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BA201

UNIT7

Accounting and Business Finance


Unit 7 Content

The Role of Accounting in Business


fromExploringBusinessChapter12
Publisher: Flat World Knowledge

0 1

A New Form of GPS: The Gregarious People Seeker


Letssaythatyouredoingyoureconomicshomework,tryingtocalculatetheeffectoftherecession
onroomratesinFortLauderdale.[487]Forsomereason,yougetasinkingfeelingthatyourfriends
areoutsomewherehavingfunwithoutyou.Whatsaquickwaytofindoutwheretheyareandwhat
theyreupto?Ifyouresignedup,youcancheckinwiththeFoursquareapponyoursmartphone,
tabletPC,orwhateverdeviceyouusetoconnecttoawirelessnetwork.Foursquareisamobile
socialnetwork,andinadditiontothehandyfriendfinderfeature,youcanuseittofindnewand
interestingplacesaroundyourneighborhoodtodowhateveryouandyourfriendsliketodo.Iteven
rewardsyoufordoingbusinesswithsponsorcompanies,suchaslocalrestaurants.
Foursquare,whichhasbeengettingalotofbuzzlately,wasstartedin2009bytwoyoung
entrepreneurs,DennisCrowleyandNaveenSelvadurai.Itsalreadyattractedmorethanamillion
users,andCrowleyandSelvaduraiareunderstandablyenthusiasticabouttheirprospects.Not
everybody,however,isasoptimisticastheyare.Rightnow,Foursquareisbringinginmoneyand
growing,butletsfacefactsitsastartupanditsbarelytwoyearsold.Amongtheexpertswhopay
attentiontothebusinessofsoftwareapps,Foursquarehasbothoptimistsandskeptics,and,as
usual,therealotofpeoplewhothinkthatCrowleyandSelvaduraishouldtakethemoneyandrun
thatis,sellouttoalargercompanyandmoveon.
Clearly,CrowleyandSelvaduraihavesomequestionstoanswerandatsomepoint,ifnot

necessarilyrightnowdecisionstomake.Thisiswheretheyllhavetorelyonanaccountant,
becausetheyllneedsomebodywithaknowledgeofaccountingtohelpthemaskandanswerthe
rightquestionsandformulateandmaketherightdecisions:Howmuchrevenuearewebringingin?
Canweincreaseit?Whatareourexpenses?Willtheycontinuetogethigherorcanwecutthem?
Howmuchmoneyareweactuallymaking?Areweoperatingataprofitoraloss?Howmuchdowe
haveinvestedinthecompany?Howmuchdebtdowehave?Canwepayourbillsontime?Ifwe
needmoremoney,wherecanwegetit?Howmuchcashdowehaveonhand?Howmuchcash
comesineachmonthandhowmuchgoesout?Howlongwillitlast?Howmuchisourbusiness
reallyworth?Ifwedecidetosellit,howmuchshouldweaskforit?Isitagoodideatoputmoreof
ourownmoneyintotheventure?WhataretheoddsthatFoursquarewillsucceed?
Inthischapter,welllearnhowtogather,summarize,andinterpretaccountinginformationandhow
touseitinmakingbusinessdecisionsliketheonesfacingCrowleyandSelvadurai.

The Role of Accounting


Learning Objectives
1. Defineaccountingandexplainthedifferencesbetweenmanagerialaccountingand
financialaccounting.
2. Identifysomeoftheusersofaccountinginformationandexplainhowtheyuseit.

Accountingisoftencalledthelanguageofbusiness.Why?Becauseitcommunicatessomuchof
theinformationthatowners,managers,andinvestorsneedtoevaluateacompanysfinancial
performance.Thesepeopleareallstakeholdersinthebusinesstheyreinterestedinitsactivities
becausetheyreaffectedbythem.Infact,thepurposeofaccountingistohelpstakeholdersmake
betterbusinessdecisionsbyprovidingthemwithfinancialinformation.Obviously,youwouldnttryto
runanorganizationormakeinvestmentdecisionswithoutaccurateandtimelyfinancialinformation,
anditstheaccountantwhopreparesthisinformation.Moreimportantly,accountantsmakesure
thatstakeholdersunderstandthemeaningoffinancialinformation,andtheyworkwithboth
individualsandorganizationstohelpthemusefinancialinformationtodealwithbusinessproblems.
Actually,collectingallthenumbersistheeasyparttoday,allyouhavetodoisstartupyour
accountingsoftware.Thehardpartisanalyzing,interpreting,andcommunicatingtheinformation.
Ofcourse,youalsohavetopresenteverythingclearlywhileeffectivelyinteractingwithpeoplefrom
everybusinessdiscipline.Inanycase,werenowreadytodefineaccountingastheprocessof
measuringandsummarizingbusinessactivities,interpretingfinancialinformation,and
communicatingtheresultstomanagementandotherdecisionmakers.

Fields of Accounting
Accountantstypicallyworkinoneoftwomajorfields.Managementaccountantsprovide
informationandanalysistodecisionmakersinsidetheorganizationinordertohelpthemrunit.
Financialaccountantsfurnishinformationtoindividualsandgroupsbothinsideandoutsidethe
organizationinordertohelpthemassessitsfinancialperformance.
Inotherwords,managementaccountinghelpsyoukeepyourbusinessrunningwhilefinancial

accountingtellsyouhowwellyourerunningit.

Management Accounting
managementaccountingplaysakeyroleinhelpingmanagerscarryouttheirresponsibilities.
Becausetheinformationthatitprovidesisintendedforusebypeoplewhoperformawidevarietyof
jobs,theformatforreportinginformationisflexible.Reportsaretailoredtotheneedsofindividual
managers,andthepurposeofsuchreportsistosupplyrelevant,accurate,timelyinformationin
aformatthatwillaidmanagersinmakingdecisions.Inpreparing,analyzing,andcommunicating
suchinformation,accountantsworkwithindividualsfromallthefunctionalareasofthe
organizationhumanresources,operations,marketing,andfinance.

Financial Accounting
Figure12.1.

Financial statements provide a snapshot of a companys performance over a specific period.

financialaccountingisresponsibleforpreparingtheorganizationsfinancialstatements
includingtheincomestatement,thestatementofownersequity,thebalancesheet,andthe
statementofcashflowsthatsummarizeacompanyspastperformanceandevaluateitscurrent
financialcondition.Inpreparingfinancialstatements,financialaccountantsadheretoauniformset
ofrulescalledgenerallyacceptedaccountingprinciples(GAAP)thebasicprinciplesfor
financialreportingissuedbyanindependentagencycalledtheFinancialAccountingStandards
Board(FASB).Userswanttobesurethatfinancialstatementshavebeenpreparedaccordingto
GAAPbecausetheywanttobesurethattheinformationreportedinthemisaccurate.Theyalso
knowthattheycancomparethestatementsissuedbyonecompanytothoseofanothercompanyin
thesameindustry.
WhilecompaniesheadquarteredintheUnitedStatesfollowU.S.basedGAAP,manycompanies
locatedoutsidetheUnitedStatesfollowadifferentsetofaccountingprinciplescalledInternational
FinancialReportingStandards(IFRS).Thesemultinationalstandards,whichareissuedbythe
InternationalAccountingStandardsBoard(IASB),differfromU.S.GAAPinanumberofimportant
ways.IFRS,forexample,isalittlestricteraboutthewaysyoucancalculatethecostsofinventory,

butwerenotgoingtodwellunnecessarilyonsuchfinedistinctions.Bearinmind,however,that,
accordingtomostexperts,asinglesetofworldwidestandardswilleventuallyemergetogovernthe
accountingpracticesofbothU.S.andnonU.S.companies.

Who Uses Financial Accounting Information?


Theusersofmanagerialaccountinginformationareprettyeasytoidentifybasically,theyrea
firmsmanagers.Weneedtolookalittlemoreclosely,however,attheusersoffinancial
accountinginformation,andwealsoneedtoknowalittlemoreaboutwhattheydowiththe
informationthataccountantsprovidethem.

Owners and Managers


Insummarizingtheoutcomesofacompanysfinancialactivitiesoveraspecifiedperiodoftime,
financialstatementsare,ineffect,reportcardsforownersandmanagers.Theyshow,forexample,
whetherthecompanydidordidntmakeaprofitandfurnishotherinformationaboutthefirms
financialcondition.Theyalsoprovideinformationthatmanagersandownerscanuseinorderto
takecorrectiveaction.

Investors and Creditors


Ifyouloanedmoneytoafriendtostartabusiness,wouldntyouwanttoknowhowthebusiness
wasdoing?Investorsandcreditorsfurnishthemoneythatacompanyneedstooperate,andnot
surprisingly,theyfeelthesameway.Becausetheyknowthatitsimpossibletomakesmart
investmentandloandecisionswithoutaccuratereportsonanorganizationsfinancialhealth,they
studyfinancialstatementstoassessacompanysperformanceandtomakedecisionsabout
continuedinvestment.
Accordingtotheworldsmostsuccessfulinvestor(andthirdrichestindividual),WarrenBuffett,the
bestwaytoprepareyourselftobeaninvestoristolearnalltheaccountingyoucan.Buffett,
chairmanandCEOofBerkshireHathaway,acompanythatinvestsinothercompanies,turnedan
originalinvestmentof$10,000intoanetworthof$35billioninfourdecades,andhedidit,inlarge
part,bypayingcloseattentiontofinancialaccountingreports.[488]
Figure12.2.WarrenBuffet

Government Agencies
Businessesarerequiredtofurnishfinancialinformationtoanumberofgovernmentagencies.
Publiclyownedcompanies,forexampletheoneswhosesharesaretradedonastockexchange
mustprovideannualfinancialreportstotheSecuritiesandExchangeCommission(SEC),afederal
agencythatregulatesstocktrades.Companiesmustalsoprovidefinancialinformationtolocal,
state,andfederaltaxingagencies,includingtheInternalRevenueService.

Other Users
Anumberofotherexternalusershaveaninterestinacompanysfinancialstatements.Suppliers,
forexample,needtoknowifthecompanytowhichtheyselltheirgoodsishavingtroublepayingits
billsormayevenbeatriskofgoingunder.Employeesandlaborunionsareinterestedbecause
salariesandotherformsofcompensationaredependentonanemployersperformance.
Figure12.3,ManagementandFinancialAccountingsummarizesthemaindifferencesbetween
theusersofmanagementandfinancialaccountingandthetypesofinformationissuedby

accountantsinthetwoareas.Intherestofthischapter,welllearnhowtoprepareasetoffinancial
statementsandhowtointerpretthem.Wellalsodiscussissuesofethicsintheaccounting
communitiesandcareeropportunitiesintheaccountingprofession.
Figure12.3.ManagementandFinancialAccounting

Key Takeaways
Accountingisasystemformeasuringandsummarizingbusinessactivities,interpreting
financialinformation,andcommunicatingtheresultstomanagementandother
stakeholderstohelpthemmakebetterbusinessdecisions.
Accountingcanbedividedintotwomajorfields:
Managementaccountingprovidesinformationandanalysistodecisionmakersinside
theorganization(suchasownersandmanagers)tohelpthemoperatethebusiness.
Financialaccountingprovidesinformationnotonlytointernalmanagers,butalsoto
peopleoutsidetheorganization(suchasinvestors,creditors,governmentagencies,
suppliers,employees,andlaborunions)toassisttheminassessingafirmsfinancial
performance.
U.S.andnonU.S.companiesfollowdifferentsetsofstandardsinpreparingfinancial
accountingreports:

U.S.companiesadheretoauniformsetofrulescalledgenerallyaccepted
accountingprinciples(GAAP),whichareissuedbyanindependentagencycalledthe
FinancialAccountingStandardsBoard(FASB).
ManycompaniesoutsidetheUnitedStatesfollowasetofaccountingprinciplescalled
InternationalFinancialReportingStandards(IFRS),whichareissuedbythe
InternationalAccountingStandardsBoard(IASB).
Expertsexpectthatasinglesetofworldwideaccountingstandardswilleventuallyemerge
andbefollowedbybothU.S.andnonU.S.companies.

Exercise
1. Whousesaccountinginformation?Whatdotheyuseitfor,andwhydotheyfindithelpful?
Whatproblemswouldariseiftheywerentprovidedwithaccountinginformation?

Understanding Financial Statements


Learning Objectives
1. Understandthefunctionoftheincomestatement.
2. Understandthefunctionofthebalancesheet.
3. Understandthefunctionofthestatementofownersequity.

Wehopethat,sofar,wevemadeatleastonethingclear:Ifyoureinbusiness,youneedto
understandfinancialstatements.Foronething,thelawnolongerallowshighrankingexecutivesto
pleadignoranceorfallbackondelegationofauthoritywhenitcomestotakingresponsibilityfora
firmsfinancialreporting.Inabusinessenvironmenttaintedbyepisodesoffraudulentfinancial
reportingandothercorporatemisdeeds,topmanagersarenowbeingheldaccountable(soto
speak)forthefinancialstatementsissuedbythepeoplewhoreporttothem.Foranotherthing,top
managersneedtoknowifthecompanyishittingonallcylindersorsputteringdowntheroadto
bankruptcy.Toputitanotherway(andtoswitchmetaphors):ifhedidntunderstandthefinancial
statementsissuedbythecompanysaccountants,anexecutivewouldbelikeanairplanepilotwho
doesntknowhowtoreadtheinstrumentinthecockpithemightbeablekeeptheplaneintheair
forawhile,buthewouldntrecognizeanysignsofimpendingtroubleuntilitwastoolate.

The Function of Financial Statements


PutyourselfintheplaceofthewomaninFigure12.4,WhatConnieWantstoKnow.Sheruns
ConniesConfectionsoutofherhome.Sheloveswhatshedoes,andshefeelsthatshesdoing
prettywell.Infact,shehasanopportunitytotakeoveranearbystoreatveryreasonablerent,and
shecanexpandbygettingamodestbankloanandinvestingsomemoreofherownmoney.Soits

decisiontimeforConnie:Sheknowsthatthesurvivalrateforstartupsisntverygood,andbefore
takingthenextstep,shedliketogetabetterideaofwhethershesactuallydoingwellenoughto
justifytherisk.Asyoucansee,shehasseveralpertinentquestions.WearentprivytoConnies
finances,butwecantellherhowbasicfinancialstatementswillgivehersomeanswers.[489]
Figure12.4.WhatConnieWantstoKnow

Toying with a Business Idea


Weknowwhatyourethinking:Itsnicetoknowthataccountingdealswithreallifesituations,but
whileyouwishConniethebest,youdontknowenoughabouttheconfectionarybusinessto
appreciateeitherthebusinessdecisionsorthefinancialdetails.Isthereanywaytobringthislesson
alittleclosertohome?Besides,whileknowingwhatfinancialstatementswilltellyouisonething,
youwanttoknowhowtopreparethem.
Agreed.Soletsassumethatyouneedtoearnmoneywhileyoureincollegeandthatyouve
decidedtostartasmallbusiness.Yourbusinesswillinvolvesellingstufftoothercollegestudents,
andtokeepthingssimple,wellassumethatyouregoingtooperateonacashbasis:youllpayfor
everythingwithcash,andeveryonewhobuyssomethingfromyouwillpayincash.
AWordaboutCash.Youprobablyhaveatleastalittlecashonyourightnowsomecurrency,or
papermoney,andcoins.Inaccounting,however,thetermcashreferstomorethanjustpaper
moneyandcoins.Italsoreferstothemoneythatyouhaveincheckingandsavingsaccountsand
includesitemsthatyoucandepositintheseaccounts,suchasmoneyordersanddifferenttypesof
checks.
Yourfirsttaskistodecideexactlywhatyouregoingtosell.Youvenoticedthatwithhomework,
exams,socialcommitments,andthehecticlifestyleoftheaveragecollegestudent,youandmostof
thepeopleyouknowalwaysseemtobeunderalotofstress.Sometimesyouwishyoucouldjustlie

backbetweenmealsandbounceaballoffthewall.Andthatswhentheideahitsyou:Maybeyou
couldmakesomemoneybysellingaproductcalledtheStressBusterPlayPack.Hereswhatyou
haveinmind:youllbuysmalltoysandotherfunstuffinstantstressrelieversatalocaldollar
storeandpacktheminarainbowcoloredplastictreasurechestlabeledStressBuster.
Andhereswhereyoustand:Youhaveenoughcashtobuyamonthsworthofplastictreasure
chestsandtoys.Afterthat,youllusethecashgeneratedfromsalesofStressBusterPlayPacksto
replenishyoursupply.Eachplasticchestwillcost$1.00,andyoullfilleachonewithavarietyoffive
ofthefollowingtoys,allofwhichyoucanbuyfor$1.00each:
Ahappyfacestressball
Aroomarang(anindoorboomerang)
Somesillyputty
Aninflatablebeachball
Acoilslinkyspring
Apaddleballgame
Aballforbouncingoffwalls
YouplantoselleachStressBusterPlayPackfor$10fromarentedtablestationedoutsideamajor
dininghall.Rentingthetablewillcostyou$20amonth.Becauseyourowngradesarentwhatyour
parentsandthedeanwouldlikethemtobe,youdecidetohirefellowstudents(trustworthypeople
withbettergradesthanyours)tostaffthetableatpeaktrafficperiods.Theyllbeondutyfromnoon
until2:00p.m.eachweekday,andyoullpaythem$6anhour.Wages,therefore,willcostyou$240
amonth(2hours5days4weeks=40hours$6).Finally,youllrunadsinthecollege
newspaperatamonthlycostof$40.Thusyourtotalmonthlycostswillamountto$300($20+$240
+$40).

The Income Statement


Letssaythatduringyourfirstmonth,yousellonehundredplaypacks.Notbad,yousaytoyourself,
butdidImakeaprofit?Tofindout,youprepareanincomestatementshowingrevenues,or
sales,andexpensesthecostsofdoingbusiness.Youdivideyourexpensesintotwocategories:
Costofgoodssold:thetotalcostofthegoodsthatyouvesold
Operatingexpenses:thecostsofoperatingyourbusinessexceptforthecostsofthingsthat
youvesold
Nowyouneedtodoalittlesubtracting:
1. Thepositivedifferencebetweensalesandcostofgoodssoldisyourgrossprofit(orgross
margin).
2. Thepositivedifferencebetweengrossprofitandoperatingexpensesisyournetincome(or
netprofit)orprofit,whichistheproverbialbottomline.(Ifthisdifferenceisnegative,youtook
alossinsteadofmakingaprofit.)
Figure12.5,IncomeStatementforStressBusterCompanyisyourincomestatementforthefirst
month.(Rememberthatwevemadethingssimplerbyhandlingeverythingincash.)

Figure12.5.IncomeStatementforStressBusterCompany

Did You Make Any Money?


Whatdoesyourincomestatementtellyou?Ithasprovidedyouwithfourpiecesofvaluable
information:
1. Yousold100unitsat$10each,bringinginrevenuesorsalesof$1,000.
2. Eachunitthatyousoldcostyou$6$1forthetreasurechestplus5toyscosting$1each.So
yourcostofgoodssoldis$600(100units$6perunit).
3. Yourgrossprofittheamountleftaftersubtractingcostofgoodssoldfromsalesis$400(100
units$4each).
4. Aftersubtractingoperatingexpensesof$300thecostsofdoingbusinessotherthanthecost
ofproductssoldyougeneratedapositivenetincomeorprofitof$100.

What If You Want to Make More Money?


Yourequiterelievedtoseethatyoumadeaprofitduringyourfirstmonth,butyoucanthelpbut
wonderwhatyoullhavetodotomakeevenmoremoneynextmonth.Youconsiderthree
possibilities:
1. Reduceyourcostofgoodssold(say,packagefourtoysinsteadoffive)
2. Reduceyouroperatingcosts(salaries,advertising,tablerental)
3. Increasethequantityofunitssold
Inordertoconsiderthesepossibilitiesfully,youneedtogeneratenewincomestatementsforeach
option.Andtodothat,youllhavetoplayafewwhatifgames.Becausepossibility#1packaging
fourtoysinsteadoffiveisthemostappealing,youstartthere.Yourcostofgoodssoldwouldgo
downfrom$6to$5perunit(4toysat$1each+1plastictreasurechestat$1).Figure12.6,
ProposedIncomeStatementNumberOneforStressBusterCompanyisyourhypotheticalincome

statementifyouchoosethisoption.
Figure12.6.ProposedIncomeStatementNumberOneforStressBusterCompany

Possibility#1seemstobeagoodidea.Underthisscenario,yourincomedoublesfrom$100to
$200becauseyourperunitgrossprofitincreasesby$1(andyousold100stresspacks).But
theremaybeacatch:Ifyoucutbackonthenumberoftoys,yourcustomersmightperceiveyour
productasalesservalueforthemoney.Infact,youreremindedofaconversationthatyouonce
hadwithafriendwhosefather,arestaurantowner,hadcutbackonthecostofthefoodheserved
bybuyinglessexpensivemeat.Intheshortterm,grossprofitpermealwentup,butcustomers
eventuallystoppedcomingbackandtherestaurantnearlywentoutofbusiness.
Thusyoudecidetoconsiderpossibility#2reducingyouroperatingcosts.Intheory,itsagood
idea,butinpracticeatleastinyourcaseitprobablywontwork.Whynot?Foronething,you
cantdowithoutthetableandyouneedyourworkers(becauseyourgradeshaventimproved,you
stilldonthavetimetositatthetableyourself).Second,ifyoucutsalariesfrom,say,$6to$5an
hour,youmayhaveahardtimefindingpeoplewillingtoworkforyou.Finally,youcouldreduce
advertisingcostsbyrunninganadeverytwoweeksinsteadofeveryweek,butthistacticwould
increaseyourincomebyonly$20amonthandcouldeasilyleadtoadropinsales.
Nowyoumoveontopossibility#3increasesales.Theappealingthingaboutthisoptionisthatit
hasnodownside.Ifyoucouldsomehowincreasethenumberofunitssoldfrom100StressBuster
packspermonthto150,yourincomewouldgoup,evenifyoustickwithyouroriginalfivetoy
product.Soyoudecidetocrunchsomenumbersforpossibility#3andcomeupwiththenewwhat
ifincomestatementinFigure12.7,ProposedIncomeStatementNumberTwoforStressBuster
Company.
Figure12.7.ProposedIncomeStatementNumberTwoforStressBusterCompany

Asyoucansee,thisisanattractivepossibility,eventhoughyouhaventfiguredouthowyoure
goingtoincreasesales(maybeyoucouldputupsomeeyepoppingpostersandplaycoolmusicto
attractpeopletoyourtable.Ormaybeyourworkerscouldattractbuyersbydemonstrating
relaxationandstressreductionexercises).

Breakeven Analysis
Playingthesewhatifgameshasstartedyouthinking:istheresomewaytofigureoutthelevelof
salesyouneedtoavoidlosingmoneytobreakeven?Thiscanbedoneusingbreakeven
analysis.Tobreakeven(havenoprofitorloss),yourtotalsalesrevenuemustexactlyequalall
yourexpenses(bothvariableandfixed).Foramerchandiser,likeahypotheticalonecalledThe
CollegeShop,thisbalancewilloccurwhengrossprofitequalsallother(fixed)costs.Todetermine
thelevelofsalesatwhichthiswilloccur,youneedtodothefollowing:
1. Determineyourtotalfixedcosts,whicharesocalledbecausethetotalcostdoesntchangeas
thequantityofgoodssoldchanges):
Fixedcosts=$240salaries+$40advertising+$20table=$300
2. Identifyyourvariablecosts.Thesearecoststhatvary,intotal,asthequantityofgoodssold
changesbutstayconstantonaperunitbasis.Statevariablecostsonaperunitbasis:
Variablecostperunit=$6($1forthetreasurechestand$5forthetoys)
3. Determineyourcontributionmarginperunit:sellingpriceperunitvariablecostperunit:
Contributionmarginperunit=$10sellingprice$6variablecostperunit=$4
4. Calculateyourbreakevenpointinunits:fixedcostscontributionmarginperunit:
Breakeveninunits=$300fixedcosts$4contributionmarginperunit=75units
Yourcalculationmeansthatifyousell75units,youllendupwithzeroprofit(orloss)andwillexactly
breakeven.Totestyourcalculation,youcanprepareawhatifincomestatementfor75unitsin

sales(whichisyourbreakevennumberofsales).TheresultingstatementisshowninFigure12.8,
ProposedIncomeStatementNumberThreeforStressBusterCompany.
Figure12.8.ProposedIncomeStatementNumberThreeforStressBusterCompany

Whatifyouwanttodobetterthanjustbreakeven?Whatifyouwanttoearnaprofitof$200next
month?HowmanyStressBusterPackunitswouldyouneedtosell?Youcanfindoutbybuildingon
theresultsofyourbreakevenanalysis.Notethateachadditionalsalewillbringin$4(contribution
marginperunit).Ifyouwanttomakeaprofitof$200whichis$200aboveyourbreakevenpoint
youmustsellanadditional50units($200desiredprofitdividedby$4contributionmarginper
unit)aboveyourbreakevenpointof75units.Ifyousell125units(75breakevenunits+the
additional50),youllmakeaprofitof$200amonth.
Asyoucansee,breakevenanalysisisratherhandy.Itenablesyoutodeterminethelevelofsales
thatyoumustreachtoavoidlosingmoneyandthelevelofsalesthatyouhavetoreachtoearna
profitof$200.Suchinformationwillhelpyouplanforyourbusiness.Forexample,knowingyou
mustsell125StressBusterPackstoearna$200profitwillhelpyoudecidehowmuchtimeand
moneyyouneedtodevotetomarketingyourproduct.

The Balance Sheet


Yourbalancesheetreportsthefollowinginformation:
Yourasset:theresourcesfromwhichitexpectstogainsomefuturebenefit
Yourliability:thedebtsthatitowestooutsideindividualsororganizations
Yourownersequity:yourinvestmentinyourbusiness
Whereasyourincomestatementtellsyouhowmuchincomeyouearnedoversomeperiodof
time,yourbalancesheettellsyouwhatyouhave(andwhereitcamefrom)ataspecificpointin
time.

Mostcompaniespreparefinancialstatementsonatwelvemonthbasisthatis,forafiscalyear
whichendsonDecember31orsomeotherlogicaldate,suchasJune30orSeptember30.Whydo
fiscalyearsvary?Acompanygenerallypicksafiscalyearenddatethatcoincideswiththeendofits
peaksellingperiodthusacrabmeatprocessormightenditsfiscalyearinOctober,whenthecrab
supplyhasdwindled.Mostcompaniesalsoproducefinancialstatementsonaquarterlyormonthly
basis.ForStressBuster,youllwanttoprepareamonthlybalancesheet.

The Accounting Equation


Thebalancesheetisbasedontheaccountingequation:
assets=liabilities+ownersequity
Thisimportantequationhighlightsthefactthatacompanysassetscamefromsomewhere:either
fromloans(liabilities)orfrominvestmentsmadebytheowners(ownersequity).Thismeansthat
theassetsectionofthebalancesheetontheonehandandtheliabilityandownersequitysection
ontheothermustbeequal,orbalance.Thusthetermbalancesheet.
Letspreparetwobalancesheetsforyourcompany:oneforthefirstdayyoustartedandoneforthe
endofyourfirstmonthofbusiness.WellassumethatwhenyoustartedStressBuster,you
borrowed$400fromyourparentsandputin$200ofyourownmoney.Ifyoulookatyourfirst
balancesheetinFigure12.9,BalanceSheetNumberOneforStressBusterCompanyyoullsee
thatyourbusinesshas$600incash(yourassets):Ofthistotal,youborrowed$400(your
liabilities)andinvested$200ofyourownmoney(yourownersequity).Sofar,sogood:Your
assetssectionbalanceswithyourliabilitiesandownersequitysection.
Figure12.9.BalanceSheetNumberOneforStressBusterCompany

Nowletsseehowthingshavechangedbytheendofthemonth.RecallthatStressBusterearned
$100(basedonsalesof100units)duringthemonthofSeptemberandthatyoudecidedtoleave
theseearningsinthebusiness.This$100profitincreasestwoitemsonyourbalancesheet:the
assetsofthecompany(itscash)andyourinvestmentinit(itsownersequity).Figure12.10,
BalanceSheetNumberTwoforStressBusterCompanyshowswhatyourbalancesheetwilllook
likeonSeptember30.Onceagain,itbalances.Younowhave$700incash:$400thatyou
borrowedplus$300thatyouveinvestedinthebusiness(youroriginal$200investmentplusthe

$100profitfromthefirstmonthofoperations,whichyouvekeptinthebusiness).
Figure12.10.BalanceSheetNumberTwoforStressBusterCompany

The Statement of Owners Equity


Notethatweusedthenetincomefigurefromyourincomestatementtoupdatetheownersequity
sectionofyourendofmonthbalancesheet.Often,companiesprepareanadditionalfinancial
statement,calledthestatementofownersequity,whichdetailschangesinownersequityforthe
reportingperiod.Figure12.11,SampleStatementofOwnersEquityforStressBusterCompany
showswhatthisstatementlookslike.
Figure12.11.SampleStatementofOwnersEquityforStressBusterCompany

How Do Financial Statements Relate to One Another?


Whenyouprepareyourfinancialstatements,youshouldcompletetheminacertainorder:
1. Incomestatement
2. Statementofownersequity

3. Balancesheet
Whymusttheybepreparedinthisorder?Becausefinancialstatementsareinterrelated:Numbers
generatedononefinancialstatementappearonotherfinancialstatements.Figure12.12,How
FinancialStatementsRelatetoOneAnotherpresentsStressBustersfinancialstatementsforthe
monthendedSeptember30,20X1.Asyoureviewthesestatements,notethatintwocases,
numbersfromonestatementappearinanotherstatement:
Figure12.12.HowFinancialStatementsRelatetoOneAnother

Iftheinterlinkingnumbersarecarriedforwardcorrectly,andifassetsandliabilitiesarelisted
correctly,thenthebalancesheetwillbalance:Totalassetswillequalthetotalofliabilitiesplus
ownersequity.

Key Takeaways
Accountantspreparefourfinancialstatements:incomestatement,statementof
ownersequity,balancesheet,andstatementofcashflows(whichisdiscussedlater
inthechapter).
Theincomestatementshowsafirmsrevenuesandexpensesandwhetheritmadea
profit.
Thebalancesheetshowsafirmsassets,liabilitiesandownersequity(theamount
thatitsownershaveinvestedinit).
Thebalancesheetisbasedontheaccountingequation:
assets=liabilities+ownersequity
Thisequationhighlightsthefactthatacompanysassetscamefromoneoftwosources:
eitherfromloans(itsliabilities)orfrominvestmentsmadebyowners(itsowners
equity).

Thestatementofownersequityreportsthechangesinownersequitythathave
occurredoveraspecifiedperiodoftime.
Financialstatementsshouldbecompetedinacertainorder:incomestatement,
statementofownersequity,andbalancesheet.Thesefinancialstatementsare
interrelatedbecausenumbersgeneratedononefinancialstatementappearonother
financialstatements.
Breakevenanalysisisatechniqueusedtodeterminethelevelofsalesneededtobreak
eventooperateatasaleslevelatwhichyouhaveneitherprofitnorloss.
Tobreakeven,totalsalesrevenuemustexactlyequalallyourexpenses(bothvariable
andfixedcosts).
Tocalculatethebreakevenpointinunitstobesold,youdividefixedcostsby
contributionmarginperunit(sellingpriceperunitminusvariablecostperunit).
Thistechniquecanalsobeusedtodeterminethelevelofsalesneededtoobtaina
specifiedprofit.

Exercises
1. (AACSB)Analysis
Describetheinformationprovidedbyeachofthesefinancialstatements:income
statement,balancesheet,statementofownersequity.Identifytenbusinessquestionsthat
canbeansweredbyusingfinancialaccountinginformation.Foreachquestion,indicate
whichfinancialstatement(orstatements)wouldbemosthelpfulinansweringthequestion,
andwhy.
2. (AACSB)Analysis
Yourethepresidentofastudentorganization,andtoraisefundsforalocalwomens
shelteryouwanttosellsinglelongstemredrosestostudentsonValentinesDay.Each
prewrappedrosewillcost$3.Anadforthecollegenewspaperwillcost$100,andsupplies
forposterswillcost$60.Ifyouselltherosesfor$5,howmanyrosesmustyouselltobreak
even?Becausebreakingevenwontleaveyouanymoneytodonatetotheshelter,you
alsowanttoknowhowmanyrosesyoudhavetoselltoraise$500.Doesthisseemlikea
realisticgoal?Ifthenumberofrosesyouneedtosellinordertoraise$500isunrealistic,
whatcouldyoudotoreachthisgoal?

Accrual Accounting
Learning Objectives
1. Understandthedifferencebetweencashbasisandaccrualaccounting.
2. Understandthepurposeofastatementofcashflowsanddescribeitsformat.

Inthissection,weregoingtotakeastepfurtherintotheworldofaccountingbyexaminingthe
principlesofaccrualaccounting.InourStressBusterillustration,weveassumedthatallyour
transactionshavebeenmadeincash:Youpaidcashforyourinputs(plastictreasurechestsand
toys)andforyourotherexpenses,andyourcustomerspaidcashwhentheyboughtStressBuster
packs.Intherealworld,ofcourse,thingsarerarelythatsimple.Inthefollowingcases,timingplays
aroleinmakingandreceivingpayments:
Customersdontalwayspayincashtheyoftenbuysomethingandpaylater.Whenthis
happens,thesellerisowedmoneyandhasanaccountreceivable(itwillreceivesomething
later).
Companiesdontgenerallypaycashformaterialsandotherexpensestheyoftenpaylater.If
thisisthecase,thebuyerhasanaccountpayable(itwillpaysomethinglater).
Manycompaniesmanufactureorbuygoodsandholdthemininventorybeforesellingthem.
Underthesecircumstances,theydontreportpaymentforthegoodsuntiltheyvebeensold.
Companiesbuylongtermassets(alsocalledfixedassets),suchascars,buildings,and
equipment,whichtheyplantouseoveranextendedperiod(asarule,formorethanoneyear).

What Is Accrual Accounting?


Insituationssuchasthese,firmsuseaccrualaccounting:asysteminwhichtheaccountant
recordsatransactionwhenitoccurs,withoutwaitinguntilcashispaidoutorreceived.Herearea
fewbasicprinciplesofaccrualaccounting:
Asaleisrecognizedontheincomestatementwhenittakesplace,regardlessofwhencashis
collected.
Anexpenseisrecognizedontheincomestatementwhenitsincurred,regardlessofwhen
paymentismade.
Anitemmanufacturedforlatersaleorboughtforresalebecomespartofinventoryandappears
onthebalancesheetuntilitsactuallysoldatthatpoint,itgoesontheincomestatement
undercostofgoodssold.
Alongtermassetthatwillbeusedforseveralyearsforexample,avehicle,machine,or
buildingappearsonthebalancesheet.Itscostisspreadoveritsusefullifethenumberof
yearsthatitwillbeused.Itsannualallocatedcostappearsontheincomestatementasa
depreciationexpense.

Going to School on a New Business Idea


AswesawinourStressBusterillustration,itseasiertomakesenseofaccountingconceptswhen
youseesomerealoratleastrealisticnumbersbeingputtorealisticuse.Soletsnowassume
thatyousuccessfullyoperatedtheStressBusterCompanywhileyouwereincollege.Nowfast
forwardtograduation,andratherthanworkforsomeoneelse,youvedecidedtosetupamore
ambitiousbusinesssomekindofretailoutletclosetothecollege.Duringyourfouryearsin
school,younoticedthattherewasnostorenearcampusthatmetthewiderangeofstudents
specificneeds.Thusthemissionofyourproposedretailbusiness:toprovideproductsthatsatisfy
thespecificneedsofcollegestudents.

Figure12.13.TheCollegeShop

YouvedecidedtocallyourstoreTheCollegeShop.Yourproductlinewillrangefromthings
neededtooutfitadormroom(linens,towels,smallappliances,desks,rugs,dormrefrigerators)to
thingsthatarejustplainfunandmakestudentlifemoreenjoyable(giftpackages,posters,lava
lamps,games,inflatablefurniture,beanbagchairs,messageboards,showerradios,backpacks).
AndofcourseyoullalsoselltheoriginalStressBusterFunPack.Youlladvertisetostudentsand
parentsthroughthecollegenewspaperandyourownWebsite.

Accrual-Basis Financial Statements


Atthispoint,weregoingtorepeatprettymuchthesameprocessthatwewentthroughwithyour
firstbusiness.First,wellprepareabeginningbalancesheetthatreflectsyournewcompanys
assets,liabilities,andownersequityonyourfirstdayofbusinessJanuary1,20X6.Next,well
prepareanincomestatementandastatementofownersequity.Finally,wellcreateabalance
sheetthatreflectsthecompanysfinancialstateattheendofyourfirstyearofbusiness.
Althoughtheprocessshouldnowbefamiliar,thedetailsofournewstatementswillbemore
complexafterall,yourtransactionswillbemorecomplicated:Youregoingtosellandbuystuffon

credit,maintainaninventoryofgoodstobesold,retainassetsforuseoveranextendedperiodof
time,borrowmoneyandpayinterestonit,anddealwithavarietyofexpensesthatyoudidnthave
before(rent,insurance,etc.).

Beginning Balance Sheet


YournewbeginningbalancesheetcontainsthesameitemsastheonethatyoucreatedforStress
Bustercash,loans,andownersequity.Butbecauseyouvealreadyperformedabroaderrangeof
transactionsbeforeyouopenedforbusiness,youllneedsomenewcategories:
Youveboughtfurnitureandequipmentthatyoulluseoverthenextfiveyears.Youllallocatethe
costoftheselongtermassetsbydepreciatingthem.Becauseyouestimatethatthisfurniture
andequipmentwillhaveausefullifeoffiveyears,youallocateonefifthofthecostperyearfor
fiveyears.
Youvepurchasedaninventoryofgoodsforlaterresale.
Youvetakenouttwotypesofloans:onethatscurrentbecauseitspayableinoneyearandone
thatslongtermbecauseitsdueinfiveyears.
Obviously,then,youneedtoprepareamoresophisticatedbalancesheetthantheoneyoucreated
foryourfirstbusiness.Wecallthisnewkindofbalancesheetaclassifiedbalancesheetbecause
itclassifiesassetsandliabilitiesintoseparatecategories.

Types of Assets
Onaclassifiedbalancesheet,assetsarelistedinorderofliquidityhowquicklytheycanbe
convertedintocash.Theyrealsobrokendownintotwocategories:
1. Currentassetassetsthatyouintendtoconvertintocashwithinayear
2. Longtermasset(orfixedasset)assetsthatyouintendtoholdformorethanayear
Yourcurrentassetswillbecashandinventory,andyourlongtermassetswillbefurnitureand
equipment.Welltakeacloserlookattheassetssectionofyourbeginningbalancesheet,butit
makessensetoanalyzeyourliabilitiesfirst.

Types of Liabilities
Liabilitiesaregroupedinmuchthesamemannerasassets:
1. Currentliabilityliabilitiesthatyoullpayoffwithinoneyear
2. Longtermliabilityliabilitiesthatdontbecomedueformorethanoneyear
Recallthatyourliabilitiescomefromyourtwoloans:onewhichispayableinayearandconsidered
current,andonewhichislongtermanddueinfiveyears.
Nowwerereadytoreviewyourbeginningbalancesheet,whichisshowninFigure12.14,
BeginningBalanceSheetforTheCollegeShop.Onceagain,yourbalancesheetbalances:Your
totalassetsof$275,000equalyourtotalliabilitiesplusownersequityof$275,000.
Figure12.14.BeginningBalanceSheetforTheCollegeShop

Liabilities and Owners Equity


Letsbeginouranalysisofyourbeginningbalancesheetwiththeliabilitiesandownersequity
sections.Wereassumingthat,thankstoastrongbusinessplan,youveconvincedalocalbankto
loanyouatotalof$125,000ashorttermloanof$25,000andalongtermloanof$100,000.
Naturally,thebankchargesyouinterest(whichisthecostofborrowingmoney)yourrateis8
percentperyear.Inaddition,youpersonallycontributed$150,000tothebusiness(thankstoatrust
fundthatpaidoffwhenyouturned21).

Assets
Nowletsturntotheassetssectionofyourbeginningbalancesheet.Whatdoyouhavetoshowfor
your$275,000inliabilitiesandownersequity?Ofthisamount,$50,000isincashthatis,money
depositedinthecompanyscheckingandotherbankaccounts.Youusedanother$75,000topay
forinventorythatyoullsellthroughouttheyear.Finally,youspent$150,000onseverallongterm
assets,includingasignforthestore,furniture,storedisplays,andcomputerequipment.You
expecttousetheseassetsforfiveyears,atwhichpointyoullprobablyreplacethem.

Income Statement
Finally,letslookatyourincomestatement,whichisshowninFigure12.15,IncomeStatementfor
TheCollegeShop,YearEndedDecember31.LikeyourCollegeShopbalancesheet,yourCollege
ShopincomestatementismorecomplexthantheoneyoupreparedforStressBuster,andthe
amountsaremuchlarger.Inaddition,thestatementcoversafullcalendaryear.
Figure12.15.IncomeStatementforTheCollegeShop,YearEndedDecember31

Note,bytheway,thattheincomestatementthatwepreparedforTheCollegeShopisdesignedfor
amerchandiseracompanythatmakesaprofitbysellinggoods.Howcanyoutell?Businesses
thatsellservices(suchasaccountingfirmsorairlines)ratherthanmerchandisedonthavelines
labeledcostofgoodssoldontheirstatements.
Theformatofthisincomestatementalsohighlightsthemostimportantfinancialfactinrunninga
merchandisingcompany:youmustsellgoodsataprofit(calledgrossprofit)thatishigh
enoughtocoveryouroperatingcosts,interest,andtaxes.Yourincomestatement,for
example,showsthatTheCollegeShopgenerated$225,000ingrossprofitthroughsalesof
goods.Thisamountissufficienttocoveryouroperatingexpense,interest,andtaxesandstill
produceanetincomeof$30,000.

A Few Additional Expenses


NotethatTheCollegeShopincomestatementalsolistsafewexpensesthattheStressBuster
didntincur:
Depreciationexpense.Recallthatbeforeopeningforbusiness,youpurchasedsomelongterm
assets(storesign,displays,furniture,andequipment)foratotalamountof$150,000.In
estimatingthatyouwouldusetheseassetsforfiveyears(yourestimateoftheirusefullives),you
spreadthecostof$150,000overfiveyears.Foreachofthesefiveyears,then,yourincome
statementwillshow$30,000indepreciationexpense($150,0005years=$30,000).
Interestexpense.Whenyouborrowedmoneyfromthebank,youagreedtopayinterestatan
annualrateof8percent.Yourinterestexpenseof$10,000($125,0000.08)isacostof
financingyourbusinessandappearsonyourincomestatementafterthesubheadingoperating
income.
Incometaxes.Yourcompanyhastopayincometaxesatarateof25percentofnetincome

beforetaxes.Thisamountof$10,000($40,00025%)appearsonyourincomestatementafter
thesubheadingnetincomebeforeincometaxes.Itssubtractedfromincomebeforeincome
taxesbeforeyouarriveatyourbottomline,ornetincome.

Statement of Owners Equity


Ournextstepistoprepareastatementofownersequity,whichisshowninFigure12.16,
StatementofOwnersEquityforTheCollegeShop.Notethatthenetincomeof$30,000fromthe
incomestatementwasusedtoarriveattheyearendbalanceinownersequity.
Figure12.16.StatementofOwnersEquityforTheCollegeShop

End-of-First-Year Balance Sheet


Wellconcludewithyourbalancesheetfortheendofyourfirstyearofoperations,whichisshownin
Figure12.17,EndofYearBalanceSheetforTheCollegeShop.First,lookatyourassets.At
yearsend,youhaveacashbalanceof$70,000andinventoryof$80,000.Youalsohavean
accountsreceivableof$90,000becausemanyofyourcustomershaveboughtgoodsoncredit
andwillpaylater.Inaddition,thebalancesheetnowshowstwonumbersforlongtermassets:the
originalcostoftheseassets,$150,000,andanaccumulateddepreciationamountof$30,000,
whichreflectstheamountthatyouvechargedasdepreciationexpensesincethepurchaseofthe
assets.Thecarryingvalueoftheselongtermassetsisnow$120,000($150,000$30,000),which
isthedifferencebetweentheiroriginalcostandtheamountthattheyvebeendepreciated.Your
totalassetsarethus$360,000.
Figure12.17.EndofYearBalanceSheetforTheCollegeShop

Thetotalofyourliabilitiesof$180,000plusownersequityof$180,000alsoequals$360,000.Your
liabilitiesconsistofalongtermloanof$100,000(whichisnowdueinfouryears)andaccounts
payableof$80,000(moneythatyoullhavetopayoutlaterforpurchasesthatyouvemadeon
credit).Yourownersequity(yourinvestmentinthebusiness)totals$180,000(the$150,000you
originallyputinplusthe$30,000infirstyearearningsthatyouretainedinthebusiness).

Statement of Cash Flows


Owners,investors,andcreditorscanlearnalotfromyourbalancesheetandyourincome
statement.Indeed,eachtellsitsownstory.Thebalancesheettellswhatassetsyourcompanyhas
nowandwheretheycamefrom.Theincomestatementreportsearnedincomeonanaccrualbasis
(recognizingrevenueswhenearnedandexpensesasincurredregardlessofwhencashisreceived
orpaid).Butthekeytosurvivinginbusinessisgeneratingthecashyouneedtokeepitupand
running.Itsnotunusualtohearreportsaboutcompanieswithcashproblems.Sometimesthey
arisebecausetheproductsinwhichthefirmhasinvestedarentsellingaswellasithadforecast.
Maybethecompanytieduptoomuchmoneyinaplantthatstoobigforitsoperations.Maybeit
soldproductstocustomerswhocantpay.Maybemanagementjustoverspent.Whateverthe
reason,cashproblemswillhamperanybusiness.Ownersandotherinterestedpartiesneeda
financialstatementthathelpsthemunderstandacompanyscashflow.
Thestatementofcashflowstellsyouwhereyourcashcamefromandwhereitwent.Itfurnishes
informationaboutthreecategoriesofactivitiesthatcausecasheithertocomein(cashinflows)or
togoout(cashoutflows):
1. Cashflowsfromoperatingactivitycomefromthedaytodayoperationsofyourmainlineof
business.
2. Cashflowsfrominvestingactivityresultfrombuyingorsellinglongtermassets.
3. Cashflowsfromfinancingactivityresultfromobtainingorpayingbackfundsusedtofinance
yourbusiness.

AcashflowstatementforTheCollegeShopwouldlookliketheoneinFigure12.18,Statementof
CashFlowsforTheCollegeShop.Yougenerated$45,000incashfromyourcompanysoperations
(acashinflow)andused$25,000ofthisamounttopayoffyourshorttermloan(acashoutflow).
Thenetresultwasanincreaseincashof$20,000.This$20,000increaseincashagreeswiththe
changeinyourcashduringtheyearasitsreportedinyourbalancesheets:Youhadanendofthe
yearcashbalanceof$70,000andabeginningoftheyearbalanceof$50,000($70,000$50,000
=$20,000).Becauseyoudidntbuyorsellanylongtermassetsduringtheyear,yourcashflow
statementshowsnocashflowsfrominvestingactivities.
Figure12.18.StatementofCashFlowsforTheCollegeShop

Key Takeaways
Therearetwodifferentmethodsforreportingfinancialtransactions:
Companiesusingcashbasisaccountingrecognizerevenueasearnedonlywhen
cashisreceivedandrecognizeexpensesasincurredonlywhencashispaidout.
Companiesusingaccrualaccountingrecognizerevenueswhentheyreearned
(regardlessofwhenthecashisreceived)andexpenseswhentheyreincurred
(regardlessofwhenthecashispaidout).
Anitemmanufacturedforlatersaleorboughtforresaleappearsonthebalancesheetas
anassetcalledinventory.Whenitssold,itgoesontheincomestatementasanexpense
underthecategorycostofgoodssold.
Thedifferencebetweensalesandcostofgoodssoldiscalledgrossprofit.
Amerchandisingcompanysgrossprofitmustbehighenoughtocoveritsoperatingcosts,
interest,andtaxes.
Anassetthatwillbeusedforseveralyears(say,atruck)appearsonthebalancesheetas
alongtermasset.Itscostisallocatedoveritsusefullifeandappearsontheincome
statementasadepreciationexpense.
Aclassifiedbalancesheetseparatesassetsandliabilitiesintotwocategoriescurrent

andlongterm:
Currentassetsincludethosethatyouintendtoconvertintocashwithinayearlong
termassetsincludethosethatyouplantoholdformorethanayear.
Currentliabilitiesincludethosethatyoullpayoffwithinayearlongtermliabilities
includethosethatdonotbecomedueformorethanayear.
Thestatementofcashflowsshowshowmuchcashthebusinesshascominginand
goingout.
Thestatementofcashflowsfurnishesinformationaboutthreecategoriesofactivities
thatcausecasheithertocomeinortogoout:operatingactivities,investingactivities,
andfinancingactivities.

Exercises
1. (AACSB)Analysis
Toearnmoneytopaysomecollegeexpenses,youranalawnmowingbusinessduringthe
summer.BeforeheadingtocollegeattheendofAugust,youwantedtofindouthowmuch
moneyyouearnedforthesummer.Fortunately,youkeptgoodaccountingrecords.During
thesummer,youchargedcustomersatotalof$5,000forcuttinglawns(whichincludes
$500stillowedtoyoubyoneofyourbiggestcustomers).Youpaidout$1,000forgasoline,
lawnmowerrepairs,andotherexpenses,including$100foralawnmowertuneupthat
youhaventpaidforyet.Youdecidedtoprepareanincomestatementtoseehowyoudid.
Becauseyoucouldntdecidewhetheryoushouldprepareacashbasisstatementoran
accrualstatement,youpreparedboth.Whatwasyourincomeundereachapproach?
Whichmethod(cashbasisoraccrual)moreaccuratelyreflectstheincomethatyouearned
duringthesummer?Why?
2. (AACSB)Analysis
Identifythecategoriesusedonaclassifiedbalancesheettoreportassetsandliabilities.
Howdoyoudeterminewhatgoesintoeachcategory?Whywouldabankerconsideringa
loantoyourcompanywanttoknowwhetheranassetorliabilityiscurrentorlongterm?
3. (AACSB)Analysis
Youreviewacompanysstatementofcashflowsandfindthatcashinflowsfromoperations
are$150,000,netoutflowsfrominvestingare$80,000,andnetinflowsfromfinancingare
$60,000.Didthecompanyscashbalanceincreaseordecreasefortheyear?Bywhat
amount?Whattypesofactivitieswouldyoufindunderthecategoryinvestingactivities?
Underfinancingactivities?Ifyouhadaccesstothecompanysincomestatementand
balancesheet,whywouldyoubeinterestedinreviewingitsstatementofcashflows?What
additionalinformationcanyougatherfromthestatementofcashflows?

Financial Statement Analysis

Learning Objective
1. Evaluateacompanysperformanceusingfinancialstatementsandratioanalysis.

Nowthatyouknowhowfinancialstatementsareprepared,letsseehowtheyreusedtohelp
owners,managers,investors,andcreditorsassessafirmsperformanceandfinancialstrength.You
cangleanawealthofinformationfromfinancialstatements,butfirstyouneedtolearnafewbasic
principlesforunlockingit.

The Comparative Income Statement


LetsfastforwardagainandassumethatyourbusinessTheCollegeShophasjustcompletedits
secondyearofoperations.Aftercreatingyoursecondyearincomestatement,youdecideto
comparethenumbersfromthisstatementwiththosefromyourfirststatement.Soyoupreparethe
comparativeincomestatementinFigure12.19,ComparativeIncomeStatementforTheCollege
Shop,whichshowsincomefiguresforyear2andyear1(accountantsgenerallyputnumbersfor
themostrecentyearintheinsidecolumn).
Figure12.19.ComparativeIncomeStatementforTheCollegeShop

Vertical Percentage Analysis


Whatdoesthisstatementtellusaboutyoursecondyearinbusiness?Somethingslookgoodand
somedont.Yoursaleswentupfrom$500,000to$600,000(a20percentincreasenotbad).But
yourprofitwasdownfrom$30,000to$18,000(abadsign).Asyoustareatthestatement,youre
askingyourselfthequestion:Whydidmyprofitgodowneventhoughmysaleswentup?Doesthis
resultmakesense?Istheresomewayofcomparingtwoincomestatementsthatwillgivemea
morehelpfulviewofmycompanysfinancialhealth?Onewayiscalledverticalpercentage
analysis.Itsusefulbecauseitrevealstherelationshipofeachitemontheincomestatementtoa
specifiedbasegenerallysalesbyexpressingeachitemasapercentageofthatbase.
Figure12.20,ComparativeIncomeStatementUsingVerticalPercentageAnalysisshowswhat

comparativeincomestatementslooklikewhenyouuseverticalpercentageanalysisshowingeach
itemasapercentageofsales.Letsseeifthishelpsclarifythings.Whatdoyouthinkaccountedfor
thecompanysdropinincomeeventhoughTheCollegeShopsaleswentup?
Figure12.20.ComparativeIncomeStatementUsingVerticalPercentageAnalysis

Thepercentageshelpyoutoanalyzechangesintheincomestatementitemsovertime,butitmight
beeasierifyouthinkofthepercentagesaspennies.Inyear1,forexample,forevery$1.00of
sales,$0.55wenttopayforthegoodsthatyousold,leaving$0.45tocoveryourothercostsand
leaveyouaprofit.Operatingexpenses(salaries,rent,advertising,andsoforth)usedup$0.35of
every$1.00ofsales,whileinterestandtaxestookup$0.02each.Afteryoucoveredallyourcosts,
youhad$0.06profitforevery$1.00ofsales.

Asking the Right Questions


Now,comparethesefigurestothoseforyear2.Whereisthemajordiscrepancy?ItsinCostof
goodssold.Insteadofusing$0.55ofevery$1.00ofsalestobuythegoodsyousold,youused
$0.64.Asaresult,youhad$0.09less($0.64$0.55)tocoverothercosts.Thisisthemajorreason
whyyouwerentasprofitableinyear2asyouwereinyear1:yourGrossprofitasapercentage
ofsaleswaslowerinyear2thanitwasinyear1.Thoughthisinformationdoesntgiveyouallthe
answersyoudliketohave,itdoes,however,raisesomeinterestingquestions.Whywastherea
changeintherelationshipbetweenSalesandCostofgoodssold?Didyouhavetopaymoreto
buygoodsforresaleand,ifso,wereyouunabletoincreaseyoursellingpricetocoverthe
additionalcost?Didyouhavetoreducepricestomovegoodsthatwerentsellingwell?(Ifyour
costsstaythesamebutyoursellingpricegoesdown,youmakelessoneachitemsold.)Answersto
thesequestionsrequirefurtheranalysis,butatleastyouknowwhattheusefulquestionsare.

Ratio Analysis
Verticalpercentageanalysishelpsyouanalyzerelationshipsbetweenitemsonyourincome
statement.Buthowdoyoucompareyourfinancialresultswiththoseofothercompaniesinyour
industryorwiththeindustryoverall?Andwhataboutyourbalancesheet?Arethererelationshipson
thisstatementthatalsowarrantinvestigation?Shouldyoufurtherexamineanyrelationships

betweenitemsonyourincomestatementanditemsonyourbalancesheet?Theseissuescanbe
exploredbyusingratioanalysis,atechniqueforevaluatingacompanysfinancialperformance.
First,rememberthataratioisjustonenumberdividedbyanother,withtheresultexpressingthe
relationshipbetweenthetwonumbers.Letssay,forexample,thatyouwanttoknowthe
relationshipbetweenthecostofgoingtoamovieandthecostofrentingaDVDmovie.Youcould
makethefollowingcalculation:

GoingtoamoviecoststwotimesasmuchasrentingaDVD.
Ratioanalysisisalsousedtoassessacompanysperformanceovertimeandtocompareone
companytosimilarcompaniesortotheoverallindustryinwhichitoperates.Youdontlearnmuch
fromjustoneratio,orevenanumberofratioscoveringthesameperiod.Rather,thevalueinratio
analysisliesinlookingatthetrendofratiosovertimeandincomparingtheratiosforseveraltime
periodswiththoseofcompetitorsandtheindustryasawhole.Thereareanumberofdifferentways
tocategorizefinancialratios.Heresjustonesetofcategories:
Profitmarginratiotellyouhowmuchofeachsalesdollarisleftaftercertaincostsarecovered.
Managementefficiencyratiotellyouhowefficientlyyourassetsarebeingmanaged.
Managementeffectivenessratiotellyouhoweffectivemanagementisatrunningthebusiness
andmeasureoverallcompanyperformance.
Financialconditionratiohelpyouassessafirmsfinancialstrength.
Usingeachofthesecategories,wecanfinddozensofdifferentratios,butwellfocusonafew
examples.

Profit Margin Ratios


Wevealreadydeterminedthetwomostcommonprofitmarginratiosgrossprofitmarginandnet
profitmarginwhenweusedverticalpercentageanalysistodeterminetherelationshiptoSalesof
eachitemonTheCollegeShopsincomestatement.Wewereexamininggrossprofitwhenwe
foundthatGrossprofitforyear1was45percentofSalesandthat,inyear2,ithaddeclinedto36
percent.Wecanexpressthesamerelationshipsasratios:

Wecanseethatgrossprofitmargindeclined(asituationthat,aswelearnedearlier,probablyisnt
good).Buthowcanyoutellwhetheryourgrossprofitmarginforyear2isappropriateforyour
company?Foronething,wecanuseittocompareTheCollegeShopsresultstothoseofits
industry.Whenwemakethiscomparison,wefindthatthespecializedretailindustry(inwhichyour
companyoperates)reportsanaveragegrossprofitmarginof41percent.Foryear1,therefore,we

hadahigherratiothantheindustryinyear2,thoughwehadalowerratio,wewerestillinthe
proverbialballpark.
Itsworthwhiletotrackgrossprofitmargin,whetherforyourcompanyorforcompaniesthatyou
mightinvestinorlendmoneyto.Inparticular,youllgainsomeinsightintochangesthatmightbe
occurringinabusiness.Forinstance,whatifyoudiscoverthatafirmsgrossprofitmarginhas
declined?Isitbecauseitscostingmoreforthecompanytobuyormakeitsproducts,orisit
becauseitscompetitionisforcingittoloweritsprices?

Net Profit Margin


Netprofitisthemoneythatacompanyearnsafterpayingallitsexpenses,includingthecostsof
buyingormakingitsproducts,runningitsoperations,andpayinginterestandtaxes.Lookagainat
Figure12.20,ComparativeIncomeStatementUsingVerticalPercentageAnalysis.Usingvertical
percentageanalysis,wefoundthatforTheCollegeShop,netprofitasapercentageofsaleswas6
percentinyear1butdeclinedto3percentinyear2.Expressedasratios,theserelationshipswould
looklikethis:

Yourealizethatadecliningnetprofitmarginisntgood,butyouwonderhowyoucomparewithyour
industry.Alittleresearchinformsyouthataveragenetprofitmarginintheindustryis7percent.You
performednearlyaswellastheindustryinyear1butfellfurtherfromyourtargetinyear2.What
doesthisinformationtellyou?Thatagoalforyear3shouldbetryingtoincreaseyournetprofit
margin.

Management Efficiency Ratios


Theseratiosrevealthewayinwhichassets(shownonthebalancesheet)arebeingusedto
generateincome(shownontheincomestatement).Tocomputethisgroupofratios,therefore,you
mustlookatbothstatements.InFigure12.19,ComparativeIncomeStatementforTheCollege
Shop,weproducedacomparativeincomestatementforTheCollegeShopsfirsttwoyears.
Figure12.21,ComparativeBalanceSheetforTheCollegeShopisacomparativebalancesheet
forthesameperiod.
Figure12.21.ComparativeBalanceSheetforTheCollegeShop

AsyoucanseefromFigure12.21,ComparativeBalanceSheetforTheCollegeShop,running
evenasmallbusinessentailsasubstantialinvestmentinassets.Evenifyourentspace,for
example,youmuststillbuyfurnitureandequipment.Tohaveproductsonhandtosell,youneedto
tieupmoneyininventory.Andonceyouvesoldthem,youmayhavemoneytiedupinaccounts
receivablewhileyourewaitingforcustomerstopayyou.Thus,investinginassetsisanormalpart
ofdoingbusiness.Managingyourassetsefficientlyisabasicrequirementofbusinesssuccess.
Letslookatarepresentativemanagementefficiencyratio.Theinventoryturnoverratiomeasures
afirmsefficiencyinsellingitsinventory.
Youdontmakemoneyfromunsoldinventory.Youmakemoneywhenyousellinventory,andthe
fasteryousellit,themoremoneyyoumake.Todeterminehowfastyourinventoryisturning,you
needtoexaminetherelationshipbetweensalesandinventory.[490]LetsseehowwellTheCollege
Shopisdoinginmovingitsinventory:

Foryear1,TheCollegeShopconverteditsinventoryintosales6.25times:onaverage,yourentire
inventorywassoldandreplaced6.25timesduringtheyear.Foryear2,however,inventorywas
convertedintosalesonly5.45times.Theindustrydidbetter,averagingturnoverof6.58times.
BeforewediscusspossiblereasonsforthedropinTheCollegeShopsinventoryturnoverratio,lets
lookatanalternativewayofdescribingthisratio.Simplyconvertthisratiointotheaveragenumber

ofdaysthatyouheldanitemininventory.Inotherwords,divide365daysbyyourturnoverratio:

TheCollegeShopwasdoingfineinyear1(relativetotheindustry),butsomethinghappenedin
year2tobreakyourstride.Holdingontoinventoryforanextra9days(67daysforyear2minus58
daysforyear1)iscostly.Whathappened?Perhapsinventorylevelsweretoohighbecauseyou
overstocked.Itsgoodtohaveproductsavailableforcustomers,butstockingtoomuchinventoryis
costly.Maybesomeofyourinventorytakesalongtimetosellbecauseitsnotasappealingto
customersasyouthought.Ifthisisthecase,youmayhaveaproblemforthenextyearbecause
youllhavetocutprices(andreduceprofitability)inordertosellthesameslowmovinginventory.
Optimalinventoryturnovervariesbyindustryandevenbycompany.Asupermarket,forexample,
willhaveahighinventoryturnoverbecausemanyofitsproductsareperishableandbecauseit
makesmoneybysellingahighvolumeofgoods(makingonlypenniesoneachsale).Acompany
thatbuildsexpensivesailboats,bycontrast,willhavealowinventoryturnover:itsellsfewboatsbut
makesaheftyprofitoneachone.Somecompanies,suchasDellComputer,areknownforkeeping
extremelylowinventorylevels.Becausecomputersaremadetoorder,Dellmaintainsonlyminimal
inventoryandsoenjoysaveryhighratioofsalestoinventory.

Management Effectiveness Ratios


Ittakesmoneytomakemoney,goestheoldsaying,anditstrue.Eventhesmallestbusinessuses
moneytogrow.Managementeffectivenessratiosaddressthequestion:howwellisacompany
performingwiththemoneythatownersandothershaveinvestedinit?
Theseratiosarewidelyregardedasthebestmeasureofcorporateperformance.Youcangivea
firmhighmarksforpostinggoodprofitmarginsorforturningoveritsinventoryquickly,butthefinal
gradedependsonhowmuchprofititgenerateswiththemoneyinvestedbyownersandcreditors.
Or,toputitanotherway,thatgradedependsontheanswertothequestion:isthecompanymaking
asufficientlyhighreturnonitsassets?
Likemanagementefficiencyratios,managementeffectivenessratiosexaminetherelationship
betweenitemsontheincomestatementanditemsonthebalancesheet.Fromtheincome
statementyoualwaysneedtoknowthebottomlinenetprofit.Theinformationthatyouneed
fromthebalancesheetvariesaccordingtotheratiothatyouretryingtocalculate,butitsalways
somemeasureoftheamountofcapitalusedinthebusiness.Commonmeasuresofcapital
investmentincludetotalequity,totalassets,oracombinationofequityandlongtermdebt.Letssee
whetherTheCollegeShopmadethegrade.Diditgenerateareasonableprofitontheassets
investedinthecompany?

Becausetheindustryaveragereturnonassetsis7.9percent,TheCollegeShopgetsanAforits
firstyearsperformance.ItslippedinthesecondyearbutisprobablystillintheBrange.

Financial Condition Ratios


Financialconditionratiosmeasurethefinancialstrengthofacompany.Theyassessitsabilitytopay
itscurrentbillsandtodeterminewhetheritsdebtloadisreasonable,theyexaminetheproportion
ofitsdebttoitsequity.

Current Ratio
Letslookfirstatacompanysabilitytomeetcurrentobligations.Theratiothatevaluatesthisability
iscalledthecurrentratio,whichexaminestherelationshipbetweenacompanyscurrentassets
anditscurrentliabilities.ThebalanceofTheCollegeShopscurrentassetsandcurrentliabilities
appearsonthecomparativebalancesheetinFigure12.21,ComparativeBalanceSheetforThe
CollegeShop.Bycalculatingitscurrentratio,wellseewhetherthebusinessislikelytohavetrouble
payingitscurrentliabilities.

TheCollegeShopscurrentratioindicatesthat,inyear1,thecompanyhad$3.00incurrentassets
forevery$1.00ofcurrentliabilities.Inthesecondyear,thecompanyhad$4.00ofcurrentassetsfor
every$1.00ofcurrentliabilities.Theaveragecurrentratiofortheindustryis2.42.Thegoodnewsis
thatTheCollegeShopshouldhavenotroublemeetingitscurrentobligations.Thebadnewsisthat,
ironically,itscurrentratiomightbetoohigh:companiesshouldhaveenoughliquidassetsonhand
tomeetcurrentobligations,butnottoomany.Holdingexcesscashcanbecostlywhenthereare
alternativeusesforit,suchaspayingdownloansorbuyingassetsthatcangeneraterevenue.
PerhapsTheCollegeShopshouldreduceitscurrentassetsbyusingsomeofitscashtopaya
portionofitsdebt.

Debt-to-Equity Ratio
NowletslookatthewayTheCollegeShopisfinanced.Thedebttoequityratio(ordebtratio)
(alsocalleddebtratio)examinestheriskinessofacompanyscapitalstructuretherelationship
betweenfundsacquiredfromcreditors(debt)andfundsinvestedbyowners(equity):

Inyear1,theratioof1indicatesthatTheCollegeShophasanequalamountofequityanddebt(for
every$1.00ofequity,ithas$1.00ofdebt).Butthisproportionchangesinyear2,whenthe

companyhasmoreequitythandebt:forevery$1.00ofequity,itnowhas$0.85indebt.Howdoes
thisratiocomparetothatoftheindustry?TheCollegeShop,itseems,isheavyonthedebtside:the
industryaverageof0.49indicatesthat,onaverage,companiesintheindustryhaveonly$0.49of
debtforevery$1.00ofequity.ItshighdebttoequityratiomightmakeithardforTheCollegeShop
toborrowmoremoneyinthefuture.
Howmuchdifferencecanthisproblemmaketoabusinesswhenitneedsfunding?Considerthe
followingexample.Saythatyouhavetwofriends,bothofwhomwanttoborrowmoneyfromyou.
Youvedecidedtoloanmoneytoonlyoneofthem.Bothareequallyresponsible,butyouhappento
knowthatonehasonly$100inthebankandowes$1,000.Theotheralsohas$100inthebankbut
owesonly$50.Towhichonewouldyoulendmoney?Thefirsthasadebttoequityratioof10
($1,000debtto$100equity)andthesecondaratioof0.50($50debtto$100equity).Youlikea
bankerwillprobablylendmoneytothefriendwiththebetterdebttoequityratio,eventhoughthe
otheroneneedsthemoneymore.
Itspossible,however,foracompanytomakeitsinterestpaymentscomfortablyeventhoughithas
ahighdebttoequityratio.Thus,itshelpfultocomputetheinterestcoverageratio,which
measuresthenumberoftimesthatafirmsoperatingincomecancoveritsinterestexpense.We
computethisratiobyexaminingtherelationshipbetweeninterestexpenseandoperatingincome.A
highinterestcoverageratioindicatesthatacompanycaneasilymakeitsinterestpaymentsalow
ratiosuggeststrouble.HerearetheinterestcoverageratiosforTheCollegeShop:

Asthecompanysincomewentdown,sodiditsinterestcoverage(whichisntgood).Butthereal
problemsurfaceswhenyoucomparethefirmsinterestcoveragewiththatofitsindustry,whichis
muchhigher14.5.Thisfiguremeansthatcompaniesintheindustryhave,onaverage,$14.50in
operatingincometocovereach$1.00ofinterestthatitmustpay.Unfortunately,TheCollegeShop
hasonly$3.30.
Again,consideranexampleonamorepersonallevel.Letssaythatfollowinggraduation,youhave
aregularinterestpaymentdueonsomestudentloans.Ifyougetafairlylowpayingjobandyour
incomeisonly3timestheamountofyourinterestpayment,youllhavetroublemakingyour
payments.If,ontheotherhand,youlandagreatjobandyourincomeis15timestheamountof
yourinterestpayments,youcancoverthemmuchmorecomfortably.

What Have the Ratios Told Us?


So,whathavewelearnedabouttheperformanceofTheCollegeShop?Whatdoweforeseeforthe
companyinthefuture?Toanswerthisquestion,letsidentifysomeofthebasicthingsthatevery
businesspersonneedstodoinordertoachievesuccess:
Makeagoodprofitoneachitemyousell.
Moveinventory:thefasteryousellinventory,themoremoneyyoumake.

Provideyourselfandotherswithagoodreturnoninvestment:makeinvestinginyourbusiness
worthwhile.
Watchyourcash:ifyourunoutofcashandcantpayyourbills,youreoutofbusiness.
TheratiosthatwevecomputedinthissectionallowustoevaluateTheCollegeShoponeachof
thesedimensions,andhereswhatwefound:
Profitmarginratios(grossprofitmarginandnetprofitmargin)indicatethatthecompanymakes
areasonableprofitonitssales,thoughprofitabilityisdeclining.
Onemanagementefficiencyratio(inventoryturnover)suggeststhatinventoryismovingquickly,
thoughtherateofturnoverisslowing.
Onemanagementeffectivenessratio(returnonassets)tellsusthatthecompanygeneratedan
excellentreturnonitsassetsinitsfirstyearandagoodreturninitssecondyear.Butagain,the
trendisdownward.
Financialconditionratios(currentratio,totaldebttoequity,andinterestcoverage)painta
pictureofacompanyheadingforfinancialtrouble.Whilemeetingcurrentbillsisnotpresentlya
problem,thecompanyhastoomuchdebtandisntearningenoughmoneytomakeitsinterest
paymentscomfortably.Moreover,repaymentofabigloaninafewyearswillputacashstrainon
thecompany.
What,then,doesthefutureholdforTheCollegeShop?Itdepends.Ifthecompanyreturnstoyear
1levelsofgrossmargin(whenitmade$0.45oneach$1.00ofsales),andifitcanincreaseitssales
volume,itmightgenerateenoughcashtoreduceitslongtermdebt.Butifthesecondyeardecline
inprofitabilitycontinues,itwillrunintofinancialdifficultyinthenextfewyears.Itcouldevenbe
forcedoutofbusinesswhenthebankdemandspaymentonitslongtermloan.

Key Takeaways
Twocommontechniquesforevaluatingacompanysfinancialperformancearevertical
percentageanalysisandratioanalysis.
Verticalpercentageanalysisrevealstherelationshipofeachitemontheincomestatement
toaspecifiedbasegenerallysalesbyexpressingeachitemasapercentageofthat
base.
Thepercentageshelpyoutoanalyzechangesintheincomestatementitemsovertime.
Ratiosshowtherelationshipofonenumbertoanothernumberforexample,grossprofit
tosalesornetprofittototalassets.
Ratioanalysisisusedtoassessacompanysperformanceandfinancialconditionover
timeandtocompareonecompanytosimilarcompaniesortoanoverallindustry.
Ratioscanbedividedintofourcategories:profitmarginratios,managementefficiency
ratios,managementeffectivenessratios,anddebttoequityratios.
Profitmarginratiosshowhowmuchofeachsalesdollarisleftaftercertaincostsare
covered.
Twocommonprofitabilityratiosarethegrossprofitmargin(whichshowshowmuchof

eachsalesdollarremainsafterpayingforthegoodssold)andnetprofitmargin(which
showshowmuchofeachsalesdollarremainsafterallcostsarecovered).
Managementefficiencyratiostellyouhowefficientlyyourassetsarebeingmanaged.
Oneoftheratiosinthiscategoryinventoryturnovermeasuresafirmsefficiencyin
sellingitsinventorybylookingattherelationshipbetweensalesandinventory.
Managementeffectivenessratiostellyouhoweffectivemanagementisatrunningthe
businessandmeasureoverallcompanyperformancebycomparingnetprofittosome
measureoftheamountofcapitalusedinthebusiness.
Thereturnonassetsratio,forinstance,comparesnetprofittototalassetsto
determinewhetherthecompanygeneratedareasonableprofitontheassetsinvested
init.
Financialconditionratiosareusedtoassessafirmsfinancialstrength.
Thecurrentratio(whichcomparescurrentassetstocurrentliabilities)providesa
measureofacompanysabilitytomeetcurrentliabilities.
Thedebttoequityratioexaminestheriskinessofacompanyscapitalstructureby
lookingattheamountofdebtthatithasrelativetototalequity.
Finally,theinterestcoverageratio(whichmeasuresthenumberoftimesafirms
operatingincomecancoveritsinterestexpense)assessesacompanysabilitytomake
interestpaymentsonoutstandingdebt.

Exercises
1. (AACSB)Analysis
Theaccountantformycompanyjustranintomyofficeandtoldmethatourgrossprofit
marginincreasedwhileournetprofitmargindecreased.Shealsoreportedthatwhileour
debttoequityratioincreased,ourinterestcoverageratiodecreased.Shewaspuzzledby
theapparentinconsistencies.Helpheroutbyprovidingpossibleexplanationsforthe
behavioroftheseratios.
2. Whichcompanyismorelikelytohavethehigherinventoryturnoverratio:agrocerystore
oranautomobilemanufacturer?Giveanexplanationforyouranswer.

The Profession: Ethics and Opportunities


Learning Objectives
1. Understandwhyitsnotagoodideatofalsifyfinancialstatements.
2. AppreciatethebackgroundbehindstricterlegalandprofessionalstandardsinU.S.
businessandaccountingpractice.

3. Understandethicsandtheirimportanceintheaccountingprofession.
4. Identifycareeropportunitiesinaccounting.

Accountant, Audit Thyself?


Considerthefollowingscenario.Youfeelgoodthatyouvemanagedtocreaterelevant,accurate,
timelyfinancialstatementsforyourfirstyearinbusinessasTheCollegeShop,butyoufindthat
youredisappointedaboutonethingyournetincomefigure.Forsometimenow,youvebeen
tryingtoconvinceafriendtoinvestinTheCollegeShop,tellinghimthatthebusinesswouldbringin
atleast$40,000inincomeduringitsfirstyear.Everytimeyoureviewtheincomestatementin
Figure12.15,IncomeStatementforTheCollegeShop,YearEndedDecember31(shownin
abbreviatedformbelow),however,youreforcedtofacethefactthatyouearnedjust$30,000
$10,000shortofyouroptimisticprojection.
RevenuesExpenses(CGS,operatingexpenses,interestandtaxes)=Netincome
$500,000$470,000=$30,000
Asyoustareonemoretimeatyourbottomline,yourewishingthattherewassomewaytochange
thatsinglebothersomedigitandtransform$30,000into$40,000.Thenithitsyou.Youknowthatits
notexactlythemostuprightthingtodo,butwhatifyouweretoshifthalfofyourfirstyear
advertisingexpenseof$20,000intoyoursecondyearofoperation?Ifyoudidthat,thenyoudcut
theadvertisingexpenseonyourfirstyearincomestatementby$10,000.Now,withyournewly
acquiredunderstandingofaccountingprinciples,youknowthatifyoureduceexpensesonyour
incomestatementby$10,000,yournetincomewillincreasebythesameamount.Sojusttosee
whatyourrevisedincomestatementwouldlooklike,yougoaheadandmakeyourhypothetical
change.Sureenough,missionaccomplished:Yourincomestatementnowreportsanetincomeof
$40,000youractualnetincomeof$30,000plusyourupwardadjustmentof$10,000.
RevenuesExpenses(CGS,operatingexpenses,interestandtaxes)=Netincome
$500,000$460,000=$40,000
Althoughyounowfeelevenmoresatisfiedthaneverwithyournewfoundexpertiseinaccounting
strategy,youreonceagainforcedtostopandthink.Ifyoumerelychangeyournetincomeand
nothingelse,thebalancesheetinFigure12.17,EndofYearBalanceSheetforTheCollegeShop
wontbalanceanymore.Whynot?Becausewhenyouinflatedyournetincometo$40,000and
addedittoyourbeginningownersequitybalanceof$150,000,thisincreasedyourownersequity
by$10,000from$180,000to$190,000.Tomakesurethatyouveaccuratelyassessedthesnag
inyourstrategy,youplugintheaccountingequation
assets=liabilities+ownersequity
andthis,unfortunately,iswhatyouget:
$360,000$180,000+$190,000.
So,nowwhat?Asyouponderthetroublesomeramificationsofyourbalancesheet,yetanother
accountingstrategypopsintoyourhead.Attheendoftheyear,youstillowed$6,000forradioads
and$4,000fornewspaperads$10,000thatsincludedinaccountspayableonyouryearend

balancesheet.Whatifyoujustreducedyouraccountspayablebalanceby$10,000?Ifyoudid
that,youdalsoreduceby$10,000theamountunderliabilitiesandownersequity,cuttingitfrom
$370,000to$360,000.Wouldntthatmakeeverythingbalance?Plugginginthenumbersfromyour
latestbrainstorm,younowget:
$360,000=$170,000+$190,000.
Thatsmorelikeit.Nowyoucangoaheadandadjustyourfinancialstatements,satisfiedthat
yourewellonyourwaytomasteringalloftheaccountingstrategythatyoullneedtohandlethe
financialreportingneedsofyournewbusiness.

Accounting Strategy, Ethics, and the Law


Unfortunately,youmayalsobewellonyourwaytobecomingtheBernieEbbersofthesmall
businessset.In2002,whenthegianttelecomcompanyWorldComcollapsedundertheweightofan
$11billionfraudscheme,CEOEbbers,whowasconvictedofsecuritiesfraudandconspiracy,got
twentyfiveyearsinafederalpenitentiary(Idontknowaccounting,hetoldthejudge).AndEbbers
wasnttheonlypersonontheWorldCompayrollwhowaschargedwithillegalactivities:Accounting
departmentmanagerswentdownwithhim.BettyVinson,forexample,afortysevenyearold
midlevelaccountantwhodfollowedorderstofalsifyaccountingrecords,wassentencedtofive
monthsinjail.Andshewasluckyshegotminimaljailtimebecauseshecooperatedwithfederal
prosecutors.[491]
ThedamagedoneatWorldComspreadtoinnocentemployeesaswell,nottomentioninvestors,
creditors,andbusinesspartners.In2001,whenEnron,theseventhlargestcompanyinAmerica,
melteddownintheheatofaninvestigationintoitsfinancialreportingpractices,ittookdownan
entireaccountingfirmwithiteightynineyearoldArthurAndersen,thenoneoftheBigFive
publicaccountingfirms.Volumeshavebeenwrittenaboutwhatwentwrong,butwecanprettymuch
boilitdowntothis:Enronexecutivesbehavedunethicallyandillegally,andAndersen
auditorslookedtheotherway.Insteadofperformingitsroleaspublicwatchdog,Andersenwas
watchingitsownpocketbook:Theaccountingfirmprotectedtherevenuesgeneratedbylucrative
consultingcontractswithitsclientinsteadofprotectingtheclientsstakeholders.Insodoing,
Andersennotonlyshirkeditsresponsibilitiesasapublicauditorbutalsocoveredupevidenceofits
owninappropriateactions.
In2002,AndersengaveupitslicensestopracticeascertifiedpublicaccountantsintheUnited
States,andacompanythathademployed85,000peopleonly10yearsearliernowemploysabout
200,mostofthemtodealwithlawsuitsandtooverseetheprocessofshuttingdownthecompany
forgood.[492]

Who Can You Trust?


Inaveryrealsense,theissueatthebottomofallthisfinancialmisconductistrustworthiness.As
weveseen,accountantsaresupposedtoprovideuserswithfinancialreportsthatareuseful
becausetheyrerelevant,timely,and,mostimportant,accurate.Itshouldgowithoutsayingthatif
userswhetherinternalorexternalcanttrustthesereportstobeaccurate,theycantrelyon
themtobeasusefulastheyshouldbe.Wouldyou,forinstance,investinorloanmoneytoa
companywhosefinancialreportsyoucanttrust?
Whichappropriatelybringsusbacktoyouandyourlittleforayintofalsifyingaccountingrecords.

LetssaythatinFebruaryofyoursecondyearofoperations,youhaveanunexpectedopportunityto
expandintothevacatedstorerightnexttoTheCollegeShop.Itstoogoodtopassup,butyoull
needquiteabitofmoneytooutfitthespaceandexpandyourinventory.First,yougotothefriend
forwhosebenefityouadjustedyourfinancialstatements,buthesjustlostabundleinthestock
marketandcanthelpyouout.Youronlyoption,then,istogetabankloan.Soyougotoyour
banker,andsomeversionofthefollowingexchangeoccursearlyintheconversation:

YOU:

Ineedaloan.

BANKER:

Letmeseeyourfinancialstatements.

Shemeans,ofcourse,thefirstyearstatementsthatyoufalsified,andifyoureofferedandaccepta
loanunderthesecircumstances,youcouldbeguiltyofafinancialcrimethat,accordingtotheFBI,is
normallycharacterizedbydeceit,concealment,orviolationoftrustandcommittedtoobtain
personalorbusinessadvantage.Themaximumyoucouldgetunderfederallawistwentyyears,
althoughyourcasenodoubtcallsforasentencemeasuredinmeremonths.[493]

Are You Ethical?


Wecouldgiveyouthebenefitofthedoubtandagreethatyouwouldnthavegottenyourselfintothis
messhadyouknownthelegalramifications.Wemustassume,however,thatyouknewwhatyou
didwasethicallywrong.Ethicsreferstotheabilityandwillingnesstodistinguishrightfromwrong
andtoknowwhenyouredoingoneortheother.Ethicalandtrustworthybehavioriscriticalinboth
businessandaccounting,andalthoughthevastmajorityofbusinesspeopleandaccountants
behaveethically,allofthemespeciallyprovidersoffinancialinformationconstantlyfaceethical
dilemmasinthecourseoftheirwork.

Sarbanes-Oxley Act (SOX)


Itwillbehelpfultorememberthatboththelawandtheaccountingprofessionhavetakenstepsto
remindyouofyourresponsibilitieswhenyourereportingfinancialinformation.Inthewakeof
corporatescandalsliketheoneswedescribedabove,CongresspassedtheSarbanesOxleyAct
(SOX)of2002,whichwasdesignedtoencourageethicalcorporatebehaviorandtodiscourage
fraudandotherformsofcorporatewrongdoing.Amongotherthings,SOXrequiresitstop
executivestotakeresponsibilityforacompanysfinancialstatementsandsubjectsthemtocriminal
penaltiesforfalselycertifyingitsfinancialreports.SOXalsosetupthePublicCompanyAccounting
OversightBoard(PCAOB)toregulateaccountingprofessionals,especiallyintheareaofauditing
standards.

The Professions Code of Ethics


Finally,youcanalwaysturntotheCodeofProfessionalEthicsoftheAmericanInstituteofCertified
PublicAccountants(AICPA),whichsetsdowntwohallmarksofethicalbehavior:[494]
Integrity.Anaccountantshouldbehonestandcandidandshouldneversubordinatethe
publictrusttopersonalgainandadvantage.

Objectivityandindependence.Anaccountantshouldbeimpartial,intellectuallyhonest,and
freeofconflictsofinterest.Heorsheisscrupulousin[the]applicationofgenerallyaccepted
accountingprinciplesandcandidinalldealingswithmembersinpublicpractice.

Careers in Accounting
YoumayknowthatPhilKnightisthefounderofNike.Butyoumaynotknowthathebeganhis
businesscareerasanaccountant.Anotherthingthatyoumaynotknowisthataccountingisa
peopleprofession.Alotofpeoplethinkthataccountantsspendthedaysittingbehinddesks
crunchingnumbers,butthisisaseriousmisconception.Accountantsworkwithotherpeopletosolve
businessproblems.Theyneedstronganalyticalskillstoassessfinancialdata,buttheymustalsobe
abletoworkeffectivelywithcolleagues.Thustheyneedgoodinterpersonalskills,andbecausethey
mustwriteandspeakclearlyandpresentcomplexfinancialdataintermsthateveryonecan
understand,theyneedexcellentcommunicationskillsaswell.

Job Descriptions
Ifyouchooseacareerinaccounting,youhavetwocareeroptions:
Workasapublicaccountant,whetherforaBigFourpublicaccountingfirmorforamidsizeor
smallercompany
Workasaprivateaccountantforabusiness,notforprofitorganization,orgovernmentagency
Letstakeacloserlookattheseoptions.Publicaccountingfirmsprovideclientswithaccountingand
taxservicesinreturnforfees.Mostmembersofsuchfirmsarecertifiedpublicaccountant(CPA)
whohavemeteducationalandworkrequirementssetbythestateandpassedarigorousexam.
Althoughpublicaccountingfirmsofferconsultingandtaxservices,thehallmarkoftheprofessionis
performingexternalaudit:thepublicaccountantexaminesacompanysfinancialstatementsand
submitsanopiniononwhethertheyvebeenpreparedinaccordancewithGAAP.Thisstampof
approvalprovidestheinvestingpublicwithconfidencethatafirmsfinancialreportsareaccurate.
Typically,publicaccountantsareselfemployed,workforsmall,sometimesregionalfirms,orare
associatedwithoneoftheBigFourpublicaccountingfirmsDeloitte&Touche,Ernst&Young,
KPMG,andPricewaterhouseCoopersoroneofthelargesecondtierpublicaccountingfirms,such
asBDOSeidmanorGrantThornton.
Oftencalledmanagementorcorporateaccountants,privateaccountantmayworkforspecific
companies,nonprofitorganizations,orgovernmentagencies.Afirmschiefaccountingofficeris
calledacontroller.Asarule,thecontrollerreportstotheorganizationschieffinancialofficer
(CFO),whosresponsibleforallofitsaccountingandotherfinancialactivities.Thejobsofprivate
accountantsvaryaccordingtothecompanyorindustryinwhichtheyreemployed.Mostprivate
accountantsrecordandanalyzefinancialinformationandprovidesupporttoothermembersofthe
organizationinsuchdiverseareasasmarketing,strategicplanning,newproductdevelopment,
operations,humanresources,andfinance.Privateaccountantsalsoconductinternalaudits.In
thiscapacity,theyensurethataccountingrecordsareaccurate,companypoliciesareadheredto,
assetsaresafeguarded,andoperationsareefficientlyconducted.Finally,theymayalsoprovidea
varietyofspecializedservices:
Developandpreparefinancialreports
Preparetaxreturns

Performcostaccountingfunctions(thatis,determinethecostofgoodsorservices)
Prepareandsupervisebudgets
Managesuchfunctionsaspayroll,accountspayable,andreceivables
Accountantswhopassaspecialexamandmeetotherprofessionalrequirementsinthefieldof
managementaccountingaredesignatedcertifiedmanagementaccountants(CMAs).CMAs
oftenhavegreaterjobresponsibilitiesandreceivehighercompensationthanotheraccountants.

The Job and Its Prospects


So,whatsthejoblike?Forthatmatter,whatstheprofessionallifeofanaccountantlike?Or
perhapsevenmoreimportant,whatareyourprospectsforgettingajobinaccounting,andwhat
kindofincomecanyouexpectifyoureabletomakeacareerforyourselfinthefield?Ifyoure
lookingforacareerthatschallengingandforwhichthedynamicschangeconstantlythenthisis
whereitsat,advisesonepracticingCPA.[495]BeatriceSanders,formerdirectorofAcademicand
CareerDevelopmentfortheAmericanInstituteofCertifiedPublicAccountants,agrees:Whatever
formofpracticeyouchoose,accountingprovidesachallengingandrewardingcareerinwhichthere
arenolimitsonwhereyoucango,orhowfar.[496]

The Job Market Today


Theonegreatbenefitofchoosingaccountingasyourcareeristhatyouwillalwayshaveajob
whenyougraduate.OrsosaysoneaccountantCPA(infact,thesameCPAwhopromisesa
challengingcareerinadynamicprofession).Obviously,wecantmakeanyguarantees,butinorder
tohelpyoubetterassessyourprospectsforasatisfyingcareerinaccounting,wecanofferyou
somerelevantfactsandfigures.
Firstofall,wecanconfirmthataccountinggraduateshavealwaysfacedafavorablejobmarketand
that,accordingtoasurveyconductedbytheNationalAssociationofCollegesandEmployers
(NACE),theyear2010isnodifferent.IntheJuneeditionofitsSalarySurvey,NACEreportedthat
accountingemployersextendedthelargestnumberofofferstonewcollegegraduates.[497]Andwhat
abouttheareathatprobablyinterestsyoumostrightnowsalary?Forthemostpart,wecanreport
goodnews.TheNACEsurvey,forexample,reportsthat,withaveragesalaryoffersofjustover
$50,000,2010accountinggraduatescouldexpecttobeamongthehighestpaidentrantsintothe
workforce.

Key Takeaways
CurrentstatutesandstandardsgoverningU.S.businessandaccountingpracticereflect
publicreactiontoawaveofcorporatemisconductinthe2000s.
Ethicalandtrustworthybehavioriscriticalinaccountingbecauseuserstrustaccountantsto
providefinancialreportsthatarerelevant,timely,and,mostimportant,accurate.
ThefederalSarbanesOxleyAct(SOX)of2002wasdesignedtoencourageethical
corporatebehaviorandtodiscouragefraudandotherformsofcorporatemalfeasance.
TheCodeofProfessionalEthicsoftheAmericanInstituteofCertifiedPublicAccountants
(AICPA)setsdowntwohallmarksofethicalbehavior:integrityandobjectivityand

independence.
Ifyouchooseacareerinaccounting,youhavetwocareeroptions:workasapublic
accountantorworkasaprivateaccountant.
Publicaccountingfirmsprovideclientswithexternalauditsinwhichtheyexaminea
companysfinancialstatementsandsubmitanopiniononwhethertheyvebeenprepared
inaccordancewithGAAP.Theyalsoprovideotheraccountingandtaxservices.
Mostmembersofpublicaccountingfirmsarecertifiedpublicaccountants(CPAs)who
havemetrequirededucationalandworkrequirements.
Privateaccountants,oftencalledmanagementorcorporateaccountants,workfor
specificcompanies,nonprofitorganizations,orgovernmentagencies.
Mostprivateaccountantsrecordandanalyzefinancialinformationandprovidesupportto
othermembersoftheorganization.Theyalsoconductinternalauditsaswellasavariety
ofspecializedservices.
Accountantswhopassaspecialexamandmeetotherprofessionalrequirementsinthe
fieldofmanagementaccountingaredesignatedcertifiedmanagementaccountants
(CMAs).

Exercises
1. Whatisaccountingandwhatpurposedoesitserve?Whatdoaccountantsdo?What
careerchoicesdotheyhave?Whichcareerchoiceseemsmostinterestingtoyou?Why?
2. (AACSB)Analysis
Whatactionshavebeentakentohelprestorethetrustthatthepubliconcehadinthe
accountingprofession?Doyoubelievetheseactionswillhelp?Why,orwhynot?What
othersuggestionsdoyouhavetohelptheaccountingprofessionandcorporateAmerica
regainthepublictrust?

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