Note:Thistextisintendedtobeahigh-levelintroductiontoaccounting/bookkeeping.Theauthorwill
makehisbestefforttokeeptheinformationcurrentandaccurate;however,giventheever-changing
nature of industry regulations, no guarantee can be made as to the accuracy of the information
containedwithin.

AccountingMadeSimple:

AccountingExplainedin100PagesorLess

MikePiper

Copyright©2010MikePiper
Nopartofthispublicationmaybereproducedordistributedwithoutexpresspermissionoftheauthor.
SimpleSubjects,LLC
Chicago,Illinois60626
ISBN:978-0-9814542-2-1

www.ObliviousInvestor.com

Dedication

Toyou,thereader.Thankyou.

YourFeedbackisAppreciated.

Astheauthorofthisbook,I’mveryinterestedtohearyourthoughts.Ifyoufindthebookhelpful,
pleaseletmeknow!Alternatively,ifyouhaveanysuggestionsofwaystomakethebookbetter,I’m
eagertohearthattoo.

Finally,ifyou’reunsatisfiedwithyourpurchaseforanyreason,letmeknow,andI’llbehappyto

provideyouwitharefundofthecurrentlistpriceofthebook.

Youcanreachmeat:

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BestRegards,
MikePiper

Introduction

Like the other books in the “…in100PagesorLess”series, this book is designed to give you a

basicunderstandingofthetopic(inthiscase,accounting),anddoitasquicklyaspossible.

Theonlywaytopackatopicsuchasaccountingintojust100pagesistobeasbriefaspossible.In

other words, the goal is not to turn you into an expert. With 100 pages, it’s simply not possible to
provide a comprehensive discussion of every topic in the field of accounting. (So if that’s what
you’relookingfor,lookforadifferentbook.)

Now,havingmadethatlittledisclaimer,IshouldstatethatIdothinkthisbookwillhelpyouachieve

adecentunderstandingofthemostimportantaccountingconcepts.

SoWhatExactlyIsAccounting?

Someprofessorsliketosaythataccountingis“thelanguageofbusiness.”Thatdefinitionhasalways
beensomewhattooabstractformytastes.Thatsaid,allthoseprofessorsareright.

At its most fundamental level, accounting is the system of tracking the income, expenses, assets,

anddebtsofabusiness.Whenlookedatwithatrainedeye,abusiness’saccountingrecordstrulytell
thestoryofthebusiness.Usingnothingbutabusiness’s“books”(accountingrecords),youcanlearn
practically anything about a business. You can learn simple things such as whether it’s growing or
declining,healthyorintrouble.Or,ifyoulookclosely,youcanseethingssuchaspotentialthreatsto
thebusiness’shealththatmightnotbeapparenteventopeoplewithinthecompany.

WhereWe’reGoing

Thisbookisbrokendownintotwomainparts:

1. A discussion of the most important financial statements used in accounting: How to read each

one,aswellaswhatlessonsyoucandrawfromeach.

2. AlookataccountingusingGenerallyAcceptedAccountingPrincipals(GAAP),including:

Topics such as double-entry bookkeeping, debits and credits, and the cash vs. accrual
methods.
How to account for some of the more complicated types of transactions, such as
depreciation expense, gains or losses on sales of property, inventory and cost of goods
sold,andsoon.

Solet’sgetstarted.

PARTONE

FinancialStatements

CHAPTERONE

TheAccountingEquation

Before you can create financial statements, you need to first understand the single most

fundamentalconceptofaccounting:TheAccountingEquation.

TheAccountingEquationstatesthatatalltimes,andwithoutexceptions,thefollowingwillbetrue:

Assets=Liabilities+Owners’Equity

Sowhatdoesthatmean?Let’stakealookattheequationpiecebypiece.

Assets:Allofthepropertyownedbythecompany.

Liabilities:Allofthedebtsthatthecompanycurrentlyhasoutstandingtolenders.

Owners’Equity(a.k.a.Shareholders’Equity):

Thecompany’sownershipinterestinitsassets,afteralldebtshavebeenrepaid.

Let’suseasimple,everydayexample:homeownership.

EXAMPLE:Lisaownsa$300,000home.Topayforthehome,shetookoutamortgage,onwhich
she still owes $230,000. Lisa would be said to have $70,000 “equity in the home.” Applying the
AccountingEquationtoLisa’ssituationwouldgiveusthis:

Assets

= Liabilities + Owners’Equity

$300,000 = $230,000 + $70,000

Inotherwords,owners’equity(thepartthatoftenconfusespeople)isjustaplugfigure.It’ssimply
the leftover amount after paying off the liabilities/debts. So while the Accounting Equation is
conventionallywrittenas:

Assets=Liabilities+Owners’Equity,

…itmightbeeasiertothinkofitthisway:

Assets–Liabilities=Owners’Equity

If,oneyearlater,Lisahadpaidoff$15,000ofhermortgage,heraccountingequationwouldnow

appearasfollows:

Assets

= Liabilities + Owners’Equity

$300,000 = $215,000 + $85,000

Becauseherliabilitieshavegonedownby$15,000—andherassetshavenotchanged—herowner ’s
equityhas,bydefault,increasedby$15,000.

MyAssetisYourLiability

Oneconceptthatcantripupaccountingnovicesistheideathataliabilityforonepersonis,infact,an
asset for somebody else. For example, if you take out a loan with your bank, the loan is clearly a
liabilityforyou.Fromtheperspectiveofyourbank,however,theloanisanasset.

Similarly,thebalanceinyoursavingsorcheckingaccountis,ofcourse,anasset(toyou).Forthe

bank,however,thebalanceisaliability.It’smoneythattheyoweyou,asyou’reallowedtodemand
fullorpartialpaymentofitatanytime.

Chapter1SimpleSummary

Acompany’sassetsconsistofallthepropertythatthecompanyowns.
Acompany’sliabilitiesconsistofallthedebtthatthecompanyowestolenders.
Acompany’sowners’equityisequaltotheowners’interestinthecompany’sassets,after
payingbackallthecompany’sdebts.
TheAccountingEquationisalwayswrittenasfollows:
Assets=Liabilities+Owners’Equity
However,it’slikelyeasiertothinkoftheAccountingEquationthisway:
Assets–Liabilities=Owners’Equity.

CHAPTERTWO

TheBalanceSheet

Acompany’sbalancesheetshowsitsfinancialsituationatagivenpointintime.Itis,quitesimply,a

formalpresentationoftheAccountingEquation.Asyou’dexpect,thethreesectionsofabalancesheet
areassets,liabilities,andowners’equity.

Havealookattheexampleofabasicbalancesheetonthefollowingpage.Let’sgooverwhateach

oftheaccountsrefersto.

Assets

CashandCashEquivalents:Balancesincheckingandsavingsaccounts,aswellasanyinvestments
thatwillmaturewithin3monthsorless.

BalanceSheet

Assets

CashandCashEquivalents

$50,000

Inventory

$110,000

AccountsReceivable

$20,000

Property,Plant,andEquipment

$300,000

TotalAssets:

$480,000

Liabilities

AccountsPayable

$20,000

NotesPayable

$270,000

TotalLiabilities:

$290,000

Owners’Equity

CommonStock

$50,000

RetainedEarnings

$140,000

TotalOwners’Equity

$190,000

TotalLiabilities+Owners’Equity: $480,000

Inventory:Goodskeptinstock,availableforsale.

Accounts Receivable: Amounts due from customers for goods or services that have already been
delivered.

Property,Plant,andEquipment:Assetsthatcannotreadilybeconvertedintocash—thingssuchas
computers,manufacturingequipment,vehicles,furniture,etc.

Liabilities

AccountsPayable:Amountsduetosuppliersforgoodsorservicesthathavealreadybeenreceived.

NotesPayable:Contractualobligationsduetolenders(e.g.,bankloans).

Owners’Equity

CommonStock:Amountsinvestedbytheownersofthecompany.

Retained Earnings: The sum of all net income over the life of the business that has not been
distributed to owners in the form of a dividend. (If this is confusing at the moment, don’t worry. It
willbeexplainedinmoredetailinChapter4,whichdiscussestheStatementofRetainedEarnings.)

Currentvs.Long-Term

Often, the assets and liabilities on a balance sheet will be broken down into current assets (or
liabilities) and long-term assets (or liabilities). Current assets are those that are expected to be
converted into cash within 12 months or less. Typical current assets include Accounts Receivable,
Cash,andInventory.

Everythingthatisn’tacurrentassetis,bydefault,along-termasset.Sometimes,long-termassets

arereferredto,understandably,asnon-currentassets.Property,Plant,andEquipmentisalong-term
assetaccount.

Current liabilities are those that will need to be paid off within 12 months or less. The most

common example of a current liability is Accounts Payable. Notes Payable that are paid off over a
periodoftimearesplituponthebalancesheetsothatthenext12months’paymentsareshownasa
currentliability,whiletheremainderofthenoteisshownasalong-termliability.

Multiple-PeriodBalanceSheets

Whatyou’lloftenseewhenlookingatpublishedfinancialstatementsisabalancesheet—suchasthe
oneonthefollowingpage—thathastwocolumns.Onecolumnshowsthebalancesasoftheendof
the most recent accounting period, and the adjoining column shows the balances as of the prior
period-end. This is done so that a reader can see how the financial position of the company has
changedovertime.

Forexample,lookingatthebalancesheetonthefollowingpagewecanlearnafewthingsabout

the health of the company. Overall, it appears that things are going well. The company’s assets are
increasingwhileitsdebtisbeingpaiddown.

The only thing that might be of concern is an increase in Accounts Receivable. An increase in

AccountsReceivablecouldbeindicativeoftroublewithgettingclientstopayontime.Ontheother
hand,it’salsoquitepossiblethatit’ssimplytheresultofanincreaseinsales,andthere’snothingto
worryabout.

BalanceSheet

CurrentAssets

12/31/11 12/31/10

CashandCashEquivalents

$50,000 $30,000

AccountsReceivable

$20,000

$5,000

TotalCurrentAssets

$70,000 $35,000

Non-CurrentAssets

Property,Plant,andEquipment

$330,000 $330,000

TotalNon-CurrentAssets:

$330,000 $330,000

TotalAssets

$400,000 $365,000

CurrentLiabilities

AccountsPayable

$20,000 $22,000

CurrentPortionofNotePayable $12,000 $12,000

TotalCurrentLiabilities

$32,000 $34,000

Long-TermLiabilities

Non-CurrentPortionofNote

$250,000 $262,000

TotalLong-TermLiabilities

$250,000 $262,000

TotalLiabilities:

$282,000 $296,000

Owners’Equity

CommonStock

$30,000 $30,000

RetainedEarnings

$88,000 $39,000

TotalOwners’Equity

$118,000 $69,000

TotalLiabilities+Equity:

$400,000 $365,000

Chapter2SimpleSummary

Acompany’sbalancesheetshowsitsfinancialpositionatagivenpointintime.Balancesheets
areformattedinaccordancewiththeAccountingEquation:
Assets=Liabilities+Owners’Equity
Currentassetsarethosethatareexpectedtobeconvertedintocashwithin12monthsorless.
Anyassetthatisnotacurrentassetisanon-current(a.k.a.long-term)assetbydefault.
Currentliabilitiesarethosethatwillneedtobepaidoffwithinthenext12months.Bydefault,
anyliabilitythatisnotacurrentliabilityisalong-termliability.

CHAPTERTHREE

TheIncomeStatement

Acompany’sincomestatementshowsthecompany’sfinancialperformanceoveraperiodoftime

(usuallyoneyear).Thisisincontrasttothebalancesheet,whichshowsfinancialpositionatapointin
time. A frequently used analogy is that the balance sheet is like a photograph, while the income
statementismoreakintoavideo.

The income statement—sometimes referred to as a profit and loss (or P&L) statement—is

organized exactly how you’d expect. The first section details the company’s revenues, while the
secondsectiondetailsthecompany’sexpenses.

IncomeStatement

Revenue

Sales

$300,000

CostofGoodsSold (100,000)

GrossProfit

200,000

Expenses

Rent

30,000

SalariesandWages

80,000

Advertising

15,000

Insurance

10,000

TotalExpenses

135,000

NetIncome

$65,000

GrossProfitandCostofGoodsSold

GrossProfitreferstothesumofacompany’srevenues,minusCostofGoodsSold.CostofGoods
Sold (CoGS) is the amount that the company paid for the goods that it sold over the course of the
period.

EXAMPLE:Laurarunsasmallbusinesssellingt-shirtswithbandlogosonthem.Atthebeginningof
themonth,Lauraordered100t-shirtsfor$3each.Bytheendofthemonth,shehadsoldallofthet-
shirtsforatotalof$800.Forthemonth,Laura’sCostofGoodsSoldis$300,andherGrossProfitis
$500.

EXAMPLE:Richrunsasmallbusinesspreparingtaxreturns.Allofhiscostsareoverhead—thatis,
eachadditionalreturnhepreparesaddsnothingtohistotalcosts—sohehasnoCostofGoodsSold.
HisGrossProfitissimplyequaltohisrevenues.

OperatingIncomevs.NetIncome

Sometimes, you’ll see an income statement—like the one on the following page—that separates
“OperatingExpenses”from“Non-OperatingExpenses.”OperatingExpensesaretheexpensesrelated
tothenormaloperationofthebusinessandarelikelytobeincurredinfutureperiodsaswell.Things
suchasrent,insurancepremiums,andemployees’wagesaretypicalOperatingExpenses.

Non-OperatingExpensesarethosethatareunrelatedtotheregularoperationofthebusinessand,

as a result, are unlikely to be incurred again in the following year. (A typical example of a Non-
OperatingExpensewouldbealawsuit.)

IncomeStatement

Revenue

Sales

$450,000

CostofGoodsSold

(75,000)

GrossProfit

375,000

OperatingExpenses

Rent

45,000

SalariesandWages

120,000

Advertising

25,000

Insurance

10,000

TotalOperatingExpenses

200,000

OperatingIncome

175,000

Non-OperatingExpenses

LawsuitSettlement

120,000

TotalNon-OperatingExpenses 120,000

NetIncome

$55,000

ThereasoningbehindseparatingOperatingExpensesfromNon-OperatingExpensesisthatitallows
forthecalculationofOperatingIncome.Intheory,OperatingIncomeisamoremeaningfulnumber
thanNetIncome,asitshouldofferabetterindicatorofwhatthecompany’sincomeisgoingtolook

likeinfutureyears.

The effect of this focus on Operating Income as opposed to Net Income has been to cause many

companies to make efforts to classify as many expenses as possible as Non-Operating with the
intention of making their Operating Income look more impressive to investors. As a result of this
“creativeaccounting,”it’sbecomeabitofadebatewhichincomefigureis,infact,thebetterindicator
offuturesuccess.

Chapter3SimpleSummary

Theincomestatementshowsacompany’sfinancialperformanceoveraperiodoftime(usually
ayear).
Acompany’sGrossisequaltoitsrevenuesminusitsCostofGoodsSold.
Acompany’sOperatingIncomeisequaltoitsGrossProfitminusitsOperatingExpenses—the
expensesthathavetodowiththenormaloperationofthebusiness.
Acompany’sNetIncomeisequaltoitsOperatingIncome,minusanyNon-OperatingExpenses.

CHAPTERFOUR

TheStatementofRetainedEarnings

Thestatementofretainedearningsisaverybrieffinancialstatement.(Seeexampleonfollowing

page.)Ithasonlyonepurpose,which,asyouwouldexpect,istodetailthechangesinacompany’s
retainedearningsoveraperiodoftime.

Again, retained earnings is the sum of all of a company’s undistributed profits over the entire

existenceofthecompany.Wesay“undistributed”inordertodistinguishfromprofitsthathave been
distributedtocompanyshareholdersintheformofdividendpayments.

EXAMPLE: ABC Construction is formed on January 1, 2011. At its date of formation, it naturally
hasaRetainedEarningsbalanceofzero(becauseithasn’thadanynetincomeyet).

Over the course of 2011, ABC Construction’s net income is $50,000. In December of the year, it

paysadividendof$20,000toitsshareholders.Itsretainedearningsstatementfortheyearwouldlook
asfollows.

StatementofRetainedEarnings

RetainedEarnings,1/1/2011

NetIncome

50,000

DividendsPaidtoShareholders (20,000)

RetainedEarnings,12/31/2011 $30,000

If,in2012,ABCConstruction’snetincomewas$70,000anditagainpaida$20,000dividend,its

2012retainedearningsstatementwouldappearasfollows:

StatementofRetainedEarnings

RetainedEarnings,1/1/2012

$30,000

NetIncome

70,000

DividendsPaidtoShareholders (20,000)

RetainedEarnings,12/31/2012 $80,000

BridgeBetweenFinancialStatements

Thestatementofretainedearningsfunctionsmuchlikeabridgebetweentheincomestatementandthe
balance sheet. It takes information from the income statement, and it provides information to the
balancesheet.

Thefinalstepofpreparinganincomestatementiscalculatingthecompany’snetincome:

IncomeStatement

Revenue

Sales

$240,000

GrossProfit

240,000

Expenses

Rent

70,000

SalariesandWages

80,000

TotalExpenses

150,000

NetIncome

$90,000

Netincomeisthenusedinthestatementofretainedearningstocalculatetheend-of-yearbalancein
RetainedEarnings:

StatementofRetainedEarnings

RetainedEarnings,Beginning

$40,000

NetIncome

90,000

DividendsPaidtoShareholders (50,000)

RetainedEarnings,Ending

$80,000

The ending Retained Earnings balance is then used to prepare the company’s end-of-year balance
sheet:

BalanceSheet

Assets

CashandCashEquivalents

$130,000

Inventory

80,000

TotalAssets:

210,000

Liabilities

AccountsPayable

20,000

TotalLiabilities:

20,000

Owners’Equity

CommonStock

110,000

RetainedEarnings

80,000

TotalOwners’Equity

190,000

TotalLiabilities+Owners’Equity: $210,000

Dividends:NotanExpense!

When first learning accounting, many people are tempted to classify dividend payments as an
expense. It’s true, they do look a lot like an expense in that they are a cash payment made from the
companytoanotherparty.

Unlike many other cash payments, however, dividends are simply a distribution of profits (as

opposed to expenses, which reduce profits). Because they are not a part of the calculation of net
income, dividend payments do not show up on the income statement. Instead, they appear on the
statementofretainedearnings.

RetainedEarnings:It’sNottheSameasCash

The definition of retained earnings—the sum of a company’s undistributed profits over the entire
existence of the company—makes it sound as if a company’s Retained Earnings balance must be
sittingaroundsomewhereascashinacheckingorsavingsaccount.Inalllikelihood,however,that
isn’tthecaseatall.

Just because a company hasn’t distributed its profits to its owners doesn’t mean it hasn’t already

usedthemforsomethingelse.Forinstance,profitsarefrequentlyreinvestedingrowingthecompany
bypurchasingmoreinventoryforsaleorpurchasingmoreequipmentforproduction.

Chapter4SimpleSummary

Thestatementofretainedearningsdetailsthechangesinacompany’sretainedearningsovera
periodoftime.
Thestatementofretainedearningsactsasabridgebetweentheincomestatementandthe
balancesheet.Ittakesinformationfromtheincomestatement,anditprovidesinformationtothe
balancesheet.
Dividendpaymentsarenotanexpense.Theyareadistributionofprofits.
Retainedearningsisnotthesameascash.Often,asignificantportionofacompany’sretained
earningsisspentonattemptstogrowthecompany.

CHAPTERFIVE

TheCashFlowStatement

Thecashflowstatementdoesexactlywhatitsoundslike:Itreportsacompany’scashinflowsand

outflowsoveranaccountingperiod.

CashFlowStatementvs.IncomeStatement

At first, it may sound as if a cash flow statement fulfills the same purpose as an income statement.
Thereare,however,someimportantdifferencesbetweenthetwo.

First, there are often differences in timing between when an income or expense item is recorded

and when the cash actually comes in or goes out the door. We’ll discuss this topic much more
thoroughlyinChapter9:Cashvs.Accrual.Fornow,let’sjustconsiderabriefexample.

EXAMPLE:In September, XYZ Consulting performs marketing services for a customer who does
not pay until the beginning of October. In September, this sale would be recorded as an increase in
bothSalesandAccountsReceivable.(AndthesalewouldshowuponaSeptemberincomestatement.)

The cash, however, isn’t actually received until October, so the activity would not appear on

September ’scashflowstatement.

Thesecondmajordifferencebetweentheincomestatementandthecashflowstatementisthatthe

cash flow statement includes several types of transactions that are not included in the income
statement.

EXAMPLE:XYZConsultingtakesoutaloanwithitsbank.Theloanwillnotappearontheincome
statement,asthetransactionisneitherarevenueitemnoranexpenseitem.Itissimplyanincreaseof
an asset (Cash) and a liability (Notes Payable). However, because it’s a cash inflow, the loan will
appearonthecashflowstatement.

EXAMPLE: XYZ Consulting pays its shareholders a $30,000 dividend. As discussed in Chapter 4,
dividendsarenotanexpense.Therefore,thedividendwillnotappearontheincomestatement.Itwill,
however,appearonthecashflowstatementasacashoutflow.

CategoriesofCashFlow

Onacashflowstatement(suchastheexampleonpage39)allcashinflowsoroutflowsareseparated
intooneofthreecategories:

1. Cashflowfromoperatingactivities,
2. Cashflowfrominvestingactivities,and
3. Cashflowfromfinancingactivities.

CashFlowfromOperatingActivities

TheconceptofcashflowfromoperatingactivitiesisquitesimilartothatofOperatingIncome.The
goal is to measure the cash flow that is the result of activities directly related to normal business
operations(i.e.,thingsthatwilllikelyberepeatedyearafteryear).

Commonitemsthatarecategorizedascashflowfromoperatingactivitiesinclude:

Receiptsfromthesaleofgoodsorservices,
Paymentsmadetosuppliers,
Paymentsmadetoemployees,and
Taxpayments.

CashFlowfromInvestingActivities

Cash flow from investing activities includes cash spent on—or received from—investments in
financial securities (stocks, bonds, etc.) as well as cash spent on—or received from—capital assets
(i.e.,assetsexpectedtolastlongerthanoneyear).Typicalitemsinthiscategoryinclude:

Purchaseorsaleofproperty,plant,orequipment,
Purchaseorsaleofstocksorbonds,and
Interestordividendsreceivedfrominvestments.

CashFlowfromFinancingActivities

Cashflowfromfinancingactivitiesincludescashinflowsandoutflowsrelatingtotransactionswith
thecompany’sownersandcreditors.Commonitemsthatwouldfallinthiscategoryinclude:

Dividendspaidtoshareholders,
Cashflowrelatedtotakingout—orpayingback—aloan,and
Cashreceivedfrominvestorswhennewsharesofstockareissued.

CashFlowStatement

CashFlowfromOperatingActivities:

Cashreceiptsfromcustomers

$320,000

Cashpaidtosuppliers

(50,000)

Cashpaidtoemployees

(40,000)

Incometaxespaid

(55,000)

NetCashFlowFromOperatingActivities 175,000

CashFlowfromInvestingActivities:

Cashspentonpurchaseofequipment

(210,000)

NetCashFlowFromInvestingActivities (210,000)

CashFlowfromFinancingActivities:

Dividendspaidtoshareholders

(25,000)

Cashreceivedfromissuingnewshares

250,000

NetCashFlowFromFinancingActivities 225,000

Netincreaseincash:

$190,000

Chapter5SimpleSummary

Thecashflowstatementandtheincomestatementdifferinthattheyreporttransactionsat
differenttimes.(We’lldiscussthismorethoroughlyinChapter9:Cashvs.Accrual.)
Thecashflowstatementalsodiffersfromtheincomestatementinthatitshowsmany
transactionsthatwouldnotappearontheincomestatement.
Cashflowfromoperatingactivitiesincludescashtransactionsthatoccurasaresultofnormal
businessoperations.

Cashflowfrominvestingactivitiesincludescashtransactionsrelatingtoacompany’s
investmentsinfinancialsecuritiesandcashtransactionsrelatingtolong-termassetssuchas
property,plant,andequipment.
Cashflowfromfinancingactivitiesincludescashtransactionsbetweenthecompanyandits
ownersorcreditors.

CHAPTERSIX

FinancialRatios

Ofcourse,nowthatyouknowhowtoreadfinancialstatements,alogicalnextstepwouldbetotake

alookatthedifferentconclusionsyoucandrawfromacompany’sfinancials.Forthemostpart,this
workisdonebycalculatingandcomparingseveraldifferentratios.

LiquidityRatios

Liquidity ratios are used to determine how easily a company will be able to meet its short-term
financialobligations.Generallyspeaking,withliquidityratios,higherisbetter.Themostfrequently
usedliquidityratioisknownasthecurrentratio:

A company’s current ratio serves to provide an assessment of the company’s ability to pay off its
currentliabilities(liabilitiesduewithinayearorless)usingitscurrentassets(cashandassetslikely
tobeconvertedtocashwithinayearorless).

A company’s quick ratio serves the same purpose as its current ratio: It seeks to assess the

company’sabilitytopayoffitscurrentliabilities.

The difference between quick ratio and current ratio is that the calculation of quick ratio excludes
inventorybalances.Thisisdoneinordertoprovideaworst-case-scenarioassessment:Howwellwill
the company be able to fulfill its current liabilities if sales are slow (that is, if inventories are not
convertedtocash)?

EXAMPLE:ABCToys(seebalancesheetonpage43)wouldcalculateitsliquidityratiosasfollows:

Acurrentratioof1tellsusthatABCToys’currentassetsmatchitscurrentliabilities,meaningit

shouldn’thaveanytroublehandlingitsfinancialobligationsoverthenext12months.

However,aquickratioofonly0.5indicatesthatABCToyswillneedtomaintainatleastsomelevel

ofsalesinordertosatisfyitsliabilities.

BalanceSheet,ABCToys

Assets

CashandCashEquivalents

$40,000

Inventory

100,000

AccountsReceivable

60,000

Property,Plant,andEquipment

300,000

TotalAssets:

500,000

Liabilities

AccountsPayable

50,000

IncomeTaxPayable

150,000

TotalLiabilities:

200,000

Owners’Equity

CommonStock

160,000

RetainedEarnings

140,000

TotalOwners’Equity

300,000

TotalLiabilities+Owners’Equity: $500,000

ProfitabilityRatios

Whileacompany’snetincomeiscertainlyavaluablepieceofinformation,itdoesn’ttellthewhole
storyintermsofhowprofitableacompanyreallyis.Forexample,Google’snetincomeisgoingto
absolutelydwarfthenetincomeofyourfavoritelocalItalianrestaurant.Butthetwobusinessesareof
such different sizes that the comparison is rather meaningless, right? That’s why we use the two
followingratios:

Acompany’sreturnonassetsshowsusacompany’sprofitabilityincomparisontothecompany’ssize
(as measured by total assets). In other words, return on assets seeks to answer the question, “How
efficientlyisthiscompanyusingitsassetstogenerateprofits?”

Returnonequityissimilarexceptthatshareholders’equityisusedinplaceoftotalassets.Return

onequityasks,“Howefficientlyisthiscompanyusingitsinvestors’moneytogenerateprofits?”

By using return on assets or return on equity, you can actually make meaningful comparisons

betweentheprofitabilityoftwocompanies,evenifthecompaniesareofdrasticallydifferentsizes.

EXAMPLE:Usingthebalancesheetfrompage43andtheincomestatementbelow,wecancalculate
thefollowingprofitabilityratiosforABCToys:

IncomeStatement,ABCToys

Revenue

Sales

$300,000

CostofGoodsSold (100,000)

GrossProfit

200,000

Expenses

Rent

30,000

SalariesandWages

80,000

TotalExpenses

110,000

NetIncome

$90,000

Acompany’sgrossprofitmarginshowswhatpercentageofsalesremainsaftercoveringthecost

ofthesoldinventory.Thisgrossprofitisthenusedtocoveroverheadcosts,withtheremainderbeing
thecompany’snetincome.

EXAMPLE:Virginiarunsabusiness sellingcosmetics.Over thecourseofthe year,hertotalsales
were$80,000,andherCostofGoodsSoldwas$20,000.Virginia’sgrossprofitmarginfortheyearis
75%,calculatedasfollows:

Gross profit margin is often used to make comparisons between companies within an industry. For
example,comparingthegrossprofitmarginoftwodifferentgrocerystorescangiveyouanideaof
whichonedoesabetterjobofkeepinginventorycostsdown.

Gross profit margin comparisons across different industries can be rather meaningless. For

instance,agrocerystoreisgoingtohavealowerprofitmarginthanasoftwarecompany,regardless
ofwhichcompanyisruninamorecost-effectivemanner.

FinancialLeverageRatios

Financial leverage ratios attempt to show to what extent a company has used debt (as opposed to
capitalfrominvestors)tofinanceitsoperations.

Acompany’sdebtratioshowswhatportionofacompany’sassetshasbeenfinancedwithdebt.

Acompany’sdebt-to-equityratioshowstheratiooffinancingviadebttofinancingviacapitalfrom
investors.

TheProsandConsofFinancialLeverage

It’sobviouslyriskyforacompanytobeveryhighlyleveraged(thatis,financedlargelywithdebt).
There is, however, something to be gained from using leverage. The more highly leveraged a
companyis,thegreateritsreturnonequitywillbeforagivenamountofnetincome.Thatmaysound
confusing;let’slookatanexample.

EXAMPLE:XYZSoftwarehas$200millionofassets,$100millionofliabilities,and$100million
ofowners’equity.XYZ’snetincomefortheyearis$15million,givingthemareturnonequityof
15%($15millionnetincomedividedby$100millionowners’equity).

If, however, XYZ Software’s capital structure was more debt-dependent—such that they had $150

million of liabilities and only $50 million of equity—their return on equity would now be much
greater.Infact,withthesamenetincome,XYZwouldhaveareturnonequityof30%($15millionnet
incomedividedby$50millionowners’equity),therebyofferingthecompany’sownerstwiceasgreat
areturnontheirmoney.

Inotherwords,whenthecompany’sdebt-to-equityratioincreased(from1inthefirstexampleto3

in the second example), the company’s return on equity increased as well, even though net income
remainedthesame.

Inshort,thequestionofleverageisaquestionofbalance.Beingmorehighlyleveraged(i.e.,more
debt,lessinvestmentfromshareholders)allowsforagreaterreturnontheshareholders’investment.
On the other hand, financing a company primarily with loans is obviously a risky way to run a
business.

AssetTurnoverRatios

Assetturnoverratiosseektoshowhowefficientlyacompanyusesitsassets.Thetwomostcommonly
usedturnoverratiosareinventoryturnoverandaccountsreceivablesturnover.

The calculation of inventory turnover shows how many times a company’s inventory is sold and
replaced over the course of a period. The “average inventory” part of the equation is the average
Inventorybalanceovertheperiod,calculatedasfollows:

Inventoryperiodshowshowlong,onaverage,inventoryisonhandbeforeitissold.

Ahigherinventoryturnover(andthus,alowerinventoryperiod)showsthatthecompany’sinventory
issellingquicklyandisindicativethatmanagementisdoingagoodjobofstockingproductsthatare
indemand.

A company’s receivables turnover (calculated as credit sales over a period divided by average

Accounts Receivable over the period) shows how quickly the company is collecting upon its
AccountsReceivable.

Averagecollectionperiodisexactlywhatitsoundslike:theaveragelengthoftimethatareceivable
fromacustomerisoutstandingpriortocollection.

Obviously,higherreceivablesturnoverandloweraveragecollectionperiodisgenerallythegoal.Ifa
company’s average collection period steadily increases from one year to the next, it could be an
indication that the company needs to address its policies in terms of when and to whom it extends
creditwhenmakingasale.

Chapter6SimpleSummary

Liquidityratiosshowhoweasilyacompanywillbeabletomeetitsshort-termfinancial
obligations.Thetwomostfrequentlyusedliquidityratiosarecurrentratioandquickratio.
Profitabilityratiosseektoanalyzehowprofitableacompanyisinrelationtoitssize.Returnon
assetsandreturnonequityarethemostimportantprofitabilityratios.
Financialleverageratiosexpresstowhatextentacompanyisusingdebt(insteadofshareholder
investment)tofinanceitsoperations.
Themoreleveragedacompanyis,thehigherreturnonequityitwillbeabletoprovideits
shareholders.However,increasingdebtfinancingcandramaticallyincreasethebusiness’srisk
level.
Assetturnoverratiosseektoshowhowefficientlyacompanyusesitsassets.Inventoryturnover
andreceivablesturnoverarethemostimportantturnoverratios.

PARTTWO

GenerallyAcceptedAccountingPrinciples(GAAP)

CHAPTERSEVEN

WhatisGAAP?

In the United States, Generally Accepted Accounting Principles (GAAP) is the name for the

frameworkofaccountingrulesusedinthepreparationoffinancialstatements.GAAPiscreatedbythe
FinancialAccountingStandardsBoard(FASB).

The goal of GAAP is to make it so that potential investors can compare financial statements of

variouscompaniesinordertodeterminewhichone(s)theywanttoinvestin,withouthavingtoworry
that one company appears more profitable on paper simply because it is using a different set of
accountingrules.

WhoisRequiredtoFollowGAAP?

All publicly traded companies are required by the Securities and Exchange Commission to follow
GAAP procedures when preparing their financial statements. In addition, because of GAAP’s
prevalence in the field of accounting—and because of the resulting fact that accountants are trained
according to GAAP when they go through school—many companies follow GAAP even when they
arenotrequiredtodoso.

GovernmentalentitiesarerequiredtofollowGAAPaswell.Thatsaid,thereareadifferentsetof

GAAP guidelines (created by a different regulatory body) for government organizations. So, while
they are following GAAP, their financial statements are quite different from those of public
companies.

Chapter7SimpleSummary

GenerallyAcceptedAccountingPrinciples(GAAP)istheframeworkofaccountingrulesand
guidelinesusedinthepreparationoffinancialstatements.
TheSecuritiesandExchangeCommissionrequiresthatallpubliclytradedcompaniesadhereby
GAAPwhenpreparingtheirfinancialstatement

CHAPTEREIGHT

DebitsandCredits

Most people (without knowing it) use a system of accounting known as single-entry accounting

when they record transactions relating to their checking or savings accounts. For each transaction,
oneentryismade(eitheranincreaseordecreaseinthebalanceofcashintheaccount).

Likely the single most important aspect of GAAP is the use of double-entry accounting, and the

accompanyingsystemofdebitsandcredits.Withdouble-entryaccounting,eachtransactionresultsin
twoentriesbeingmade.(Thesetwoentriescollectivelymakeupwhatisknownasa“journalentry.”)

Thisisactuallyfairlyintuitivewhenyouthinkbacktotheaccountingequation:

Assets=Liabilities+Owners’Equity.

Ifeachtransactionresultedinonlyoneentry,theequationwouldnolongerbalance.That’swhy,with
eachtransaction,entrieswillberecordedtotwoaccounts.

EXAMPLE:Acompanyuses$40,000cashtopurchaseanewpieceofequipment.Inthejournalentry
torecordthistransaction,Cashwilldecreaseby$40,000andEquipmentwillincreaseby$40,000.As
aresult,the“Assets”sideoftheequationwillhaveanetchangeofzero,andnothingchangesatallon
the“Liabilities+Owners’Equity”sideoftheequation.

Assets = Liabilities + Owners’Equity
-40,000 nochange nochange
+40,000

Alternatively,ifthecompanyhadpurchasedtheequipmentwithaloan,thejournalentrywouldbean
increasetoEquipmentof$40,000andanincreasetoNotesPayableof$40,000.Inthiscase,eachside
oftheequationwouldhaveincreasedby$40,000.

Assets = Liabilities + Owners’Equity
+40,000 +40,000

nochange

So,WhatareDebitsandCredits?

Debitsandcreditsaresimplythetermsusedforthetwohalvesofeachtransaction.Thatis,eachof
thesetwo-entrytransactionsinvolvesadebitandacredit.

Now,ifyou’vebeenusingabankaccountforanyperiodoftime,youlikelyhaveanideathatdebit

meansdecreasewhilecreditmeansincrease.Thatis,however,notexactlytrue.Adebit(orcredit)to
anaccountmayincreaseitordecreaseit,dependinguponwhattypeofaccountitis:

A debit entry will increase an asset account, and it will decrease a liability or owners’ equity
account.
A credit entry will decrease an asset account, and it will increase a liability or owners’ equity
account.

Fromtheperspectiveofyourbank,yourcheckingaccountisaliability—thatis,it’smoneythatthey
oweyou.Becauseit’saliability,yourbankcreditstheaccounttoincreasethebalanceanddebitsthe
accounttodecreasethebalance.

Let’sapplythissystemofdebitsandcreditstoourearlierexample.

EXAMPLE:Acompanyuses$40,000cashtopurchaseanewpieceofequipment.Cashwilldecrease
by $40,000 and Equipment will increase by $40,000. To record this decrease to Cash (an asset
account)weneedtocreditCashfor$40,000.TorecordthisincreasetoEquipment(anassetaccount),
weneedtodebitEquipmentfor$40,000.

Thistransactioncouldberecordedasajournalentryasfollows:

DR.Equipment 40,000

CR.Cash

40,000

As you can see, when recording a journal entry, the account that is debited is listed first, and the
accountthatiscreditedislistedsecond,withanindentationtotheright.Also,debitisconventionally
abbreviated as “DR” and credit is abbreviated as “CR.” (Often, these abbreviations are omitted, and
creditsaresignifiedentirelybythefactthattheyareindentedtotheright.)

An easy way to keep everything straight is to think of “debit” as meaning “left,” and “credit” as

meaning“right.”Inotherwords,debitsincreaseaccountsontheleftsideoftheaccountingequation,
andcreditsincreaseaccountsontherightside.Also,thishelpsyoutorememberthatthedebithalfof
ajournalentryisontheleft,whilethecredithalfisindentedtotheright.

Let’s take a look at a few more example transactions and see how they would be recorded as

journalentries.

EXAMPLE: Chris’ Construction takes out a $50,000 loan with a local bank. Cash will increase by
$50,000, and Notes Payable will increase by $50,000. To increase Cash (an asset account), we will
debitit.ToincreaseNotesPayable(aliabilityaccount),wewillcreditit.

DR.Cash

50,000

CR.NotesPayable 50,000

EXAMPLE: Last month, Chris’ Construction purchased $10,000 worth of building supplies, using
credittodoso.BuildingSupplies(asset)andAccountsPayable(liability)eachneedtobeincreased
by$10,000.Todoso,we’lldebitBuildingSupplies,andcreditAccountsPayable.

DR.BuildingSupplies 10,000
CR.AccountsPayable 10,000

Eventually, Chris’s Construction will pay the vendor for the supplies. When they do, we’ll need to
decrease Accounts Payable and Cash by $10,000 each. To decrease a liability, we debit it, and to
decreaseanasset,wecreditit.

DR.AccountsPayable 10,000

CR.Cash

10,000

RevenueandExpenseAccounts

So far, we’ve only discussed journal entries that deal exclusively with balance sheet accounts.
Naturally,journalentriesneedtobemadeforincomestatementtransactionsaswell.

For the most part, when making a journal entry to a revenue account, we use a credit, and when

making an entry to an expense account, we use a debit. This makes sense when we consider that
revenuesincreaseowners’equity(andthus,likeowners’equity,shouldbeincreasedwithacredit)and
thatexpensesdecreaseowners’equity(andtherefore,unlikeowners’equity,shouldbeincreasedwith
adebit).

EXAMPLE:Darla’sDresseswritesacheckfortheirmonthlyrent:$4,500.WeneedtodecreaseCash
andincreaseRentExpense.

DR.RentExpense 4,500
CR.Cash

4,500

EXAMPLE:Connie,asoftwareconsultant,makesasalefor$10,000andispaidincash.We’llneed
toincreasebothCashandSalesby$10,000each.

DR.Cash 10,000
CR.Sales 10,000

Sometimesatransactionwillrequiretwojournalentries.

EXAMPLE:Darla’sDressessellsaweddingdressfor$1,000cash.Darlahadoriginallypurchased
thedressfromasupplierfor$450.WehavetoincreaseSalesandCashby$1,000each.Wealsohave
todecreaseinventoryby$450andincreaseCostofGoodsSold(anexpenseaccount)by$450.

DR.Cash

1,000

CR.Sales

1,000

DR.CostofGoodsSold 450

CR.Inventory

450

TheGeneralLedger

The general ledger is the place where all of a company’s journal entries get recorded. Of course,
hardlyanybodyusesanactualpaperdocumentforageneralledgeranymore.Instead,journalentries
areenteredintothecompany’saccountingsoftware,whetherit’sahigh-endcustomizedprogram,a
more affordable program like QuickBooks, or even something as simple as a series of Excel
spreadsheets.

The general ledger is a company’s most important financial document, as it is from the general

ledger ’sinformationthatacompany’sfinancialstatementsarecreated.

T-Accounts

Inmanysituations,itcanbeusefultolookatalltheactivitythathasoccurredinasingleaccountover
a given time period. The tool most frequently used to provide this one-account view of activity is
knownasthe“T-Account.”OnelookatanexampleT-accountandyou’llknowwhereitgetsitsname:

TheaboveT-accountshowsusthat,overtheperiodinquestion,Cashhasbeendebitedfor$400,$550,
and$300,aswellascreditedfor$200and$950.

Often,aT-accountwillincludetheaccount’sbeginningandendingbalances:

ThisT-accountshowsusthatatthebeginningoftheperiod,Inventoryhadadebitbalanceof$600.It
wasthendebitedforatotalof$750(250+500)andcreditedforatotalof$500(200+300).Asaresult,
Inventoryhadadebitbalanceof$850attheendoftheperiod($600beginningbalance,plus$250net
debitovertheperiod).

TheTrialBalance

A trial balance is simply a list indicating the balances of every single general ledger account at a
givenpointintime.Thetrialbalanceistypicallypreparedattheendofaperiod,priortopreparing
theprimaryfinancialstatements.

Thepurposeofthetrialbalanceistocheckthatdebits—intotal—areequaltothetotalamountof

credits. If debits do not equal credits, you know that an erroneous journal entry must have been
posted.Whileatrialbalanceisahelpfulcheck,it’sfarfromperfect,astherearenumeroustypesof
errorsthatatrialbalancedoesn’tcatch.(Forexample,atrialbalancewouldn’talertyouifthewrong
asset account had been debited for a given transaction, as the error wouldn’t throw off the total
amountofdebits.)

Chapter8SimpleSummary

Foreverytransaction,ajournalentrymustberecordedthatincludesbothadebitandacredit.
Debitsincreaseassetaccountsanddecreaseequityandliabilityaccounts.
Creditsdecreaseassetaccountsandincreaseequityandliabilityaccounts.
Debitsincreaseexpenseaccounts,whilecreditsincreaserevenueaccounts.
Thegeneralledgeristhedocumentinwhichacompany’sjournalentriesarerecorded.
AT-accountshowstheactivityinaparticularaccountoveragivenperiod.
Atrialbalanceshowsthebalanceineachaccountatagivenpointintime.Thepurposeofatrial
balanceistocheckthattotaldebitsequaltotalcredits.

CHAPTERNINE

Cashvs.Accrual

Individualsandmostsmallbusinessesuseamethodofaccountingknownas“cashaccounting.”In

order to be in accordance with GAAP, however, businesses must use a method known as “accrual
accounting.”

TheCashMethod

Under the cash method of accounting, sales are recorded when cash is received, and expenses are
recordedwhencashissentout.It’sstraightforwardandintuitive.Theproblemwiththecashmethod,
however,isthatitdoesn’talwaysreflecttheeconomicrealityofasituation.

EXAMPLE:Pamrunsaretailicecreamstore.Herleaserequireshertoprepayherrentforthenext3
monthsatthebeginningofeveryquarter.Forexample,inApril,sheisrequiredtopayherrentfor
April,May,andJune.

IfPamusesthecashmethodofaccounting,hernetincomeinAprilwillbesubstantiallylower

thanhernetincomeinMayorJune,evenifhersalesandotherexpensesareexactlythesamefrom
monthtomonth.Ifapotentialcreditorwastolookatherfinancialstatementsonamonthlybasis,the
lender would get the impression that Pam’s profitability is subject to wild fluctuations. This is, of
course,adistortionofthereality.

TheAccrualMethod

Under the accrual method of accounting, revenue is recorded as soon as services are provided or
goods are delivered, regardless of when cash is received. (Note: This is why we use an Accounts
Receivableaccount.)

Similarly, under the accrual method of accounting, expenses are recognized as soon as the

companyreceivesgoodsorservices,regardlessofwhenitactuallypaysforthem.(AccountsPayable
isusedtorecordtheseas-yet-unpaidobligations.)

Thegoaloftheaccrualmethodistofixthemajorshortcomingofthecashmethod:Distortionsof

economic reality due to the frequent time lag between a service being performed and the service
beingpaidfor.

EXAMPLE:Mariorunsanelectronicsstore.Onthe5thofeverymonth,hepayshissalesrepstheir
commissionsforsalesmadeinthepriormonth.InAugust,hissalesrepsearnedtotalcommissionsof
$93,000.IfMariousestheaccrualmethodofaccounting,hemustmakethefollowingentryattheend
ofAugust:

CommissionsExpense 93,000
CommissionsPayable 93,000

Wheneveranexpenseisrecordedpriortoitsbeingpaidfor—suchasintheaboveentry—thejournal
entryisreferredtoasan“accrual,”hence,the“accrualmethod.”Theneedfortheaboveentrycould
be stated by saying that, at the end of August, “Mario has to accrue for $93,000 of Commissions
Expense.”

Then, on the 5th of September, when he pays his reps for August, he must make the following

entry:

CommissionsPayable 93,000

Cash

93,000

A few points are worthy of specific mention. First, because Mario uses the accrual method, the
expense is recorded when the services are performed, regardless of when they are paid for. This
ensures that any financial statements for the month of August reflect the appropriate amount of
CommissionsExpenseforsalesmadeduringthemonth.

Second,afterbothentrieshavebeenmade,theneteffectisadebittotherelevantexpenseaccount

andacredittoCash.(Notehowthisisexactlywhatyou’dexpectforanentryrecordinganexpense.)

Last point of note: Commissions Payable will have no net change after both entries have been

made.ItsonlypurposeistomakesurethatfinancialstatementspreparedattheendofAugustwould
reflectthat—atthatparticularmoment—anamountisowedtothesalesreps.

Let’srunthroughafewmoreexamplessoyoucangetthehangofit.

EXAMPLE: Lindsey is a freelance writer. During February she writes a series of ads for a local
business and sends them a bill for the agreed-upon fee: $600. Lindsey makes the following journal
entry:

AccountsReceivable 600

Sales

600

WhenLindseyreceivespayment,shewillmakethefollowingentry:

Cash

600

AccountsReceivable 600

EXAMPLE:OnJanuary1st,whenLindseystartedherbusiness,shetookouta6-month,$3,000loan
with a local credit union. The terms of the loan were that, rather than making payments over the

courseoftheloan,shewouldrepayitall(alongwith$180ofinterest)onJuly1st.

BecauseLindseyusestheaccrualmethod,shemustrecordtheinterestexpenseoverthelifeofthe

loan,ratherthanrecordingitallattheendwhenshepaysitoff.

WhenLindseyinitiallytakesouttheloan,shemakesthefollowingentry:

Cash

3,000

NotesPayable 3,000

Then, at the end of every month, Lindsey records 1/6th of the total interest expense by making the
followingentry:

InterestExpense 30
InterestPayable 30

OnJuly1st,Lindseypaysofftheloan,makingthefollowingentry:

NotesPayable

3,000

InterestPayable 180

Cash

3,180

PrepaidExpenses

Sofar,allofourexampleshavelookedatscenariosinwhichthecashexchangeoccurredafter the
goods/servicesweredelivered.Naturally,thereareoccasionsinwhichtheoppositesituationarises.

Again,thegoaloftheaccrualmethodistorecordtherevenuesorexpensesintheperiodduring

which the real economic transaction occurs (as opposed to the period in which cash is exchanged).
Let’srevisitourearlierexampleofPamwiththeicecreamstore.

EXAMPLE:Pam’smonthlyrentis$1,500.However,Pam’slandlord—RetailRentals—requiresthat
sheprepayherrentforthenext3monthsatthebeginningofeveryquarter.OnApril1st,Pamwritesa
checkfor$4,500(rentforApril,May,andJune).Shemakesthefollowingentry:

PrepaidRent 4,500

Cash

4,500

Intheaboveentry,PrepaidRentisanassetaccount.Overthecourseofthethreemonths,the$4,500
will be eliminated as the expense is recorded. Assets caused by the prepayment of an expense are
known,quitereasonably,as“prepaidexpenseaccounts.”

Then,attheendofeachmonth(April,May,andJune),Pamwillmakethefollowingentrytorecord

herrentexpensefortheperiod:

RentExpense 1,500
PrepaidRent 1,500

Again,bytheendofthethreemonths,PrepaidRentwillbebacktozero,andshewillhaverecognized
the proper amount of Rent Expense each month ($1,500). Of course, the process will start all over
againonJuly1stwhenPamprepaysherrentforthethirdquarteroftheyear.

UnearnedRevenue

From Pam’s perspective, the early rent payment created an asset account (Prepaid Rent). Naturally,
from the perspective of her landlord, the early payment must have the opposite effect: It creates a
liabilitybalanceknownas“unearnedrevenue.”

EXAMPLE:OnApril1st,whenRetailRentalsreceivesPam’scheckfor$4,500,theymustsetupan
UnearnedRentliabilityaccount.Then,theywillrecordtherevenuemonthbymonth.

OnApril1st,RetailRentalsreceivesthecheckandmakesthefollowingentry:

Cash

4,500

UnearnedRent 4,500

Then,attheendofeachmonth,RetailRentalswillrecordtherevenuebymakingthefollowingentry:

UnearnedRent 1,500
RentalIncome 1,500

Chapter9SimpleSummary

InordertobeinaccordancewithGAAP,businessesmustusetheaccrualmethodofaccounting
(asopposedtothecashmethod).
Thegoaloftheaccrualmethodistorecognizerevenue(orexpense)intheperiodinwhichthe
serviceisprovided,regardlessofwhenitispaidfor.

CHAPTERTEN

OtherGAAPConceptsandAssumptions

Again, the goal of GAAP is to ensure that companies’ financial statements are prepared using a

consistentsetofrulesandassumptionssothattheycanbecomparedtothoseofanothercompanyina
meaningfulway.Inthischapterwe’llexamineafewoftheassumptionsthatareusedwhenpreparing
GAAP-compliantfinancialstatements.

HistoricalCost

UnderGAAP,assetsarerecordedattheirhistoricalcost(i.e.,theamountpaidforthem).Thisseems
obvious,buttherearetimesinwhichitwouldappearreasonableforacompanytoreportanassetata
valueotherthantheamountpaidforit.Forexample,ifacompanyhasownedapieceofrealestate
forseveraldecades,reportingthepieceoflandatitshistoricalcostmayverysignificantlyunderstate
thevalueoftheland.

However, if GAAP allowed companies to use any other valuation method—current market value

forinstance—itwouldintroduceagreatdealofsubjectivityintotheprocess.(Tousetheexampleof
real estate again: Depending upon what method you use or who you ask, you could find several
differentanswersforthefairmarketvalueofapieceofrealestate.)Instead,GAAPusuallyrequires
thatcompaniesreportassetsusingthemostobjectivevalue:thecostpaidforthem.

Materiality

Under GAAP, the materiality (or immateriality) of a transaction refers to the impact that the
transaction will have on the company’s financial statements. If a mistake in recording a given
transactioncouldcauseaviewerofthecompany’sfinancialstatementstomakeadifferentdecision
than he or she would make if the transaction were reported correctly, the transaction is said to be
“material.”

EXAMPLE:Martin’sbusinesscurrentlyhas$50,000ofcurrentassets,$20,000ofcurrentliabilities,
andowes$75,000onaloanthatwillbeduein2years.Theloanisclearlymaterial,asamisstatement
of the amount, or an exclusion of it from the company’s balance sheet would very likely lead a
potentialinvestor(orcreditor)tomakeapoordecisionregardinginvestingin(orlendingmoneyto)
thecompany.

EXAMPLE: Carly runs a nicely profitable graphic design business. Her monthly revenues are
usually around $20,000, and her monthly expenses are approximately $8,000. In August, Carly
purchases$80worthofofficesupplies,butsheforgetstorecordthepurchase.

While Carly should make sure to record the purchase at some point, the $80 expense is clearly

immaterial. If creditors were looking at her financial statements at the end of August, the $80
understatement of expenses would be unlikely to cause them to make a different decision than they
wouldiftheexpensehadbeenaccuratelyrecorded.

MonetaryUnitAssumption

GAAP makes the assumption that the dollar is a stable measure of value. It’s no secret that this is a
faulty assumption due to inflation constantly changing the real value of the dollar. The reason for
using such a flawed assumption is that the benefit gained from adjusting the value of assets on a
regular basis to reflect inflation would be far outweighed by the cost in both time and money of
requiringcompaniestodoso.

EntityAssumption

ForGAAPpurposes,it’sassumedthatacompanyisanentirelyseparateentityfromitsowners.This
conceptisknownasthe“entityassumption”or“entityconcept.”

The most important ramification of the entity assumption is the requirement for documenting

transactions between a company and its owners. For example, if you wholly own a business, any
transfersfromthebusiness’sbankaccounttoyourbankaccountneedtoberecorded,despitethefact
that it doesn’t exactly seem like a “transaction” in that you’re really just moving around your own
money.

MatchingPrinciple

According to GAAP, the matching principle dictates that expenses must be matched to the revenues
that they help generate, and recorded in the same period in which the revenues are recorded. This
concept goes hand-in-hand with the concept of accrual accounting. For example, it’s the matching
principlethatdictatesthatacompany’sutilityexpensesforthemonthofMarchmustberecordedin
March(ratherthaninApril,whentheyarelikelypaid).ThereasoningisthatMarch’sutilityexpenses
contributetotheproductionofMarch’srevenues,sotheymustberecordedinMarch.

Similarly, it is the matching principle that dictates that if a company purchases an asset that is

expectedtoprovidebenefittothecompanyformultipleaccountingperiods(adesk,forinstance),the
costoftheassetmustbespreadoutovertheperiodforwhichitisexpectedtoprovidebenefits.This
processisknownasdepreciation,andwe’lldiscussitmorethoroughlyinChapter11.

Chapter10SimpleSummary

Anasset’shistoricalcostisoftenquitedifferentfromitscurrentmarketvalue.However,dueto
itsobjectivenature,historicalcostisgenerallyusedwhenreportingthevalueofassetsunder
GAAP.
Atransactionissaidtobeimmaterialifamistakeinrecordingthetransactionwouldnotresult
inasignificantmisstatementofthecompany’sfinancialstatements.
UnderGAAP,inordertosimplifyaccounting,currencyisgenerallyassumedtohaveastable
value.Thisisknownasthemonetaryunitassumption.
ForGAAPaccounting,abusinessisassumedtobeanentirelyseparateentityfromitsowners.
Thisisknownastheentityconceptorentityassumption.
AccordingtoGAAP’smatchingprinciple,expensesmustbereportedinthesameperiodasthe
revenueswhichtheyhelptoproduce.

CHAPTERELEVEN

DepreciationofFixedAssets

Asmentionedbrieflyinthepreviouschapter,whenacompanybuysanassetthatwillprobablylast

for greater than one year, the cost of that asset is not counted as an immediate expense. Rather, the
costisspreadoutoverseveralyearsthroughaprocessknownasdepreciation.

Straight-LineDepreciation

The most basic form of depreciation is known as straight-line depreciation. Using this method, the
costoftheassetisspreadoutevenlyovertheexpectedlifeoftheasset.

EXAMPLE: Daniel spends $5,000 on a new piece of equipment for his carpentry business. He
expectstheequipmenttolastfor5years,bywhichpointitwilllikelybeofnosubstantialvalue.Each
year,$1,000oftheequipment’scostwillbecountedasanexpense.

WhenDanielfirstpurchasestheequipment,hewouldmakethefollowingjournalentry:

DR.Equipment 5,000

CR.Cash

5,000

Then, each year, Daniel would make the following entry to record Depreciation Expense for the
equipment:

DepreciationExpense

1,000

AccumulatedDepreciation 1,000

Accumulated Depreciation is what’s known as a “contra account,” or more specifically, a “contra-
asset account.” Contra accounts are used to offset other accounts. In this case, Accumulated
DepreciationisusedtooffsetEquipment.

Atanygivenpoint,thenetofthedebitbalanceinEquipment,andthecreditbalanceinAccumulated

DepreciationgivesusthenetEquipmentbalance—sometimesreferredtoas“netbookvalue.”Inthe
example above, after the first year of depreciation expense, we would say that Equipment has a net
bookvalueof$4,000.($5,000originalcost,minus$1,000AccumulatedDepreciation.)

WemakethecreditentriestoAccumulatedDepreciationratherthandirectlytoEquipmentsothat

we:

1. Havearecordofhowmuchtheassetoriginallycost,and
2. Havearecordofhowmuchdepreciationhasbeenchargedagainsttheassetalready.

EXAMPLE(CONTINUED):Eventually,after5years,AccumulatedDepreciationwillhaveacredit
balance of 5,000 (the original cost of the asset), and the asset will have a net book value of zero.
WhenDanieldisposesoftheasset,hewillmakethefollowingentry:

AccumulatedDepreciation 5,000

Equipment

5,000

After making this entry, there will no longer be any balance in Equipment or Accumulated
Depreciation.

SalvageValue

What if a business plans to use an asset for a few years, and then sell it before it becomes entirely
worthless?Inthesecases,weusewhatiscalled“salvagevalue.”Salvagevalue(sometimesreferredto
asresidualvalue)isthevaluethattheassetisexpectedtohaveaftertheplannednumberofyearsof
use.

EXAMPLE:Lydiaspends$11,000onofficefurniture,whichsheplanstouseforthenexttenyears,
afterwhichshebelievesitwillhaveavalueofapproximately$2,000.Thefurniture’soriginalcost,
minusitsexpectedsalvagevalueisknownasitsdepreciablecost—inthiscase,$9,000.

Eachyear,Lydiawillrecord$900ofdepreciationasfollows:

DepreciationExpense

900

AccumulatedDepreciation 900

After ten years, Accumulated Depreciation will have a $9,000 credit balance. If, at that point, Lydia
doesinfactsellthefurniturefor$2,000,she’llneedtorecordtheinflowofcash,andwriteoffthe
OfficeFurnitureandAccumulatedDepreciationbalances:

Cash

2,000

AccumulatedDepreciation 9,000

OfficeFurniture

11,000

GainorLossonSale

Ofcourse,it’sprettyunlikelythatsomebodycanpredictexactlywhatanasset’ssalvagevaluewillbe
severalyearsfromthedatesheboughttheasset.Whenanassetissold,iftheamountofcashreceived
is greater than the asset’s net book value, a gain must be recorded on the sale. (Gains work like
revenueinthattheyhavecreditbalances,andincreaseowners’equity.)If,however,theassetissold
forlessthanitsnetbookvalue,alossmustberecorded.(Lossesworklikeexpenses:Theyhavedebit
balances,andtheydecreaseowners’equity.)

Determining whether to make a gain entry or a loss entry is never too difficult: Just figure out

whetheranadditionaldebitorcreditisneededtomakethejournalentrybalance.
EXAMPLE(CONTINUED): If, after ten years, Lydia had sold the furniture for $3,000 rather than
$2,000,shewouldrecordthetransactionasfollows:

Cash

3,000

AccumulatedDepreciation 9,000
OfficeFurniture

11,000

GainonSaleofFurniture 1,000

EXAMPLE (CONTINUED): If, however, Lydia had sold the furniture for only $500, she would
makethefollowingentry:

Cash

500

AccumulatedDepreciation 9,000
LossonSaleofFurniture 1,500

OfficeFurniture

11,000

OtherDepreciationMethods

Inadditiontostraight-line,thereareahandfulofother(morecomplicated)methodsofdepreciation
that are also GAAP-approved. For example, the double declining balance method consists of
multiplyingtheremainingnetbookvaluebyagivenpercentageeveryyear.Thepercentageusedis
equaltodoublethepercentagethatwouldbeusedinthefirstyearofstraight-linedepreciation.

EXAMPLE: Randy purchases $10,000 of equipment, which he plans to depreciate over five years.
Using straight-line, Randy would be depreciating 20% of the value (100% ÷ five years) in the first
year. Therefore, the double declining balance method will use 40% depreciation every year (2 x
20%).Thedepreciationforeachofthefirstfouryearswouldbeasfollows:

EXAMPLE (CONTINUED): Because the equipment is being depreciated over five years, Randy
wouldrecord$1,296(thatis,2,160–864)ofdepreciationexpenseinthefifthyearinordertoreduce
theasset’snetbookvaluetozero.

AnotherGAAP-acceptedmethodofdepreciationistheunitsofproductionmethod.Undertheunits

ofproductionmethod,therateatwhichanassetisdepreciatedisnotafunctionoftime,butrathera
functionofhowmuchtheassetisused.

EXAMPLE: Bruce runs a business making leather jackets. He spends $50,000 on a piece of
equipment that is expected to last through the production of 5,000 jackets. Using the units of
production method of depreciation, Bruce would depreciate the equipment each period based upon
howmanyjacketswereproduced(atarateof$10depreciationperjacket).

If, in a given month, Bruce’s business used the equipment to produce 150 jackets, the following

entrywouldbeusedtorecorddepreciation:

DepreciationExpense

1,500

AccumulatedDepreciation 1,500

ImmaterialAssetPurchases

The concept of materiality plays a big role in how some assets are accounted for. For example,
considerthecaseofa$15wastebasket.Giventhefactthatawastebasketisalmostcertaintolastfor
greaterthanoneyear,itshould,theoretically,bedepreciatedoveritsexpectedusefullife.

However—in terms of the impact on the company’s financial statements—the difference between

depreciating the wastebasket and expensing the entire cost right away is clearly negligible. The
benefit of the additional accounting accuracy is far outweighed by the hassle involved in making
insignificant depreciation journal entries year after year. As a result, assets of this nature are
generally expensed immediately upon purchase rather than depreciated over multiple years. Such a
purchasewouldordinarilyberecordedasfollows:

OfficeAdministrativeExpense 15.00
Cash(orAccountsPayable)

15.00

Chapter11SimpleSummary

Straight-linedepreciationisthesimplestdepreciationmethod.Usingstraight-line,anasset’s
costisdepreciatedoveritsexpectedusefullife,withanequalamountofdepreciationbeing
recordedeachmonth.
Accumulateddepreciation—acontra-assetaccount—isusedtokeeptrackofhowmuch
depreciationhasbeenrecordedagainstanassetsofar.
Anasset’snetbookvalueisequaltoitsoriginalcost,lesstheamountofaccumulated
depreciationthathasbeenrecordedagainsttheasset.
Ifanassetissoldformorethanitsnetbookvalue,againmustberecorded.Ifit’ssoldforless
thannetbookvalue,alossisrecorded.
Immaterialassetpurchasestendtobeexpensedimmediatelyratherthanbeingdepreciated.

CHAPTERTWELVE

AmortizationofIntangibleAssets

Intangibleassetsarereal,identifiableassetsthatarenotphysicalobjects.Commonintangibleassets

includepatents,copyrights,andtrademarks.

Amortization

Amortizationistheprocess—veryanalogoustodepreciation—inwhichanintangibleasset’scostis
spread out over the asset’s life. Generally, intangible assets are amortized using the straight-line
methodovertheshorterof:

Theasset’sexpectedusefullife,or
Theasset’slegallife.

EXAMPLE: Kurt runs a business making components for wireless routers. In 2011, he spends
$60,000obtainingapatentforanewmethodofproductionthathehasrecentlydeveloped.Thepatent
willexpirein2031.

Eventhoughthepatent’slegallifeis20years,itsusefullifeislikelytobemuchshorter,asit’sa

nearcertainty that thismethod will becomeobsolete in well under20 years, giventhe rapid rate of
innovationinthetechnologyindustry.Assuch,Kurtwillamortizethepatentoverwhatheprojectsto
beitsusefullife:fouryears.Eachyear,thefollowingentrywillbemade:

AmortizationExpense

15,000

AccumulatedAmortization 15,000

Chapter12SimpleSummary

Amortizationistheprocessinwhichanintangibleasset’scostisspreadoutovertheasset’s
life.
Thetimeperiodusedforamortizinganintangibleassetisgenerallytheshorteroftheasset’s
legallifeorexpectedusefullife.

CHAPTERTHIRTEEN

InventoryandCostofGoodsSold

UnderGAAP,therearetwoprimarymethodsofkeepingtrackofinventory:theperpetualmethod

andtheperiodicmethod.

PerpetualMethodofInventory

Any business that keeps real-time information on inventory levels and that tracks inventory on an
item-by-itembasisisusingtheperpetualmethod.Forexample,retaillocationsthatusebarcodesand
point-of-salescannersareutilizingtheperpetualinventorymethod.

Therearetwomainadvantagestousingtheperpetualinventorysystem.First,itallowsabusiness

toseeexactlyhowmuchinventorytheyhaveonhandatanygivenmoment,therebymakingiteasier
toknowwhentoordermore.Second,itimprovestheaccuracyofthecompany’sfinancialstatements
because it allows very accurate recordkeeping as to the Cost of Goods Sold over a given period.
(CoGSwillbecalculated,quitesimply,asthesumofthecostsofalloftheparticularitemssoldover
theperiod.)

Theprimarydisadvantagetousingtheperpetualmethodisthecostofimplementation.

PeriodicMethodofInventory

Theperiodicmethodofinventoryisasysteminwhichinventoryiscountedatregularintervals(at
month-end,forinstance).Usingthismethod,abusinesswillknowhowmuchinventoryithasatthe
beginningandendofeveryperiod,butitwon’tknowpreciselyhowmuchinventoryisonhandinthe
middleofanaccountingperiod.

Aseconddrawbackoftheperiodicmethodisthatthebusinesswon’tbeabletotrackinventoryon

an item-by-item basis, thereby requiring assumptions to be made as to which particular items of
inventoryweresold.(Moreontheseassumptionslater.)

CalculatingCoGSunderthePeriodicMethodofInventory

Whenusingtheperiodicmethod,CostofGoodsSoldiscalculatedusingthefollowingequation:

Beginning
Inventory

Inventory
Purchases

Ending
Inventory

Costof
GoodsSold

Thisequationmakesperfectsensewhenyoulookatitpiecebypiece.Beginninginventory,plusthe
amount of inventory purchased over the period gives you the total amount of inventory that could
have been sold (sometimes known, understandably, as Cost of Goods Available for Sale). We then
assume that, if an item isn’t in inventory at the end of the period, it must have been sold. (And
conversely, if an item is in ending inventory, it obviously wasn’t sold, hence the subtraction of the
endinginventorybalancewhencalculatingCoGS).

EXAMPLE: Corina has a business selling books on eBay. An inventory count at the beginning of
November shows that she has $800 worth of inventory on hand. Over the month, she purchases
another$2,400worthofbooks.HerinventorycountattheendofNovembershowsthatshehas$600
ofinventoryonhand.

Using the equation above, we learn that Corina’s Cost of Goods Sold for November is $2,600,

calculatedasfollows:

Beginning
Inventory

+ Purchases -

Ending
Inventory

Costof
GoodsSold

800

+ 2,400

- 600

= 2,600

Granted,thisequationisn’tperfect.Forinstance,itdoesn’tkeeptrackofthecostofinventorytheft.
AnystolenitemswillaccidentallygetbundledupintoCoGS,because:

1. Theyaren’tininventoryattheendoftheperiod,and
2. There is no way to know which items were stolen as opposed to sold, because inventory isn’t

beingtrackeditem-by-item.

AssumptionsUsedinCalculatingCoGSunderthePeriodicMethod

Of course, the calculation of CoGS is a bit more complex out in the real world. For example, if a
businessisdealingwithchangingper-unitinventorycosts,assumptionshavetobemadeastowhich
onesweresold(thecheaperunitsorthemoreexpensiveunits).

EXAMPLE:Maggiehasabusinesssellingt-shirtsonline.Shegetsallofherinventoryfromasingle
vendor. In the middle of April, the vendor raises its prices from $3 per shirt to $3.50 per shirt. If
Maggie sells 100 shirts during April—and she has no way of knowing which of those shirts were
purchasedatwhichprice—shouldherCoGSbe$300,$350,orsomewhereinbetween?

Theanswerdependsuponwhichinventory-valuationmethodisused.Thethreemostusedmethods

areknownasFIFO,LIFO,andAverageCost.UnderGAAP,abusinesscanuseanyofthethree.

First-In,First-Out(FIFO)

Under the “First-In, First-Out” method of calculating CoGS, we assume that the oldest units of
inventoryarealwayssoldfirst.Sointheaboveexample,we’dassumethatMaggiesoldallofher$3
shirtsbeforesellinganyofher$3.50shirts.

Last-In,First-Out(LIFO)

Underthe“Last-In,First-Out”method,theoppositeassumptionismade.Thatis,weassumethatallof
thenewestinventoryissoldbeforeanyolderunitsofinventoryaresold.So,intheaboveexample,
we’dassumethatMaggiesoldallofher$3.50shirtsbeforesellinganyofher$3shirts.

EXAMPLE(CONTINUED):AtthebeginningofApril,Maggie’sinventoryconsistedof50shirts—
allofwhichhadbeenpurchasedat$3pershirt.Overthemonth,shepurchased100shirts,60at$3per
shirt,and40at$3.50pershirt.Intotal,Maggie’sGoodsAvailableforSaleforAprilconsistsof110
shirtsat$3pershirt,and40shirtsat$3.50pershirt.

If Maggie were to use the FIFO method of calculating her CoGS for the 100 shirts she sold in

April, her CoGS would be $300. (She had 110 shirts that cost $3, and FIFO assumes that all of the
olderunitsaresoldbeforeanynewerunitsaresold.)

100x3=300

If Maggie were to use the LIFO method of calculating her CoGS for the 100 shirts she sold in

April,herCoGSwouldbe$320.(LIFOassumesthatall40ofthenewer,$3.50shirtswouldhavebeen
sold,andtheother60musthavebeen$3shirts.)

(40x3.5)+(60x3)=320

It’simportanttonotethatthetwomethodsresultnotonlyindifferentCostofGoodsSoldfor

theperiod,butindifferentendinginventorybalancesaswell.

Under FIFO—because we assumed that all 100 of the sold shirts were the older, $3, shirts—it

wouldbeassumedthat,attheendofApril,her50remainingshirtswouldbemadeupof10shirtsthat
were purchased at $3 each, and 40 that were purchased at $3.50 each. Grand total ending inventory
balance:$170.

In contrast, the LIFO method would assume that—because all of the newer shirts were sold—the

remainingshirtsmustbetheolder,$3shirts.Assuch,Maggie’sendinginventorybalanceunderLIFO
is$150.

AverageCost

Theaveragecostmethodisjustwhatitsoundslike.Itusesthebeginninginventorybalanceandthe
purchases over the period to determine an average cost per unit. That average cost per unit is then
usedtodetermineboththeCoGSandtheendinginventorybalance.

Avg.Cost/UnitxUnitsSold=CostofGoodsSold

Avg.Cost/UnitxUnitsinEnd.Inv.=End.Inv.Balance

EXAMPLE (CONTINUED): Under the average cost method, Maggie’s average cost per shirt for
Apriliscalculatedasfollows:

BeginningInventory:50shirts($3/shirt)

Purchases:100shirts(60at$3/shirtand40at$3.50/shirt)

Hertotalunitsavailableforsaleovertheperiodis150shirts.HertotalCostofGoodsAvailablefor
Saleis$470(110shirtsat$3eachand40at$3.50each).

Maggie’saveragecostpershirt=$470/150=$3.13

Usinganaveragecost/shirtof$3.13,wecancalculatethefollowing:

CoGSinApril=$313(100shirtsx$3.13/shirt)

EndingInventory=$157(50shirtsx$3.13/shirt)

Chapter13SimpleSummary

Theperiodicmethodofinventoryinvolvesdoinganinventorycountattheendofeachperiod,
thenmathematicallycalculatingCostofGoodsSold.
Theperpetualmethodofinventoryinvolvestrackingeachindividualitemofinventoryona
minute-to-minutebasis.Itcanbeexpensivetoimplement,butitimprovesandsimplifies
accounting.
FIFO(first-in,first-out)istheassumptionthattheoldestunitsofinventoryaresoldbeforethe
newerunits.
LIFO(last-in,first-out)istheoppositeassumption:Thenewestunitsofinventoryaresold
beforeolderunitsaresold.

TheaveragecostmethodisaformulaforcalculatingCoGSandendinginventorybasedupon
theaveragecostperunitofinventoryavailableforsaleoveragivenperiod.

CONCLUSION

TheHumbleLittleJournalEntry

Thegoalofaccountingistoprovidepeople—bothinternalusers(managers,owners)andexternal

users (creditors, investors)—with information about a company’s finances. This information is
provided in the form of financial statements. These financial statements are compiled using
information found in the general ledger, which is, essentially, the collection of all of a business’s
journalentries.

Inthisway,wecanseethatit’sthehumblelittlejournalentry(anditsrespectivecomponents:debits

and credits) that provides the information upon which decisions are made in the world of business.
Tensofbillionsofdollarschangehandseverydaybasedultimatelyuponthejournalentriesrecorded
byaccountants—andaccountingsoftware—aroundtheworld.

Thesejournalentriesarebased,inturn,upontheframeworkprovidedbytheAccountingEquation

andthedouble-entryaccountingsystemthatgoesalongwithit.

Meanwhile,it’stheguidelinesprovidedbyGAAPthatmakethesejournalentries(andthefinancial

statements they eventually make up) meaningful. Because without the consistency of accounting
provided for by GAAP, making a worthwhile comparison between two companies’ financial
statementswouldproveimpossible.

EndNotes

Sample accounting problems for each chapter of this book are available at:

www.obliviousinvestor.com/example-accounting-

problems

.Isuggesttakingadvantageofthemifyoufeelthatyourunderstandingofatopiccouldusesomehelp.

Just

reminder:

Sample

accounting

problems

for

each

chapter

this

book

are

available

at:

www.obliviousinvestor.com/example-accounting-problems.

Inaccounting,negativenumbersareindicatedusingparentheses.

Ifacompanydoesn’tsellallofitsinventoryoverthecourseoftheperiod,theCostofGoodsSoldcalculationbecomesalittle

moreinvolved.We’llbecoveringsuchcalculationsinChapter13.

APPENDIX

HelpfulOnlineResources

www.ObliviousInvestor.com

The author ’s blog. Includes a wide variety of articles regarding personal finance, accounting,
andtaxation.

www.quickbooks.com

RunbyIntuit,thisprogramisanexcellentbookkeepingresource.

www.nolo.com

Themostwell-known(anddeservedlyso)publisheroflegalself-helpbooks.

www.fasb.org

The website of the Financial Accounting Standards Board, the organization responsible for
creatingandupdatingGAAP.

RecommendedReading

QuickBooksforDummies,byStephenL.Nelson
QuickBooks:TheMissingManual,byBonnieBiafore

AlsobyMikePiper

InvestingMadeSimple:InvestinginIndexFundsExplainedin100PagesorLess
ObliviousInvesting:BuildingWealthbyIgnoringtheNoise
SurprisinglySimple:IndependentContractor,SoleProprietor,andLLCTaxesExplainedin100Pages
orLess,byMikePiper
SurprisinglySimple:LLCvs.S-Corpvs.C-CorpExplainedin100PagesorLess,byMikePiper
TaxesMadeSimple:IncomeTaxesExplainedin100PagesorLess,byMikePiper

Document Outline

1. Accounting Equation
2. Balance Sheet
3. Income Statement
4. Statement of Retained Earnings
5. Cash Flow Statement
6. Financial Ratios
7. What is GAAP?
- Who has to follow GAAP?
8. Debits and Credits
9. Cash vs. Accrual
10. Other GAAP Concepts & Assumptions
11. Depreciation of Fixed Assets
12. Amortization of Intangible Assets

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