Reading Financial Reports For Dummies. Lita Epstein
case, both the Cash account and the Sales revenue account increase. One increases using a debit, and the other increases using a credit. Yikes — I know, accounting can be so confusing! Whether an account increases or decreases from a debit or a credit depends on the type of account it is. See Table 4-1 to find out when debits and credits increase or decrease an account.
TABLE 4-1 Effect of Debits and Credits
| Account | Debits | Credits |
|---|---|---|
| Assets | Increases | Decreases |
| Liabilities | Decreases | Increases |
| Income | Decreases | Increases |
| Expenses | Increases | Decreases |
Depreciation and amortization
For example, each vehicle a company owns loses value throughout the normal course of business every year. Cars and trucks are usually estimated to have five years of useful life, which means the number of years the vehicle will be of use to the company.
Suppose a company pays $30,000 for a car. To calculate its depreciation on a five-year schedule, divide $30,000 by 5 to get $6,000 in depreciation. Each of the five years this car is in service, the company records a depreciation expense of $6,000.
When the company makes the initial purchase of the vehicle using a loan, it records the purchase this way:
| Account | Debit | Credit |
|---|---|---|
| 2021 ABC company car | $30,000 | |
| Loans payable — Vehicles | $30,000 |
In this transaction, both the debit and the credit increase the accounts affected. The debit recording the car purchase increases the total of the assets in the vehicle account, and the credit recording the new loan also increases the total of the loans payable for cars.
The company records its depreciation expenses for the car at the end of each year this way:
| Account | Debit | Credit |
|---|---|---|
| Depreciation expense | $6,000 | |
| Accumulated depreciation — Vehicles | $6,000 |
In this case, the debit increases the expense for depreciation. The credit increases the amount accumulated for depreciation. The line item Accumulated depreciation — Vehicles is listed directly below the asset Vehicles on the balance sheet and is shown as a negative number to be subtracted from the value of the Vehicles assets. This way of presenting the information on the balance sheet helps the financial report reader quickly see how old an asset is and how much value and useful life it has. Some financial reports only show the net value of an asset with deprecation already subtracted. In those cases, the financial report reader may need to find the detail in the Notes to the Financial Statement.
A similar process, amortization, is used for intangible assets, such as patents. Just as with depreciation, a company must write down the value of a patent as it nears expiration. Amortization expenses appear on the income statement, and the balance sheet shows the value of the asset. The line item Patent is shown first on the balance sheet, with another line item called Accumulated amortization below it. The Accumulated amortization line shows how much has been written down against the asset in the current year and any past years. The financial report reader thus has a way to quickly calculate how much value is left in a company's patents.
Checking Out the Chart of Accounts
A company groups the accounts it uses to develop the financial statements in the Chart of Accounts, which is a listing of all open accounts that the accounting department can use to record transactions, according to the role of the accounts in the statements. All businesses have a Chart of Accounts, even if it's so small that they don't even realize they do and have never formally gone about designing it.
The Chart of Accounts for a business sort of builds itself as the company buys and sells assets for its use and records revenue earned and expenses incurred in its day-to-day operations.
If you work for a company and have responsibility for its transactions, you'll have a copy of the Chart of Accounts so that you know which account you want to use for each transaction. If you're a financial report reader with no internal company responsibilities, you won't get to see this Chart of Accounts — but you still need to understand what goes into these different accounts to understand what you're seeing in the financial statements.
Each account in a Chart of Accounts is assigned a number. This clearly defined structure helps accountants move from job to job and still quickly get a handle on the Chart of Accounts. Also, because most companies use computerized accounting, the software is developed with these numerical definitions. Some companies make up an alphabetical listing of their Chart of Accounts with numbers in parentheses to make finding accounts easier for managers who are unfamiliar with the structure.
The accounts in the Chart of Accounts appear in the following order:
Balance sheet asset accounts (usually in the number range of 1,000 to 1,999)
Liability accounts (with numbers ranging from 2,000 to 2,999)
Equity accounts (3,000 to 3,999)
Income statement accounts/revenue accounts (4,000 to 4,999)
Expense accounts (5,000 to 6,999)
In the old days, these accounts were recorded on paper, and finding a specific transaction on the dozens or even hundreds of pages was