The interest expense line is a basic equation.
Unlike the previously mentioned, the accounting for income tax expense can come down to using different accounting methods. The hypothetical amount of taxable income, if the accounting methods used were used in the tax return is calculated. Then the income tax based on this hypothetical taxable income is calculated. This becomes the income tax expense reported in the income statement. A reconciliation of the two different income tax amounts is then provided in a footnote on the income statement.
Net income is like earnings before interest and tax (EBIT). It can vary depending on which accounting methods are used to report sales revenue and expenses. Profit smoothing can be used to manipulate earnings. Profit smoothing crosses the line from choosing acceptable accounting methods from the list of GAAP into the gray area of earnings management that involves accounting manipulation.
Managers and business owners have to be involved in the decisions about which accounting methods are used to measure profit and how those methods are actually implemented. That is why it is critical for manager in a company be thoroughly familiar with how the company’s financial statements are prepared.
Profit and cost of goods sold expense are crucial components of an income statement.
In reporting depreciation expense, a business has an option to use:
As depreciation can be a very big expense for some businesses, surely the choice of the method to report it becomes important as well.
Employee pensions and post-retirement benefits.
The GAAP rule on this expense is complex – expected rate of return on the portfolio of funds set aside for these future obligations and other estimates affect the amount of expense recorded. This is a truly tough nut for the reporting.
Quite often the products are sold with expressed or implied warranties and guarantees. These should be estimated as the expense in the same period that the goods are sold.
Other operating expenses may also have timing or estimating considerations.
Earnings before interest and tax (EBIT) measures the sales revenue less all the expenses above this line. It depends on all the decisions made for recording sales revenue and expenses and how the accounting methods are implemented.
Read more in Accounting Income Statement – How to Prepare Income Statement – Part 3
The first part of an income statement is the line reporting sales revenue.
Businesses are to be consistent from year to year about when they record sales. For example, when does an ad agency have to report the sales revenue for a campaign - after the work is completed or after the client approves it or atfre the ads appear in the media or after the billing is complete? You understand the point - these issues should be decided by a company for reporting sales revenue. And surely they must be consistent each year.
The next line in an income statement - the cost of goods sold expense.
There are three methods to report the cost of goods sold expense:
Other items of the income statement include inventory write-downs.
Inventory should be carefully inspected to determine any losses due to theft, damage and deterioration, and to apply the lower of cost or market (LCM) method. Another important component is made up by bad debts: bad debts are those owed to a business by customers who bought on credit (accounts receivable), but are not going to be paid. It is very important to understand and implement this in real life that the timing of when bad debts are reported is crucial.
Read more in Accounting Income Statement – How to Prepare Income Statement – Part 2
Deliberate and improper manipulation of the recording of sales revenue and/or expenses (with a purpose of making a company’s profit performance look better than it actually is) is qualified as accounting fraud.
These things and actions can be qualified as accounting/bookkeeping fraud:
- Not listing prepaid expenses or other incidental assets
- Collapsing short-term and long-term debt into one amount
- Not showing certain classifications of current assets and/or liabilities
Among one of the most common strategies of accounting fraud can be over-recording sales.
For example, a business ships products to customers that they haven’t ordered, this business knows that the customers will return the products after the end of the year. But until the returns are made – all business records shows great "actual sales."
Or another example, a business may do the channel stuffing. It delivers products to dealers and/or final customers that they really don’t want, however the business makes deals on the side that provide incentives and special privileges.
One more example is to delay the recording of products that have been returned by customers.
Another strategy is to under-record expenses. For instance, a business may choose not to record all of its cost of goods sold expense - this makes the gross margin look higher, but the business’s inventory asset would include products that actually are not in inventory because they’ve been delivered to customers.
Or a business might choose not to record asset losses that should be recognized (that can be, for example, uncollectible accounts receivable). Or a business might not record the full amount of the liability for an expense – surely the profit calculated in this case is overstated.
Follow the exact rules and sleep without fears to be messed up with accounting fraud.
Direct costs – costs that can be directly attributed to a product or product line, to one source of sales revenue, one business unit or operation of the business. For example, the cost of tires on a new automobile.
Indirect costs – cannot be attached to any specific product, unit or activity. Each business has its own method of allocating indirect costs to different products, sources of sales revenue and business units. Business managers and accounts should always keep an eye on the allocation methods used for indirect costs; this means to take the cost figures (produced by these methods) with a grain of salt.
Fixed costs - costs that stay the same over a relatively broad range of sales volume or production output.
Variable costs – can increase and decrease due to changes in sales or production level. Variable costs fluctuate in proportion with changes in production.
Relevant costs – future costs that could be incurred, depending on the strategic course taken by a specific business. For example, if car manufacturer wants to to increase production, and the cost of tires goes up – these costs need to be taken into consideration.
Irrelevant costs – costs that should be disregarded when deciding on a future course of action. Whereas relevant costs are future costs, irrelevant costs are those costs that were incurred in the past.
If security papers of a corporation are traded on the public stock exchanges, such as the New York Stock Exchange and Nasdaq then this company can be called public. And company can be called private if it is held entirely by its owners and is not traded publicly.
Shareholders of a private business are privileged to assume that the company’s financial statements and footnotes are prepared using GAAP when they receive the periodical financial reports. In case if it is not so the person who represents the directorship of the business must inform the shareholders that GAAP have not been followed in one or more respects. Usually private business’s annual financial report includes minimum of information: the balance sheet, income statement and statement of cash flows. So there is no any letter from the chief executive, no photographs or charts.
On a contrary, the annual report of a publicly traded company has more trappings to it however the requirements are more rigid too. This report must include the management discussion and analysis (MD&A) section that presents the top managers’ interpretation and analysis of the business’s profit performance and other important financial developments over the year. Earnings per share (EPS) are also required for public companies. Only this ratio is required to report a public business, however many public companies report the several others too like a three-year comparative income statement.
Almost all public companies present only concentrated financial information but not comprehensive financial statements so for more specifics they should refer the reader to a more detailed SEC financial report.
… make sure you understand in details why you need it.
Any person who has checking account, without a doubt, checks the balance periodically to follow up for any differences between the actual expenses, checks and deposits and what’s is pointed in the statement. Generally people do this once per month when they receive their statement by mail, but in the modern world with its inventions online banking is the great and useful tool to perform such checks even on a daily basis.
The main purpose of such inspections is to balance your checkbook to note any charges in your checking account that you haven’t recorded in your checkbook. Among these can be ATM fees, overdraft fees, special transaction fees or low balance fees, if you’re required to keep a minimum balance in your account. It is also necessary to check your balance thus you can find discover any credits that you haven’t noted previously. Such unnoted credits usually are automatic deposits, or refunds or other electronic deposits. One of the other reasons to check your account is to record any interest that it’s earned if your account is an interest-bearing. And the last but not the least reason for sure is to check if you’ve made any errors in your recordkeeping or if the bank has made any errors.
Filing of annual federal income tax returns is another form of accounting that we all apprehend. A lot of people use a CPA to perform their returns; others try to do it themselves. Generally forms include such items:
Income - it is all money you have earned from working or owning assets, unless they fall under some specific exemptions from income tax.
Personal exemptions – this is a particular amount of income that is not included into tax.
Standard deduction - this is such personal expenditures or business expenses that can be deducted from your income to reduce the taxable amount of income and they include items such as interest paid on your home mortgage, charitable contributions and property taxes.
Taxable income – this is the state at account of income that subdue to taxes after personal exemptions and deductions are factored in.
Accounting and bookkeeping departments – what are they for? Oh, their most important function is to calculate Payroll for everyone who is working. They must record all the salaries and taxes earned and paid by every employee for each pay period. Also this payroll department has to check that the correct federal, state and local taxes are being subtracted.
All these taxes are recorded in the pay stub attached to your paycheck. This stub generally includes income tax, social security taxes, different employment taxes that must be paid to federal and state government and the other deductions including such as for retirement, vacation, sick pay or medical benefits.
So this is main and most critical function. Various companies have their own payroll departments; others outsource these calculations to specialists. The accounting department obtains and registers any payments or cash received from customers or clients of the business or service and also they must make sure that the money is sourced accurately and deposited in the appropriate accounts. Their another function is to manage where the money goes to; how much of it is kept on-hand for areas such as payroll, or how much of it goes out to pay what the company owes its banks, vendors and other obligations.
The payables areas, or cash expenses is another side of the receivables business. The accounting department prepares all checks that have been written out during the course of year to pay for purchases, supplies, salaries, taxes, loans and services and records to whom they were disbursed, how much and for what.
These accounting departments should also be on top of purchase orders placed for inventory, such as products that will be sold to customers or clients and other assets such as a business’s property and equipment.
The Financial Accounting Standards Board (FASB) is known as organization that provides standardized guidelines for financial reporting. The mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information.
It should be mentioned that accounting standards are essential to the efficient functioning of the economy due to the fact that decisions on allocation of resources rely heavily on credible, concise, transparent and comprehensive financial information about operations and financial position of individual entities which is used by the public in making various kinds of decisions.
Hence, to accomplish its mission, the FASB acts to:
- make financial reporting more useful by focusing on the primary characteristics of relevance and reliability as well as the qualities of comparability and consistency;
- keep standards up-to-date to reflect changes both in methods of doing business and economic environment;
- promptly consider and study any significant deficiency areas in financial reporting that might be improved by implementing standard-setting process;
- promote the international convergence of accounting standards concurrent with improving the quality of financial reporting; and
- improve the comprehension of the nature and purposes of information contained in financial reports.
Therefore, it may be assumed that the FASB not only ensures development of broad accounting concepts as well as financial reporting standards, but also provides guidance on their implementation.
Concepts are believed to be quite helpful in guiding the Board in establishing standards and along with provision with a frame of reference, or conceptual framework, and, finally, for resolving accounting issues. Thus, one may come to conclusion that with the help of the framework it is possible not only to establish reasonable bounds for judgment in preparing financial information as well as to increase comprehension of, and confidence in, financial information on the part of financial reports’ users but also make the entire process, nature and limitations of information supplied by financial reporting more clear.
William A Paton, Professor of Accounting at the University of Michigan, states that accounting has one basic function, namely facilitating the administration of economic activity, which can be divided into two closely related phases:
1) measuring and arraying economic data; and
2) communicating the results of this process to interested parties.
For instance, a company’s accountants periodically measure the profit and loss for a month, a quarter or a fiscal year and publish these results in a statement of profit and loss which is also known as an income statement. These statements include two big types of elements: accounts receivable (what’s owed to the company) and accounts payable (what the company owes). At the higher levels of accounting and in the organization, it can also contain other sophisticated things like retained earnings and accelerated depreciation.
To a great extent, accounting also relates to basic bookkeeping, which is defined as the process that records every transaction; every bill paid, every dime owed, every dollar and cent spent and accumulated.
But usually, the owners of the company, which can be individual owners or millions of shareholders, are most concerned with the totals of these transactions, contained in the financial statement. The aim of the financial statement is to summarize a company’s assets. A value of an asset equals the amount of money paid for it when it was first acquired. The financial statement also includes the sources of the assets. Assets may be of different form, for example, loans that have to be paid back. Another type of business asset is profits.
Bookkeeping may be performed in the way called double-entry bookkeeping, where the liabilities are also summarized. It is done by companies to show higher amounts of assets in order to offset the liabilities and show a profit. Accounting itself represents the management of these two elements.
Of course, nowadays there is a definite system for accounting. It is not the case that every company or individual use their own accounting systems but keep to some approved one; otherwise this could lead us to chaos!
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