target="_blank" rel="nofollow" href="#fb3_img_img_00362c85-4c11-5905-a18b-e587ca46a0c9.png" alt="check"/> Deciphering debits and credits
Ah, the language of financial accounting — debits, credits, double-entry accounting! Just reading the words makes your heart beat faster, doesn't it? The language and practices of accountants can get the best of anyone, but there's a method to the madness. Figuring out that method is a crucial first step to understanding financial reports.
In this chapter, I help you understand the logic behind the baffling and unique world of financial accounting. And you don't even need a pocket protector!
Making Sense of Accounting Methods
Officially, two types of accounting methods dictate how a company records its transactions in its financial books: cash-basis accounting and accrual accounting. The key difference between the two types is how the company records cash coming into and going out of the business.
Within that simple difference lies a lot of room for error — or manipulation. In fact, many of the major corporations involved in financial scandals have gotten into trouble because they played games with the nuts and bolts of their accounting method. I talk more about those games in Chapter 23.
Cash-basis accounting
In cash-basis accounting, companies record expenses in financial accounts when the cash is actually laid out, and they book revenue when they actually hold the cash in their hot little hands — or, more likely, in a bank account. For example, if a painter completes a project on December 30, 2021, but doesn't get paid for it until the owner inspects it on January 10, 2022, the painter reports those cash earnings on their 2022 tax report. In cash-basis accounting, cash earnings include checks, credit card receipts, and any other form of revenue from customers.
Accrual accounting
If a company uses accrual accounting, it records revenue when the actual transaction is completed (such as the completion of work specified in a contract agreement between the company and its customer), not when it receives the cash. In other words, the company records revenue when it earns it, even if the customer hasn't paid yet. So the painter who finishes a job in 2021 but doesn't get the cash for that job until 2022 still reports the income on their 2021 taxes. They enter the income into the books when the job is completed.
Companies handle expenses in the same way. A company records any expenses when they're incurred, even if it hasn't yet paid for the supplies. For example, when a carpenter buys lumber for a job, they may likely do so on account and not actually lay out the cash for the lumber until a month or so later, when they get the bill.
Why method matters
The accounting method a business uses can have a major impact on the total revenue it reports, as well as on the expenses it subtracts from the revenue to get the bottom line. Here's how:
Cash-basis accounting: Expenses and revenues aren't carefully matched on a month-to-month basis. The company doesn't recognize expenses until it actually pays the money, even if it incurs the expenses in previous months. Likewise, the business doesn't recognize the revenues it earned in previous months until it actually receives the cash. However, cash-basis accounting excels in tracking the actual cash available, as well as the cash going in and out of the business.
Accrual accounting: Expenses and revenue are matched, giving a company a better idea of how much it's spending to operate each month and how much profit it's making. The company records (or accrues) expenses in the month incurred, even if it doesn't pay out the cash until the next month. Likewise, the company records revenues in the month it completes the project or ships the product, even if the company hasn't yet received the cash from the customer.
The way a company records payment of payroll taxes, for example, differs with these two methods. In accrual accounting, each month the company sets aside the amount it expects to pay toward its quarterly tax bills for employee taxes using an accrual (a paper transaction in which no money changes hands). The entry goes into a tax liability account (an account for tracking tax payments that the company has made or must still make). If the company incurs $1,000 of tax liabilities in March, it enters that amount in the tax liability account even if it hasn't yet paid out the cash. That way, the expense is matched to the month in which it's incurred.
In cash accounting, the company doesn't record the liability until it actually pays the government the cash. Although it incurs tax expenses each month, a company using cash accounting shows a higher profit during two months every quarter, and possibly even shows a loss in the third month when the taxes are paid.
To see how these two methods can result in totally different financial statements, imagine that a carpenter contracts a job with a total cost to the customer of $2,000. The carpenter's expected expenses for the supplies, labor, and other necessities are $1,200, so their expected profit is $800. They contract the work on December 23, 2021, and complete the job on 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
