surprises" coming from important business decisions. This chapter describes ways to minimize risk and uncertainty.
Risk, Uncertainty, Threats and Avoiding a "Bet-Your-Company Risk."
Chapter 18 Making Decisions About Appleseed's Future 227
AppleSeed's Board of Directors thinks that we can successfully expand and that now is a good time to do it. What are our business expansion alternatives and how should we decide between them?
Decision Tree Analysis
Strategic Alternatives
AppleSeed's "Make vs. Buy" Decision
Chapter 19 Sources and Costs of Capital 231
Taking on debt (borrowing money) and/or selling equity (exchanging an ownership portion of the company for money) are the two ways of raising capital for expansion More debt adds risk; but selling stock means our little portion of the pie gets even smaller. Sigh. AppleSeed will need more capital to expand. Our venture investor understands the mathematics of buying and selling stock, and can do the manipulations in her head. We had better understand as well. Otherwise, this friendly venture investor will eat our applesauce.
Business Valuation: "Pre-Money" & "Post-Money" Values
Selling Stock & Ownership Dilution.
Cost of Equity Capital & Weighted Average Cost of Capital
T32 Financial expansion! Sell more stock and negotiate a line of credit.
Section E Making Good Capital Investment Decisions
About This Section 239
Capital investment decisions are among the most important that a company's management can make. Often capital is a company's scarcest resource and using capital well is essential for success. The chief determinant of what a company will become is the investments it makes today. Capital budgeting decisions require analyzing business cash flows spanning years. Accounting for the "time value of money" is essential in these analyses.
Chapter 20 The Time Value of Money 241
Would you rather I give you $1,000 today or in five years? Most everyone intuitively knows that a "bird in the hand is worth two in the bush." Now you understand the "time value of money." The rest is details.
Present Value (PV)
Future Value (FV)
Interest and Interest Rates
Discounting and Discount Rates
Computing Discounted Values
Present Value Table
Chapter 21 Net Present Value (NPV) 249
We are going to invest cash now with high hopes of a large future return. But will the anticipated payback be enough to cover our initial investment? Further, would any of our alternative projects provide us with a better financial return? Net Present Value (NPV) computations are the "gold standard" for capital budgeting. NPV and Internal Rate of Return (IRR) are the two mainstays of investment valuation.
Net Present Value (NPV)
Internal Rate of Return (IRR)
Cash Flow Forecasting for NPV and IRR Analysis
Other Capital Budgeting Techniques: ROI, Payback Period, Real Options and Monte Carlo Analysis
Chapter 22 Making Good Capital Investment Decisions 259
Let's apply all that we have learned about capital budgeting and select the best business expansion course for AppleSeed. After all, the kids are getting older and will graduate soon; maybe one will want to join the business?
Make vs. Buy Decision for AppleSeed's Business Expansion
Forecasting Cash Flows
NPV & IRR Analysis of AppleSeed's Expansion Alternatives
Business Combination Accounting
T33 Chips-R-Us joins the AppleSeed happy family of companies!
Summary and Conclusion 269
Appendix A Short History of Business Fraud and Speculative Bubbles 271
Crooked investment promoters, speculative investment bubbles waiting to pop and even outright business fraud in high places have been with us for centuries. There are many ways to lose money. Some of the most infamous are discussed in this chapter. Congress recently passed far-reaching legislation to stop these shenanigans-the Sarbanes-Oxley Act-requiring that business bosses certify their company's financial statements are correct under penalty of going to jail and paying a big fines. Don't you feel much safer?
Ponzi Schemes and Pyramids
Bubbles: Tulips, Technology Stocks and U.S. Houses
Garden-Variety Frauds
Appendix B Nominal Dollars vs. Real Dollars 277
In financial calculations spanning time, currency value can be looked at from two different perspectives. It's important when doing historical analysis or making financial projections to understand these two views of value. In "nominal dollars" a McDonald's Big Mac only cost 50c 20 years ago, and it costs $3.75 today. Prices tend to increase over time primarily due to inflation. Sometimes it is useful to look at values (i.e., "real dollars") of goods in the past (or expected values in the future) rather than what they actually cost way back when in nominal dollars.
Index 281
About the Author 285
