How is Accounting Used in Business?

It's important not to confuse profit with cash flow. Profit equals sales revenue minus expenses. A business manager shouldn't assume that sales revenue equals cash inflow and that expenses equal cash outflows.

It might seem obvious, but in managing a business, it's important to understand how the business makes a profit. The business subtracts the amount of fixed expenses for the period, which gives them the operating profit before interest and income tax.

Budgeting forces a business manager to focus on the factors that need to be improved to increase profit. If nothing else, at least plug the numbers in your profit report for sales volume, sales prices, product costs and other expense and see how your projected profit looks for the coming year.

It might seem obvious, but in managing a business, it's important to understand how the business makes a profit. The business subtracts the amount of fixed expenses for the period, which gives them the operating profit before interest and income tax.

Budgeting provides important advantages, like understanding the profit dynamics and the financial structure of the business. Budgeting forces a business manager to focus on the factors that need to be improved to increase profit. If nothing else, at least plug the numbers in your profit report for sales volume, sales prices, product costs and other expense and see how your projected profit looks for the coming year.

What does an Audit Report Contain?

One modification to an auditor's report is very serious - when the CPA firm says that it has substantial doubts about the capability of the business to continue as a going concern. Unless there is evidence to the contrary, the CPA auditor assumes that the business is a going concern. If an auditor has serious concerns about whether the business is a going concern, these doubts are spelled out in the auditor's report.

Most audit reports on financial statements give the business a clean bill of health, or a clean opinion. The threat of an adverse opinion almost always motivates a business to give way to the auditor and change its accounting or disclosure in order to avoid getting the kiss of death of an adverse opinion. The SEC does not tolerate adverse opinions by auditors of public businesses; it would suspend trading in a company's stock share if the company received an adverse opinion from its CPA auditor.

What does an Audit do?

After completing an audit examination, the CPA prepares a short report stating that the business has prepared its financial statements, according to generally accepted accounting principles (GAAP), or where it has not. Federal law doesn't require audits for private businesses, banks and other lenders to private businesses may insist on audited financial statements. Instead of an audit, which they can't really afford, many smaller businesses have an outside CPA come in on a regular basis to look over their accounting methods and give advice on their financial reporting.

Federal law doesn't require audits for private businesses, banks and other lenders to private businesses may insist on audited financial statements. Instead of an audit, which they can't really afford, many smaller businesses have an outside CPA come in on a regular basis to look over their accounting methods and give advice on their financial reporting.

That's where audits come in. Audits are one means of keeping misleading financial reporting to a minimum. An audit exam can uncover problems that the business was not aware of.

After completing an audit examination, the CPA prepares a short report stating that the business has prepared its financial statements, according to generally accepted accounting principles (GAAP), or where it has not. All businesses that are publicly traded are required to have annual audits by independent CPAs.

What is Accounting Fraud?

Accounting fraud is an improper and deliberate manipulation of the recording of sales revenue and/or expenses in order to make a company's profit performance appear better than it actually is. Some things that companies do that can constitute fraud are:

The other way a business commits accounting fraud is by under-recording expenses, such as not recording depreciation expense. Or a business may choose not to record all of its cost of goods sold expense fore the sales made during a period. This would make the gross margin higher, but the business's inventory asset would include products that actually are not in inventory because they've been delivered to customers.

It delivers products to dealers or final customers that they really don't want, but business makes deals on the side that provide incentives and special privileges if the customers or dealers don't object to taking premature delivery of the products. The other way a business commits accounting fraud is by under-recording expenses, such as not recording depreciation expense. Or a business may choose not to record all of its cost of goods sold expense fore the sales made during a period.

-- Not listing prepaid expenses or other incidental assets
-- Not showing certain classifications of current assets and/or liabilities
-- Collapsing short- and long-term debt into one amount.

Until the returns are made, the business records the shipments as if they were actual sales. It delivers products to dealers or final customers that they really don't want, but business makes deals on the side that provide incentives and special privileges if the customers or dealers don't object to taking premature delivery of the products. A business may also delay recording products that have been returned by customers to avoid recognizing these offsets against sales revenue in the current year.

A business might also choose not to record asset losses that should be recognized, such as uncollectible accounts receivable, or it might not write down inventory under the lower of cost or market rule. A business might also not record the full amount of the liability for an expense, making that liability understated in the company's balance sheet. Its profit, therefore, would be overstated.

What are independent auditors?

A good auditor need technical know-how, but also needs to know how to be tough on the accounting methods of the client. His job is to be the agent of the shareholders and other users of the business's financial report. It's incumbent on an auditor to strictly uphold GAAP, and not let any irregularities slide.

There are a number of well-known companies that engaged in accounting fraud recently and that fraud was not discovered by the CPA auditors. Enron is one of these companies. In this case, the auditing firm, Arthur Anderson was found guilty of obstruction of justice because it destroyed audit evidence.

An auditor judges whether the business's accounting methods are in accordance with generally accepted accounting principles (GAAP). At times an auditor will wave a red or yellow flag.

Indpendent CPA auditors are like referees in the financial reporting arena. The CPA comes in, does an audit of the business's accounting system and methods and gives a report that is attached to the company's financial statements. Publicly owned businesses are required to have their annual financial reports audited by independent CPA firms and any privately owned businesses have audits done as well because they know that an audit report will add credibility to their financial reports.

Indpendent CPA auditors are like referees in the financial reporting arena. An auditor judges whether the business's accounting methods are in accordance with generally accepted accounting principles (GAAP). A good auditor need technical know-how, but also needs to know how to be tough on the accounting methods of the client.

An auditor must exercise professional skepticism, meaning the auditor should challenge the accounting methods and reporting practices of the client in order to make sure that its financial statement conform with accounting standards and are not misleading - in short, that the financial statement are fairly presented. The words "fairly presented" are the exact words used in the auditor's report.

What is Acid Test Ratio and ROA Ratio?

ROA is a useful ratio for interpreting profit performance, aside from determining financial gain or loss. ROA is called a capital utilization test that measures how profit before interest and income tax was earned on the total capital employed by the business.


A business may realize a financial leverage gain, meaning it earns more profit on the money it has borrowed than the interest paid for the use of the borrowed money. The ROA ratio is determined by dividing the earnings before interest and income tax (EBIT) by the net operating assets.

An investor compares the ROA with the interest rate at which the corporation borrowed money. If a business's ROA is 14 percent and the interest rate on its debt is 8 percent, the business's net gain on its capital is 6 percent more than what it's paying in interest.

Investors calculate the acid test ratio, also known as the quick ratio or the pounce ratio. This ratio excludes inventory and prepaid expenses, which the current ratio includes, and it limits assets to cash and items that the business can quickly convert to cash. This ratio is also known as the pounce ratio to emphasize that you're calculating for a worst-case scenario, where the business's creditors could pounce on the business and demand quick payment of the business's liabilities.

This ratio is also known as the pounce ratio to emphasize that you're calculating for a worst-case scenario, where the business's creditors could pounce on the business and demand quick payment of the business's liabilities. Short term creditors do not have the right to demand immediate payment, except in unusual circumstances. This ratio is a conservative way to look at a business's capability to pay its short-term liabilities.

Investors calculate the acid test ratio, also known as the quick ratio or the pounce ratio. This ratio excludes inventory and prepaid expenses, which the current ratio includes, and it limits assets to cash and items that the business can quickly convert to cash.

What are Other Ratios Used in Financial Reporting

The dividend yield ratio tells investors how much cash income they're receiving on their stock investment in a business. This is calculated by dividing the annual cash dividend per share by the current market price of the stock. This can be compared with the interest rate on high-grade debt securities that pay interest, such as Treasure bonds and Treasury notes, which are the safest.

The current ratio is a measure of a business's short-term solvency, in other words, its ability to pay it liabilities that come due in the near future. Businesses are expected to maintain a minimum 2:1 current ratio, which means its current assets should be twice its current liabilities.


The return on equity (ROE) ratio tells how much profit a bus8iness earned in comparison to the book value of its stockholders' equity. ROE is also calculated for public corporations, but it plays a secondary role to other ratios.

Book value per share is calculated by dividing total owners' equity by the total number of stock shares that are outstanding. While EPS is more important to determine the market value of a stock, book value per share is the measure of the recorded value of the company's assets less its liabilities, the net assets backing up the business's stock shares. It's possible that the market value of a stock could be less than the book value per share.