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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.
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.
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.
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?
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.
decisiontimeforConnie:Sheknowsthatthesurvivalrateforstartupsisntverygood,andbefore
takingthenextstep,shedliketogetabetterideaofwhethershesactuallydoingwellenoughto
justifytherisk.Asyoucansee,shehasseveralpertinentquestions.WearentprivytoConnies
finances,butwecantellherhowbasicfinancialstatementswillgivehersomeanswers.[489]
Figure12.4.WhatConnieWantstoKnow
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).
Figure12.5.IncomeStatementforStressBusterCompany
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.
Mostcompaniespreparefinancialstatementsonatwelvemonthbasisthatis,forafiscalyear
whichendsonDecember31orsomeotherlogicaldate,suchasJune30orSeptember30.Whydo
fiscalyearsvary?Acompanygenerallypicksafiscalyearenddatethatcoincideswiththeendofits
peaksellingperiodthusacrabmeatprocessormightenditsfiscalyearinOctober,whenthecrab
supplyhasdwindled.Mostcompaniesalsoproducefinancialstatementsonaquarterlyormonthly
basis.ForStressBuster,youllwanttoprepareamonthlybalancesheet.
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
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).
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.
credit,maintainaninventoryofgoodstobesold,retainassetsforuseoveranextendedperiodof
time,borrowmoneyandpayinterestonit,anddealwithavarietyofexpensesthatyoudidnthave
before(rent,insurance,etc.).
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
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.
beforetaxes.Thisamountof$10,000($40,00025%)appearsonyourincomestatementafter
thesubheadingnetincomebeforeincometaxes.Itssubtractedfromincomebeforeincome
taxesbeforeyouarriveatyourbottomline,ornetincome.
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).
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?
Learning Objective
1. Evaluateacompanysperformanceusingfinancialstatementsandratioanalysis.
Nowthatyouknowhowfinancialstatementsareprepared,letsseehowtheyreusedtohelp
owners,managers,investors,andcreditorsassessafirmsperformanceandfinancialstrength.You
cangleanawealthofinformationfromfinancialstatements,butfirstyouneedtolearnafewbasic
principlesforunlockingit.
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.
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.
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?
Yourealizethatadecliningnetprofitmarginisntgood,butyouwonderhowyoucomparewithyour
industry.Alittleresearchinformsyouthataveragenetprofitmarginintheindustryis7percent.You
performednearlyaswellastheindustryinyear1butfellfurtherfromyourtargetinyear2.What
doesthisinformationtellyou?Thatagoalforyear3shouldbetryingtoincreaseyournetprofit
margin.
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.
Becausetheindustryaveragereturnonassetsis7.9percent,TheCollegeShopgetsanAforits
firstyearsperformance.ItslippedinthesecondyearbutisprobablystillintheBrange.
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.
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.
3. Understandethicsandtheirimportanceintheaccountingprofession.
4. Identifycareeropportunitiesinaccounting.
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.
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]
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.
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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