Reading Financial Reports For Dummies. Lita Epstein
December 31, 2021, but they aren’t paid until January 3, 2022. The contractor takes no cash up front and instead agrees to be paid in full upon completion.
If the contractor uses the cash-basis accounting method, then because no cash changes hands, they don’t have to report any revenues from this transaction in 2021. But say the contractor lays out the cash for their expenses in 2021. In this case, their bottom line is $1,200 less, with no revenue to offset it, and their net profit (the amount of money their company earns, minus expenses) for the business in 2021 is lower. This scenario may not necessarily be bad if the contractor is trying to reduce their tax hit for 2021.
INCENTIVES AND THE BOTTOM LINE
To improve the bottom line, many companies offer their salespeople different kinds of incentives at the end of a month, quarter, or year. The more the salespeople sell, the more income the company records, allowing it to report stronger earnings for that period.
You've probably seen this concept in action if you've ever made a major purchase, such as a car, at the end of the month. You probably found that you could be much more aggressive with your negotiations if the salesperson hadn't met quota or was competing to win a sales contest.
If a company gets really aggressive with its end-of-period revenue-booking practices, it can inflate its actual earnings, especially if salespeople allow customers to sign orders with the promise that they can cancel their orders early in the next month or accounting period. Some companies have gotten into trouble by recording sales on products that weren't yet shipped in order to make a quarterly or monthly goal.
If the same carpenter uses accrual accounting, their bottom line is different. In this case, they book their expenses when those expenses are actually incurred. The contractor also records the income when they complete the job on December 31, 2021, even though they don’t get the cash payment until 2022. They increase their net income with this job — and also their tax hit. Chapter 7 covers the ins and outs of reporting income on the income statement.
Understanding Debits and Credits
You probably think of the word debit as a reduction in your cash. Most nonaccountants see debits only when they're taken out of their banking account. Credits likely have a more positive connotation in your mind. You see them most frequently when you've returned an item and your account is credited.
Both cash-basis and accrual accounting use this method, in which a credit may be added to or subtracted from an account, depending on the type of account. The same is true with debits; sometimes they add to an account, and sometimes they subtract from an account.
Double-entry accounting
When you buy something, you do two things: You get something new (say, a chair) and you have to give up something to get it (most likely, cash or your credit line). Companies that use double-entry accounting show both sides of every transaction in their books, and those sides must be equal.
For example, if a company buys office supplies with cash, the value of the office supplies account increases, while the value of the cash account decreases. If the company purchases $100 in office supplies, here's how it records the transaction on its books:
| Account | Debit | Credit |
|---|---|---|
| Office supplies | $100 | |
| Cash | $100 |
In this case, the debit increases the value of the Office supplies account and decreases the value of the Cash account. Both accounts are asset accounts, which means both accounts represent things the company owns that are shown on the balance sheet. (The balance sheet is the financial statement that gives you a snapshot of the assets, liabilities, and shareholders’ equity as of a particular date. I cover balance sheets in greater detail in Chapter 6.)
The assets are balanced or offset by the liabilities (claims made against the company's assets by creditors, such as loans) and the equity (claims made against the company's assets, such as shares of stock held by shareholders). Double-entry accounting seeks to balance these assets and claims. In fact, the balance sheet of a company is developed using this formula:
Assets = Liabilities + Equities
Profit and loss statements
In addition to establishing accounts to develop the balance sheet and make entries in the double-entry accounting system, companies must set up accounts that they use to develop the income statement (also known as the profit and loss statement, or P&L), which shows a company's revenue and expenses over a set period of time. (See Chapter 7 for more on revenue and expenses.) The double-entry accounting method impacts not only the way assets and liabilities (balance sheet accounts) are entered, but also the way revenue and expenses (income statement accounts) are entered.
The effect of debits and credits on sales
If you're a sales manager tracking how your department is doing for the year, you want to be able to decipher debits and credits. If you think you've found an error, your ability to read reports and understand the impact of debits and credits is critical. For example, anytime you think the income statement doesn't accurately reflect your department's success, you have to dig into the debits and credits to be sure your sales are being booked correctly. You also need to be aware of the other accounts — especially revenue and expense accounts — that are used to book transactions that impact your department.
A common entry that impacts both the balance sheet and the income statement is one that keeps track of the amount of cash customers pay to buy the company's product. If the customers pay $100, here's how the entry looks:
| Account | Debit | Credit |
|---|---|---|
| Cash | $100 | |
| Sales revenue | $100 |
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