machinery, office equipment, vehicles, computers and data-processing equipment, shelving and cabinets, and so on. Depreciation refers to spreading out the cost of a fixed asset over the years of its useful life to a business, instead of charging the entire cost to expense in the year of purchase. That way, each year of use bears a share of the total cost. For example, autos and light trucks are typically depreciated over five years; the idea is to charge a fraction of the total cost to depreciation expense during each of the five years. (The actual fraction each year depends on which method of depreciation used, which I explain in Chapter 7.)
Of course, depreciation applies only to fixed assets that you buy, not those you rent or lease. If you lease or rent fixed assets, which is quite common, the rent you pay each month is charged to rent expense. (I won’t go into the current controversy regarding leases and rent expense.)
Depreciation is a real expense but not a cash outlay expense in the year it is recorded. The cash outlay occurs when the fixed asset is acquired. See the
his passengers and collected in fares. At the end of the year, he has collected a certain amount of money that pays him back for part of the cost of the cab.
In summary, fixed assets are gradually liquidated, or turned back into cash, each year. Part of sales revenue recovers some of the cost of fixed assets, which is why the decrease in the fixed assets account to record depreciation expense has the effect of increasing cash (assuming your sales revenue is collected in cash during the year). What the company does with this cash recovery is another matter. Sooner or later, you need to replace fixed assets to continue in business.
Unpaid expenses → Accounts payable, accrued expenses payable, and income tax payable
A typical business pays many expenses after the period in which the expenses are recorded. Following are some common examples:
A business hires a law firm that does a lot of legal work during the year, but the company doesn’t pay the bill until the following year.
A business matches retirement contributions made by its employees but doesn’t pay its share until the following year.
A business has unpaid bills for telephone service, gas, electricity, and water that it used during the year.
Accountants use three different types of liability accounts to record a business’s unpaid expenses:
Accounts payable: This account is used for items that the business buys on credit and for which it receives an invoice (a bill). For example, your business receives an invoice from its lawyers for legal work done. As soon as you receive the invoice, you record in the accounts payable liability account the amount that you owe. Later, when you pay the invoice, you subtract that amount from the accounts payable account, and your cash goes down by the same amount.
Accrued expenses payable: A business has to make estimates for several unpaid costs at the end of the year because it hasn’t received invoices or other types of bills for them. Examples of accrued expenses include the following:
• Unused vacation and sick days that employees carry over to the following year, which the business has to pay for in the coming year
• Unpaid bonuses to salespeople
• The cost of future repairs and part replacements on products that customers have bought and haven’t yet returned for repair
• The daily accumulation of interest on borrowed money that won’t be
paid until the end of the loan period
Without invoices to reference, you have to examine your business operations carefully to determine which liabilities of this sort to record.
Income tax payable: This account is used for income taxes that a business still owes to the IRS at the end of the year. The income tax
expense for the year is the total amount based on the taxable income for the entire year. Your business may not pay 100 percent of its income tax
expense during the year; it may owe a small fraction to the IRS at year’s end. You record the unpaid amount in the income tax payable account.
Note: A business may be organized legally as a pass-through tax entity for income tax purposes, which means that it doesn’t pay income tax itself but instead passes its taxable income on to its owners. Chapter 8 explains these types of business entities. The example I offer here is for a business that is an ordinary corporation that pays income tax.
Summing Up the Diverse Financial Effects of Making Profit
Business managers should understand not only how to make profit, but also the full range of financial effects of making profit. Profit does not simply mean an increase in cash. Sales revenue and expenses affect several assets other than cash and operating liabilities. I realize that I make this point several times in this chapter, so forgive me if I seem to be harping. I simply want to drive home the importance of understanding this fact.
The profit-making activities of a business include more than just recording revenue and expenses. Additional transactions are needed, which take place before or after revenue and expenses occur. These before-and-after
transactions include the following:
Collecting cash from customers for credit sales made to them, which takes place after recording the sales revenue
Purchasing (or manufacturing) products that are put in inventory and held there until the products are sold sometime later, at which time the cost of products sold is charged to expense in order to match up with the
revenue from the sale
Paying certain costs in advance of when they are charged to expense Paying for products bought on credit and for other items that are not charged to expense until sometime after the purchase
Paying for expenses that have been recorded sometime earlier
Making payments to the government for income tax expense that has already been recorded
To sum up, the profit-making activities of a business include both making sales and incurring expenses as well as the various transactions that take place before and after the occurrence of revenue and expenses. Only revenue and expenses are reported in the income statement; however, the other transactions change assets and liabilities, and they definitely affect cash flow. I explain how the changes in assets and liabilities caused by the allied transactions affect cash flow in Chapter 6.
Figure 4-6 is a summary of the changes in assets and operating liabilities through the end of the year caused by the product company’s profit-making activities. Keep in mind that these changes include the sales and expense transactions and the preparatory and follow-through transactions. This sort of summary can be prepared for business managers, but is not presented in external financial reports.
Figure 4-6: Here’s an example of changes in assets and operating liabilities from profit-making activities through end of year for product company (dollar amounts in thousands).
Notice the differences in Figure 4-6 compared with the earlier accounting equation-based figures. The columns for debt and owners’ equity-invested capital are not included because these two are not affected by the profit- making activities of the business. In other words, making profit affects only assets, operating liabilities, and retained earnings. The bottom line in Figure 4-6 shows that the $1,990,000 total increase in assets minus the $300,000 total increase in operating liabilities equals the $1,690,000 profit for the year.
With the summary in Figure 4-6 you can find profit. The summary reveals what profit consists of, or the substance of profit based on the profit-making activities of the business. The $1,515,000 increase in cash is the largest component of profit for the year, and the other changes in assets and
operating liabilities fill out the rest of the picture. The business is
$1,690,000 better off from earning that much profit. This better offness is distributed over five assets and three liabilities. You can’t look only to cash.
You have to look at the other changes as well.
Reporting Extraordinary Gains and Losses
I have a small confession to make: The income statement examples shown in Figures 4-1 and 4-2 are sanitized versions when compared with actual income statements in external financial reports. Suppose you took the
trouble to read 100 income statements. You’d be surprised at the wide range of things you’d find in these statements. But I do know one thing for certain you would discover.
Many businesses report unusual, extraordinary gains and losses in addition to their usual revenue, income, and expenses. Remember that recording a gain increases an asset or decreases a liability. And, recording a loss
decreases an asset or increases a liability. When a business has recorded an extraordinary gain or loss during the period, its income statement is divided into two sections:
The first section presents the ordinary, continuing sales, income, and expense operations of the business for the year.
The second section presents any unusual, extraordinary, and nonrecurring gains and losses that the business recorded in the year.
The road to profit is anything but smooth and straight. Every business experiences an occasional discontinuity — a serious disruption that comes out of the blue, doesn’t happen regularly or often, and can dramatically affect its bottomline profit. In other words, a discontinuity is something that disturbs the basic continuity of its operations or the regular flow of profit- making activities.
Here are some examples of discontinuities or out of left field types of impacts:
Downsizing and restructuring the business: Layoffs require severance pay or trigger early retirement costs; major segments of the business may be disposed of, causing large losses.
Abandoning product lines: When you decide to discontinue selling a line of products, you lose at least some of the money that you paid for obtaining or manufacturing the products, either because you sell the
products for less than you paid or because you just dump the products you
can’t sell.
Settling lawsuits and other legal actions: Damages and fines that you pay — as well as awards that you receive in a favorable ruling — are obviously nonrecurring extraordinary losses or gains (unless you’re in the habit of being taken to court every year).
Writing down (also called writing off) damaged and impaired assets:
If products become damaged and unsellable, or fixed assets need to be replaced unexpectedly, you need to remove these items from the assets accounts. Even when certain assets are in good physical condition, if they lose their ability to generate future sales or other benefits to the business, accounting rules say that the assets have to be taken off the books or at least written down to lower book values.
Changing accounting methods: A business may decide to use a
different method for recording revenue and expenses than it did in the past, in some cases because the accounting rules (set by the authoritative
accounting governing bodies — see Chapter 2) have changed. Often, the new method requires a business to record a one-time cumulative effect caused by the switch in accounting method. These special items can be huge.
Correcting errors from previous financial reports: If you or your accountant discovers that a past financial report had an accounting error, you make a catch-up correction entry, which means that you record a loss or gain that had nothing to do with your performance this year.
According to financial reporting standards, a business must make these one- time losses and gains very visible in its income statement. So in addition to the main part of the income statement that reports normal profit activities, a business with unusual, extraordinary losses or gains must add a second layer to the income statement to disclose these out-of-the-ordinary happenings.
If a business has no unusual gains or losses in the year, its income statement ends with one bottom line, usually called net income (which is the situation shown in Figures 4-1 and 4-2). When an income statement includes a
second layer, that line becomes net income from continuing operations before unusual gains and losses. Below this line, each significant, nonrecurring gain or loss appears.
Say that a business suffered a relatively minor loss from quitting a product line and a very large loss from a major lawsuit whose final verdict went
against the business. The second layer of the business’s income statement would look something like the following (in thousands of dollars):
Net income from continuing operations
$267,000 Discontinued operations, net of
income taxes
($20,000) Earnings before effect of legal verdict $247,000 Loss due to legal verdict, net of
income taxes
($456,000)
Net earnings (loss) ($209,000)
The gains and losses reported in the second layer of an external income statement are generally complex and may be quite difficult to follow. So where does that leave you? In assessing the implications of extraordinary gains and losses, use the following questions as guidelines:
Were the annual profits reported in prior years overstated?
Why wasn’t the loss or gain recorded on a more piecemeal and gradual year-by-year basis instead of as a one-time charge?
Was the loss or gain really a surprising and sudden event that could not have been anticipated?
Will such a loss or gain occur again in the future?
Every company that stays in business for more than a couple of years experiences a discontinuity of one sort or another. But beware of a business that takes advantage of discontinuities in the following ways:
Discontinuities become continuities: This business makes an
extraordinary loss or gain a regular feature on its income statement. Every year or so, the business loses a major lawsuit, abandons product lines, or restructures itself. It reports “nonrecurring” gains or losses from the same source on a recurring basis.
A discontinuity is used as an opportunity to record all sorts of write- downs and losses: When recording an unusual loss (such as settling a
lawsuit), the business opts to record other losses at the same time, and everything but the kitchen sink (and sometimes that, too) gets written off.
This so-called big-bath strategy says that you may as well take a big bath now in order to avoid taking little showers in the future.
A business may just have bad (or good) luck regarding extraordinary events that its managers could not have predicted. If a business is facing a major, unavoidable expense this year, cleaning out all its expenses in the same year so it can start off fresh next year can be a clever, legitimate accounting tactic. But where do you draw the line between these accounting
manipulations and fraud? All I can advise you to do is stay alert to these potential problems.
Correcting Common Misconceptions About Profit
Many people (perhaps the majority) think that the amount of the bottomline profit increases cash by the same amount. This is not true, as I show in Figure 4-6 and as I explain in Chapter 6. In almost all situations the assets and operating liabilities used in recording profit had changes during the period that inflate or deflate cash flow from profit. This is not an easy lesson to learn. Sure, it would be simpler if profit equals cash flow, but it doesn’t. Sorry, but that’s the way it is.
Another broad misconception about profit is that the numbers reported in the income statement are precise and accurate and can be relied on down to the last dollar. Call this the exactitude misconception. Virtually every dollar amount you see in an income statement probably would have been different if a different accountant had been in charge. I don’t mean that some
accountants are dishonest and deceitful. It’s just that business transactions can get very complex and require forecasts and estimates. Different
accountants would arrive at different interpretations of the “facts” and, therefore, record different amounts of revenue and expenses. Hopefully the accountant keeps consistent over time, so that year-to-year comparisons are valid.
Another serious misconception is that if profit is good, the financial condition of the business is good. At the time of writing this sentence the profit of Apple is very good. But I didn’t automatically assume that its financial condition was equally good. I looked in Apple’s balance sheet and found that its financial condition is very good indeed. (It had more cash and marketable investments on hand than the economy of many countries.) But, the point is that its bottom line doesn’t tell you anything about the financial
condition of the business. You find this in the balance sheet.
Closing Comments
The income statement occupies center stage; the bright spotlight is on this financial statement because it reports profit or loss for the period. But remember that a business reports three primary financial statements — the other two being the balance sheet and the statement of cash flows, which I discuss in the next two chapters. The three statements are like a three-ring circus. The income statement may draw the most attention, but you have to watch what’s going on in all three places. As important as profit is to the financial success of a business, the income statement is not an island unto itself.
Also, keep in mind that financial statements are supplemented with footnotes and contain other commentary from the business’s executives. If the financial statements have been audited, the CPA firm includes a short report stating whether the financial statements have been prepared in conformity with the appropriate accounting standards.
I don’t like closing this chapter on a sour note, but I must point out that an income statement you read and rely on — as a business manager, investor, or lender — may not be true and accurate. In most cases (I’ll even say in the large majority of cases), businesses prepare their financial statements in good faith, and their profit accounting is honest. They may bend the rules a little, but basically their accounting methods are within the boundaries of GAAP even though the business puts a favorable spin on its profit number.
But some businesses resort to accounting fraud and deliberately distort their profit numbers. In this case, an income statement reports false and misleading sales revenue and/or expenses in order to make the
bottomline profit appear to be better than the facts would support. If the fraud is discovered at a later time, the business puts out revised financial statements. Basically, the business in this situation rewrites its profit history.
By the way, look at Figure 4-6 again. This summary provides a road map of sorts for understanding accounting fraud. The fraudster knows that he has to cover up and conceal his accounting fraud. Suppose the fraudster wants to make reported profit higher. But how? The fraudster has to overstate