Reading Financial Reports For Dummies - Lita Epstein

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period, the underwriter produces the red herring, which is an initial prospectus that includes the information in the SEC registration without the stock price or effective date.

      After the underwriter completes the red herring, the company and the investment bankers do road shows — presentations held around the country to introduce the business to major institutional investors and to start building interest in the pending IPO. A company can't transact sales until the SEC approves the registration information, but it can start generating excitement and getting feedback about the IPO at these meetings.

      When the SEC finishes its investigation and approves the offering, the company can set an effective date, or the date of the stock offering. The company and investment bankers then sit down and establish a final stock price. Although they discuss the stock price in initial conversations, they can't set the final price until they know the actual effective date. Market conditions can change significantly from the time the company first talks with investment bankers and the date when the stock is finally offered publicly. Sometimes the company and investment banker decide to withdraw or delay an IPO if a market crisis creates a bad climate for introducing a new stock or if the road shows don't identify enough interested major investors.

      After the stock price is set, the stock is sold to the public. The company gets the proceeds minus any commissions it pays to the investment bankers.

      Digging into Accounting Basics

      IN THIS CHAPTER

      

Understanding the two main accounting methods

      

Deciphering debits and credits

      

Examining the Chart of Accounts

      

Looking at the different types of profit

      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!

      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.

      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.

      

Smaller companies that haven't formally incorporated and most sole proprietors use cash-basis accounting because the system is easier for them to use on their own, meaning that they don't have to hire a large accounting staff.

      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.

      

All incorporated companies must use accrual accounting according to the generally accepted accounting principles (GAAP) because revenues are matched to expenses in the same month they occur. If you're reading a corporation's financial reports, what you see is based on accrual accounting.

      Why method matters

       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

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