Please read the article and answer about questions.

Why Accounting Matters to Small Business

The way many people think of it, what makes a business businesslike is its focus on making money, and in the end, the only way an owner knows or can prove to others that money is being made is through keeping careful accounting records. Accountants themselves think of five reasons why ac- counting is important to a small business:

? It proves what your business did financially. ? It shows how much your business is worth. ? Banks, creditors, development agencies, and investors require it. ? It provides easy-to-understand plans for business operations. ? You cant know how your business is doing without it.

There are three types of accounting, managerial accounting, which is used by managers for planning and control, tax accounting, which is used for calculating and reporting taxes, and finan- cial accounting, which is used by banks and outside investors.

Managerial accounting is forward-looking and attempts to predict the results of management decisions.

Tax accounting is used to produce tax returns and schedules. Tax accounting is important for avoiding penalties for noncompliance and for minimizing how much money you have to pay in taxes.

Financial accounting is a formal, rule-based system intended primarily for absentee owners, bankers, investors, and regulators.

Basic Accounting Concepts

If you, as do many folk, have an aversion to even thinking about accounting, let alone trying to do accounting, then you are about to gain a new perspective on the topic. As you read the next couple of pages youll come to realize that accounting is actually a very simple process that is based on common sense.

The most basic concepts of accounting are:

1. The idea that a business has an existence that is separate from its owner, called business entity concept.

2. The expectation that a successful business will stay in business, or the going concern concept.

3. An extremely simple equation called the accounting equation. 4. The premise of revenue and expense. 5. The principle that accounting information must be useful to the owners and managers of

businesses.7

Business Entity Concept

Because of the business entity concept, it is possible to separate business transactions from your own personal transactions. Thus we can distinguish between money that your business borrows, and money that you borrow for personal needs. It is the business entity concept that underlies the legal forms of establishing businesses, such as corporations, limited partnerships, and limited liability companies. (These are explained in detail in Chapter 18.)

Does It Belong to the Business, or Is It Mine?

Mauro Padilla III, a San Antonio, Texas, builder, ran afoul of the law because of bad accounting said his lawyer, Adam Cortez.8 U.S. Attorney James Blankinship agreed, writing in a presentencing court filing that more than $18 million of down payments and loan proceeds from different projects had been commingled with Padillas own funds to the point that it was impossible to determine from the bank records what belonged to Padilla and what belonged to the various projects.

Cortez conceded that there should have been better segregation of the funds. But he also main- tained that the failure was, in his words, not a federal crime, ... just bad accounting.9

In this case, bad accounting, specifically not keeping a bright line between business funds and personal funds (a violation of the business entity concept) led to very serious results. Padilla received a 12-year prison sentence, 5 years of supervised release, and was ordered to pay more than $6 million in restitution to banks and investors.10

Going Concern Concept

The assumption that a successful business will stay in business enables long-range planning and strategy. Accounting assumes that this years business results will affect next years, and that the intent of business is to make money over a period of many years. The going concern concept also implies that, as a separate entity, the business may continue in business even if it is sold to other owners.

The Accounting Equation

Of all the concepts and ideas of accounting, the accounting equation is the simplest, but least understood. The entire system of accounting entries, reports, and financial statements is developed from this simple equation. The primary value that accounting produces for owners and managers is that of keeping records. The accounting equation is the method that is used to place these records into understandable categories that are useful for managing your business.

This equation has its basis in keeping track of everything that the business owns, while at the same time keeping track of what the business owes to others and what it is worth to its owners. This is done as a simple two-part equivalence, which is best understood by presenting an example.

Suppose you decide to start a business making executive desks of fine hardwoods. You already have a hobby of woodworking, and have collected tools during the pursuit of your hobby. These tools, especially the power tools, are very valuable, and you want to transfer their ownership to your new business. You will also need some cash for working capital, and your local banker (who already has one of your desks) has agreed to loan money to your business. Lets take a look at how these transactions are recorded, using the accounting equation.

First, you give up ownership of your tools, transferring them to your new corporation:

Woodworking tools $50,000 Capital donated by owner $50,000

Notice that the business now owns the tools worth $50,000, but you as the owner have a claim on the business equal to the value you gave up. Should you change your mind right now, and dissolve the business, you could take back the tools. Or, were you to sell the business to someone else, you would expect to receive no less than the value of the tools.

What the Business Owns

5

Claims on the Business

Next, the bank makes a $50,000 loan to the business:

What the Business Owns

5

Claims on the Business

Cash Woodworking tools

$ 50,000

50,000

Loan payable to bank

Capital donated by owner

$ 50,000

50,000

Total value $ 100,000 Total claims $ 100,000

Now the business owns money and equipment. The total value of what it owns is $100,000. At the same time, the business owes $50,000 to the bank, and once the bank debt is paid, there will still be $50,000 value left for the owner. It may be hard to believe, but this is the entire accounting equation. The value of everything that the business owns is exactly equal to the sum of what the business owes to others plus any claims the owner has. Of course, the accounting equation is stated a bit differently. Its formal expression is:

Assets 5 Liabilities 1 Owners Equity So, lets take a look at the equation in the example, rewritten to use accounting terms:

Assets

5

Liabilities 5 Owners Equity

Current Assets

Cash

Long-Term Assets

Woodworking tools

Total assets

$ 50,000

50,000

$ 100,000

Current Liabilities

Loan payable to bank

Owners Equity

Capital donated by owner Total liabilities & equity

$ 50,000

50,000

$ 100,000

Notice that, except for using different terms, this is exactly the same as the earlier example. The only part that might be confusing is understanding what the terms assets, liabilities, equity, current, and long-term mean. An asset is simply something the business owns that will have value in the future. A liability is a legal obligation to pay some amount (or to give up product or services) at a time in the future. Owners equity is simply whatever value is left after all liabilities have been paid. Current means that the value of the item can be realized, or must be paid as cash within one year. Long-term simply means that the asset will still be valuable more than one year in the future, or that the business may take longer than one year to pay the amount owed. The for- mat used here is called a balance sheet because assets must equal the sum of liabilities and owners equity. Simple, huh?

Costs, Revenues, and Expenses

Now suppose you purchase $10,000 of hardwood and $5,000 of supplies. What does this do to the accounting equation?

As you can see, making these purchases of inventory and supplies does not change the value of the business. All that you did was trade an asset called cash for assets called inventory and supplies. However, the inventory has a cost of $10,000 and the supplies have a cost of $5,000. You gave up $15,000 in cash to obtain them. So, a cost is the value of what you give up to gain something you need or want.

5

Liabilities 1 Owners Equity

Current Assets

Cash Inventory Supplies Long-Term Assets Woodworking tools Total assets

$ 35,000 10,000 5,000

50,000

$100,000

Current Liabilities

Loan payable to bank

Owners Equity

Capital donated by owner Total liabilities & equity

$ 50,000

50,000

$100,000

To explain revenues and expenses it is best to continue our example. Suppose that, having started the business and purchased inventory and supplies, you produce and sell one desk to a local attor- ney. In making the desk, you use $1,000 of your inventory. You pay your employee $400 in wages. You present the attorney with an invoice for $2,500, and he promises to pay you in 10 days. How do these transactions affect the accounting equation?

First, recognize that only $400 has changed hands. You used inventory that youd already paid for, and you accepted the attorneys promise to pay in lieu of cash. It should be obvious to you that the value of inventory has gone down by $1,000. But what do we do with the $2,500 sales price? We recognize $2,500 of revenue, and we deduct $1,400 of expenses in this manner:

Assets

5

Liabilities 1 Owners Equity

Current Assets

Cash Accounts receivable Inventory Supplies Long-Term Assets Woodworking tools

Total assets

$ 34,600 2,500 9,000 5,000

50,000

$101,100

Current Liabilities

Loan payable to bank

Owners Equity

Capital donated by owner Revenues earned Expenses for inventory used Expense for wages paid Total liabilities & equity

$ 50,000

50,000 2,500

(1,000) (400)

$ 101,100

Now we can see the differences among costs, revenues, and expenses. Costs are the value of what- ever you give up to get what you need or want. Revenue is an increase in owners equity that is the result of selling your product or service. Expenses are reductions in owners equity that recognize thevalueofgoods(inventory)andservices(labor)usedtoproduceyourproductorservice.When you sold the desk, the business received the attorneys promise to pay, which is called accounts receivable. The business gave up the value of the inventory used and the value of labor expended.

Of course, if we continued to record transactions in this way, pretty soon the owners equity part of the balance sheet would become unreadable. Just imagine a years worth of sales and expenses being recorded as in the example, above. So, as a matter of practicality transactions are not actually entered directly into the balance sheet. Rather, we create an account. An account is simply a record of transactions that are similar in nature. Thus we have an account for sales revenue where we record each sale as it is made. Similarly, we have an account for wage expense in which we record wages as they are incurred. At the end of the accounting period, whether it is a day, a month, a quarter, or a year, we simply add up all revenues and all expenses. We then subtract expenses from revenues and the remainder is our profit (or our loss if it is a negative number).

A complete discussion of basic accounting is available as a set of interactive slides in the online learning website for this text: www.mhhe.com/katz4e.

Information Usefulness

There are only two reasons to do accounting: first, to produce information that is useful to you for managing your business, second, to meet legal or contractual requirements. To be useful, informa- tion must be accurate and relevant.11 You can ensure that your accounting information is accurate by using a computerized accounting program, as discussed in the following section. Relevance of information must be evaluated for each decision as it is made. If having the information helps you make a smarter decision, a faster decision, or a decision you feel more comfortable about, then the information was relevant.

The skill module shown below illustrates the issues discussed in this section.

Accounting Systems for Small Business

The primary reason to acquire and use a computerized accounting system is to ensure the accuracy of your accounting information. Computerized systems also simplify the accounting process by providing automatic error checking, entry screens that look like the common business forms, and automatic production of financial statements and management reports.

The most commonly used small business systems are QuickBooks, Sage 50 Accounting, Simply Accounting, One-write, and Microsoft Dynamics ERP. All these systems automatically produce fi- nancial reports that meet legal requirements for content and format. Although, as with any computer program, you will have to invest some time in learning to use it effectively, each of these accounting programs is very user-friendly. Its use can be mastered in a very short time, a matter of a few hours. Most community colleges offer night and weekend classes in QuickBooks and Sage 50 Accounting, and you may have (or have even taken) similar courses at your school. There are also numerous on- line sites that offer tutorials. Each program itself includes a tutorial, help files, and a printed manual to help you master its use.

To ensure that your accounting information is accurate, reliable, and useful, the accounting sys- tem that you choose should easily and efficiently accomplish the following tasks:

? Provide a simple, easy-to-understand user interface. ? Have an exhaustive context-sensitive help function. ? Produce an income statement that clearly lists revenues and expenses by appropriate categories

for your industry and type of business. ? Produce a classified balance sheet that clearly shows the financial position of your business. ? Facilitate the development of a cash budget. ? Facilitate the task of developing operating and investment budgets. ? Produce financial statements in approved formats to be furnished to outside investors, bankers,

and regulators. ? Produce multiple-year comparison financial statements for management use. ? Provide a method for you to define and produce custom reports to meet your management needs. ? Be able to export financial data in a form that can be used by your accountant and can be im-

ported into tax preparation and spreadsheet programs. ? Maintain an internal audit trail that records all entries and changes to the accounting system

in order to facilitate the identification and correction of errors. ? Enforce security measures to reduce the opportunity for employee misuse or fraud. ? Have provisions that will either allow the program to grow with your business or to easily

export its data into programs that can handle larger businesses.

Setting Up an Accounting System

Your specific accounting needs are largely determined by the industry youre in and by the size of your business. The smallest businesses often need little in the way of accounting records beyond an accurate check register. As businesses become larger, the difficulty of any one person being able to remember all its details increases exponentially. When a business is large enough to have one or more employees, formal record keeping is a must.

Regardless of your businesss size, the one essential element of an accounting system is cash accounting that is accurate, easy to use, and tracks all checks written and all deposits made.

As your business grows the following accounting functions will become important to your success:

? Accounts payable records to track what you owe and to make timely payments in order to capture prompt pay discounts and to maintain a good credit rating for your business.

? Payroll records to ensure that payroll and employment taxes are kept current. ? Fixed asset accounting that automatically calculates and accumulates depreciation. ? Inventory accounting that facilitates maintaining the appropriate levels of inventory and aids

in calculation of appropriate stocking and reorder levels. ? Credit card sales function to enable reconciling your sales records with the amount of dis-

count and charge backs taken by your credit card provider. ? Accounts receivable records if you provide credit to your customers. Accurate and timely

accounts receivable records are essential for making decisions concerning the extension of credit. Accurate records also help produce accurate billing of customers, and thus help to maintain good customer relations.

? Insurance register to ease the problems of keeping necessary insurance coverage current and in force.

? Investments records if your business keeps surplus cash invested in securities. ? Leasehold records if your business has made improvements to leased property or equipment.

The actual task of setting up a computerized accounting system for your business is quite easy. All the small business accounting systems listed above include all the functions that you are likely to need. Additionally, each program has a method to establish a set of records that is appropriate for your specific business. Should you have a business that is unique, setting up a set of records from scratch takes less than an hour. Quickbooks and Sage 50 Accounting include an interview function that will guide you through the setup process by furnishing a series of questions and prompts.

Often in such situations, you can get help for free from your local Small Business Develop- ment Center (www.sba.gov/content/small-business-development-centers-sbdcs) or SCORE (the Service Corps of Retired Executives; www.score.org). Alternatively, for a small fee (generally $200 to $1,000) many CPAs (certified public accountants) will set up any of these accounting pro- grams for your specific needs. You can find CPAs in your phone book (hard copy or online) or even through Google searches for an accounting consultant. As when you choose any other professional (like doctors or lawyers), it makes sense to check with others about a professional before making a major commitment.

Financial Reports

The final output of a computer system is a set of financial statements and reports. Although there is certainly room for you to customize financial reports in many ways, the overall content and form of financial statements have been made standard by long usage. Bankers and investors are famil- iar and comfortable with standard financial statements. When you apply for a loan or seek equity investment, you will be expected to present financial information in the format and containing the information that is standard for your industry.

Figure 13.1 shows examples of the most common formats. When you are familiar with them, you will find that you can easily understand and adapt them to the differences unique to your industry.

There are five common financial statements:

? Income statement ? Statement of retained earnings ? Statement of owners equity ? Balance sheet ? Cash flow statement12

To the uninitiated these financial statements can seem almost alien, but in reality each type is similar in concept and operation to financial records we use in everyday life (see Figure 13.2):

? Think of your checking account or the account tied to your debit card. You put money in and write checks or use your debit card to take money out. That is similar to the use of the income statement. ? The exact amount you have in the account at any moment depends on the deposits credited to your account (which can take anything from minutes to days, depending on how you made the deposit and the speed of your bank) and which checks have been handled by the bank. Figuring that exact amount (which some people do with their check registers or by keeping a

running tally in their heads) is the idea behind the statement of cash flow.

? The monthly bank statement gives you the check and deposit information as well as any fees the bank charged you or interest it paid into your account. That parallels the statement of retained earnings.

? When you apply for a student loan or for a loan to purchase a car, you must fill out a loan ap- plication. This form asks you to list what you own and how much it is worth. It also asks you to list all debts you owe to others. This is very similar to the balance sheet on which financial accounting is based.

The important thing about these financial statements is that they articulate, that is, information flows from the income statement through the statement of retained earnings, the statement of own- ers equity to the balance sheet. Information from the income statement and the balance sheet flows to the cash flow statement (see Figure 13.1).

Income Statement

The income statement is the primary source of information about a businesss profitability. The income statement shows the amount of revenues earned minus its expenses which equals net income:

Revenues 2 Expenses 5 Net Income

All income statements follow the same simple general format. Reading from the top down, the income statement presents answers to the questions shown in Figure 13.3.

The usefulness of the income statement for managing a small business is related to the amount of detail available in the statement. There are two formats for income statements: (1) a single-step format, illustrated in Figure 13.4A, which provides little detailit simply lists all revenues and gains together, then lists all expenses and losses together, and (2) a multiple-step format, illustrated in Figure 13.4B, which lists revenues from operations separately from other income and gains.

Most owners and managers of small businesses prefer the multiple-step format because of its greater detail. Notice that in Figure 13.4B operating income of $105,800 is reported separately from the nonoperating gains and income from leasing. The two most commonly used computerized accounting systems for small businesses, QuickBooks and Sage 50 Accounting, by default produce income statements in the multiple-step format.

Difficulties in Understanding the Income Statement

There are two typical difficulties that arise in understanding and interpreting the income statements. First, there are disagreements about what exactly should be reported as revenue. The second prob- lem arises from disputes over when to recognize revenues.

Suppose your business is a water park that is open for only 120 days between June and Septem- ber. In the late fall you run a promotion to sell season tickets as holiday gifts. Through this promo- tion, you sell for cash $200,000 worth of season tickets. Have you realized a revenue? No, to be recognized as revenue, you must have earned the money. This means that even though you have $200,000 in your bank account, it really isnt yours until the holders of season passes use them to visit the park. In fact, the amount of the season passes would be shown on your balance sheet as a liabilityyou owe the pass holders either access to the park or their money back.

Similar problems arise in determining the amounts and timing of gains, losses, and expenses. Sup- pose your business sells motor scooters. Customers who buy one will expect to receive a warranty. If they have a problem within the warranty period, they will expect that the scooter will be promptly repaired or replaced. So how much expense should you recognize for warranty? And when should you recognize it? When you sell the scooter, or when it comes back for repair? The amount of war- ranty cost and the timing of returns are not known at the time of sale.

Despite the difficulties and limitations of the income statement, it provides valuable information. Most small businesses do not have any difficulty deciding how much and when revenues and ex- penses occur. In many small businesses, all sales to customers are made either for cash or as credit card transactions that are essentially the same as cash. Subscriptions and warranties are not an issue. So in many cases, the income statement of a small business is a reliable report of just how well the business is doing in producing profits.

Use of the Income Statement

The income statement is used by you, by lenders, and by investors to analyze the effectiveness of business operations. Operating income is the most used item on the statement. It represents just how well management achieved sales and controlled costs to produce profits. Lenders use operating in- come as a measure of how much debt a business can support. Interest is deductible for determining income tax, therefore net income before tax is available to make interest payments. Equity investors similarly look to operating income as an indication of future sales, so operating income becomes a favorite indicator of the value of their investment.

Of course, any change in your financial statements has many implications; consider what effect changing your income statement from a loss of $10,000 to a profit of $190,000 would have on in- come taxes. In this case you would end up paying taxes on $190,000 in the current year. This would be a very expensive way to get a loan.

It could work the other way, though. You could immediately recognize warranty expense, for example, and reduce stated income and thus the amount of tax due. But then, the IRS takes a dim view of manipulating your financial statements to reduce your income tax.

So, the question remains, Just because you can make your business results look better, should you?

Balance Sheet

The balance sheet, also called the Statement of Financial Position, presents a snapshot of the financial holdings and liabilities at the close of business on a specified date. The balance sheet ex- plicitly details the accounting equation for your business. The balance sheet provides answers to the questions shown in Figure 13.5.

The usefulness of the balance sheet is determined by the detail it includes. As shown in Fig- ure 13.5, the minimum level of detail is to report both assets and liabilities in two categories: current, which will either produce or use cash within a year, and long term, which will convert to cash over a period of time greater than one year. However, your balance sheet may be made in greater detail if there is a need to do so. A common practice is to present multiyear balance sheets to facilitate analysis, as is shown in Figure 13.6.

Use of the Balance Sheet

The information in the balance sheet is used to determine the liquidity, financial flexibility, and financial strength of the business, which are detailed below. These measures of a businesss finan- cial position are used by owners, lenders, and equity investors in making financial and investment decisions.

Liquidity is a measure of the expected time before an asset can be converted into cash, and of the expected time before a liability must be paid. A completely liquid asset is one that can be con- verted instantly to cash, at its full value.14 Cash is the most liquid of assets, as it does not have to

be converted. An illiquid asset cannot be sold quickly without suffering a significant discount from its true value. Specialized machinery is not a liquid asset. Certainly, given enough time, special- ized machinery that is not technologically obsolete can be sold. However, it is not likely to be sold quickly, and is quite likely that when sold, it will sell for only a portion of its true value as a produc- tive asset. Think of a hot rod automobile. You might spend $20,000 or more building it. But if you must sell it, you are unlikely to get more than a tiny fraction of your cost. The same is true for any custom asset, and the more illiquid it is, the greater the discount.

Liquidity is a measure of the ability of a business to meet both short-term and long-term obliga- tions. Lenders are concerned with liquidity because it indicates the level of risk that a loan will not be repaid as contracted. Equity investors are concerned with liquidity because it affects a businesss ability to pay dividends.

The most common ratio used to estimate liquidity is the current ratio. The current ratio is cal- culated by dividing the value of current assets (those assets expected to be converted to cash within one year) by the value of current liabilities (those liabilities that must be paid within one year). The rule of thumb for evaluating current ratio is that the minimum acceptable ratio is 2.0, and higher is better. The calculation and use of financial ratios are discussed in detail in Chapter 15.

Financial flexibility is an indicator of the businesss ability to manage cash flows so that the company has the financial ability to respond appropriately if an unexpected opportunity or problem arises. There are no accepted financial ratios that are indicators of financial flexibility. Financial flexibility is a matter of judgment, usually based on experience. What owners, managers, bankers, and investors look for to help indicate levels of financial flexibility include (1) the ability to sell nonoperating assets, (2) the ability to obtain loans or to sell additional stock, and (3) the ability to increase efficiency and to lower costs of operation.15 You can see that what is similar across the three indicators is the businesss ability to rapidly and efficiently raise additional capital.

The financial strength of the business is also a matter of informed judgment. The balance sheet provides information about the nature of the assets and liabilities of the business. In evaluat- ing financial strength, more cash and cash equivalents indicate higher strength. Current assets that comprise cash, short-term investments, and accounts receivable are more indicative of strength than are inventories and prepaid expenses. In fact, excessive amounts of inventory in the current assets are indicative of management problems and financial weakness. For example, a large inventory may indicate lagging sales or products that have become obsolete or fallen out of favor with customers all indicators of out-of-touch management. Long-term assets that are relatively new, low current liabilities, low long-term debt, and fully funded retirement plans for employees are all indicative of financial strength.

Problems in Interpreting Balance Sheet Information

For all its usefulness to the owners and managers of businesses, the balance sheet has several limita- tions. First, all values listed in a balance sheet are historical valuesthe cost of the asset when it was acquired. In the case of long-lived assets, such as land, buildings, and equipment, the value re- corded in the accounting records can be widely different from the assets current value. Given even a small level of inflation, the original cost of such assets is likely to be a much smaller number of dollars than its current value. On the other hand, cash is always current. This means that ratios such as return on assets (current income/net average asset value) have a current value as numerator and a denominator that, at best, is measured in older dollars of greater purchasing power. At the extreme, the true value of the asset may have changed because of changes in population density, demograph- ics, highway access, and economic development.

Additionally, every balance sheet typically contains estimated amounts, such as estimated loss from uncollectible accounts receivable, estimated warranty cost, accumulated depreciation, deple- tion, amortization, and income taxes. Sometimes these estimates can be significantly wrong, such as when an unexpected product defect appears.

Finally, certain assets and liabilities are omitted from the balance sheet. Assets that are not listed include the value of licenses, established business with vendors, established customers, organiza- tional knowledge and expertise, employee loyalty and morale, and research and development. When such assets represent a major strength of your company, the balance sheet will underreport your firms financial strength.

1.According to this chapter, what are the five reasons accounting is important to small business?

2.According to this chapter, what are the three types of accounting and what do they mean?

3.According to this chapter, what formula expresses the Accounting Equation?

4.What is the difference between Current and Long-Term Assets & Liabilities?

5.According to this chapter, what are the two reasons to do accounting?

6.According to this chapter, what is an income statement used for?

7. According to this chapter, what is a balance sheet used for?