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Debit

      An increase in an asset is tagged as a debit; an increase in a liability or owners’ equity account is tagged as a credit. Decreases are just the reverse. Following this scheme, the total of debits must equal the total of credits in recording every transaction. In brief: Debits have to equal credits. Isn’t that clever? Well, the main point is that the method works. Debits and credits have been used for centuries. (A book published in 1494 describes how business traders and merchants of the day used debits and credits in their bookkeeping.)

      Note: Sales revenue and expense accounts also follow debit and credit rules. Revenue increases owners’ equity (and thus is a credit), and an expense decreases owners’ equity (and thus is a debit).

      Following the rules of debits and credits, asset accounts have debit balances, and liabilities and owners’ equity accounts have credit balances. (Yes, a balance sheet account can have a wrong-way balance in unusual situations, such as cash having a credit balance because the business has written more checks than it has money for in its checking account.) The total of accounts with debit balances should equal the total of accounts with credit balances. When the total of debit balance accounts equals the total of credit balance accounts, the books are in balance.

Even when the books are in balance, errors are still possible. The bookkeeper may have recorded debits or credits in the wrong accounts, or may have entered wrong amounts, or may have missed recording some transactions altogether. Having balanced books simply means that the total of accounts with debit balances equals the total of accounts with credit balances. The important thing is whether the books (the accounts) have correct balances, which depends on whether all transactions and other developments have been recorded correctly.

Juggling the Books to Conceal Embezzlement and Fraud

      

Fraud and illegal practices occur in large corporations and in one-owner/manager-controlled small businesses — and in every size business in between. Some types of fraud are more common in small businesses, including sales skimming (not recording all sales revenue, to deflate the taxable income of the business and its owner) and the recording of personal expenses through the business (to make these expenses deductible for income tax). Some kinds of fraud are committed mainly by large businesses, including paying bribes to foreign officials and entering into illegal conspiracies to fix prices or divide the market. The purchasing managers in any size business can be tempted to accept kickbacks and under-the-table payoffs from vendors and suppliers.

      Some years ago, my (coauthor John’s) wife and I hosted a Russian professor who was a dedicated Communist. I asked him what surprised him the most on his first visit to the United States. Without hesitation, he answered, “The Wall Street Journal.” I was puzzled. He then explained that he was amazed to read so many stories about business fraud and illegal practices in the most respected capitalist newspaper in the world. Many financial reporting fraud stories are on the front pages today, as they were when we wrote the previous editions of this book. And there are a number of stories of companies that agreed to pay large fines for illegal practices (usually without admitting guilt).

      None of this is news to you. You know that fraud and illegal practices happen in the business world. Our point in bringing up this unpleasant topic is that fraud and illegal practices require manipulation of a business’s accounts. For example, if a business pays a bribe, it doesn’t record the amount in a bald-faced account called “bribery expense.” Rather, the business disguises the payment by recording it in a legitimate expense account (such as “repairs and maintenance expense” or “legal expense”). If a business records sales revenue before sales have taken place (a not-uncommon type of financial reporting fraud), it does not record the false revenue in a separate account called “fictional sales revenue.” The bogus sales are recorded in the regular sales revenue account.

Here’s another example of an illegal practice. Money laundering involves taking money from illegal sources (such as drug dealing) and passing it through a business to make it look legitimate — to give the money a false identity. This money can hardly be recorded as “revenue from drug sales” in the accounts of the business. Also, if an employee embezzles money from the business, he has to cover his tracks by making false entries in the accounts or by not making entries that should be recorded.

      

Manipulating accounts to conceal fraud, illegal activities, and embezzlement is generally called juggling the accounts. Another term you’ve probably heard is cooking the books. Although this term is sometimes used in the same sense of juggling the accounts, cooking the books typically refers to deliberate accounting fraud in which the main purpose is to produce financial statements that tell a better story than is supported by the facts. Now here’s an irony: When crooks commit accounting fraud, they also need to know the real story, so they keep two sets of books — one for the fraud numbers and one for the real numbers.

      

When the accounts have been juggled or the books have been cooked, the financial statements of the business are distorted, incorrect, and misleading. Lenders, other creditors, and the owners who have capital invested in the business rely on the company’s financial statements. Also, a business’s managers and board of directors (the group of people who oversee a business corporation) may be misled — assuming that they’re not a party to the fraud — and may also have liability to third-party creditors and investors for their failure to catch the fraud. Creditors and investors who end up suffering losses have legal grounds to sue the managers and directors (and perhaps the independent auditors who did not catch the fraud) for damages suffered.

      We think that most persons who engage in fraud also cheat on their federal income taxes; they don’t declare the ill-gotten income. Needless to say, the IRS is on constant alert for fraud in federal income tax returns, both business and personal returns. The IRS has the authority to come in and audit the books of the business and also the personal income tax returns of its managers and investors. Conviction for income tax evasion is a felony, we might point out.

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