BURKS-Instructor Notes-INTRO2BUS-CHAP14-ACCOUNTING

LEARNING OBJECTIVES
1. Explain how the success of a company’s business model can be measured by financial
accounts and describe the various kinds of activities that accountants perform.
2. Analyze a company’s balance sheet and describe how it balances the assets a company
owns against the capital owed to its creditors and stockholders.
3. Explain how the income statement is used to measure a company’s bottom line profit
and the various costs and expenses that must be deducted to arrive at this total.
4. Understand why the need for cash, as well as profit, affects a company’s business
model, and how the cash flow statement measures the cash that flows into and out of a
company.
5. Appreciate how financial ratios can be used to analyze the information in a company’s
financial statements and how they help both managers and investors evaluate a
company’s current and future profitability.

I. THE NATURE OF ACCOUNTING

The primary goal of a company is to make a profit, and it can only do this if the
revenues it earns from the sales of its profits exceed the costs and expenses of making
them. Accounting makes its functional contribution by providing the tools a company
needs to accurately measure its revenues, assets, costs, money, expenses, and capital so
managers can evaluate whether the profit their business model is earning is a profitable
return on the capital invested in it.
1. Accounting is the process of
(a) collecting, measuring and recording raw financial data
(b) organizing this data using agreed-upon accounting rules and methods to create
useful information about a company’s financial performance
(c) analyzing this information and reporting and communicating the results in
financial reports and statements.
2. A company’s accounting system is the financial information system it uses to measure,
record, analyze, and report all the transactions that are involved in its value creation
process.

A. Company Accounting and Stakeholders

The knowledge and information provided by a company’s accounting function is
very important to all of its stakeholders. Financial statements, when compared to other
companies and to its own performance over time, provide insights into the source of a
company’s competitive advantage (or lack of it) and knowledge about the “key drivers”
of success in an industry. It’s important to recognize that accounting provides
information about the past, it may or may not be a good predictor of the future, because
conditions change rapidly and often.
1. Managers at all levels use financial information to analyze performance over 3,6, 9,
and 12 month periods, by breaking down the profitability of products and functions. This
information can be used to improve the profits from particular products, eliminate them,
or invest more in them.
2. Employees can use accounting information to identify ways to improve different
functions through ERP or CRM systems. They are also interested in the general health of
a company for employment security, and because they often own stock or have profit-
sharing programs as part of their compensation.
3. Investors watch a company’s financial information because it affects stock prices.
4. Government agencies such as the SEC and the IRS have a strong interest in a
company’s financial reports and want to assure that it follows legally accepted accounting
standards.
5. The general public is concerned with the general health of companies in the economy
and with their ethical and social responsibility, because they affect the job security,
standard of living, and investments of millions of people.

B. Types of Accounting Activities

Bookkeeping is the process of keeping records of all the financial transactions
involved in making and selling goods and services. Five principle accounting activities
range from those needed to capture the millions of pieces of raw data about all
transactions to preparing financial statements to summarizing overall performance.

1. Recording and managing cash inflows from products sold and cash outflows for
resources purchased, including payroll and payment of gross wages or earnings and the
taxes associated with them. .
2. Measuring and recording cost-of-goods sold through purchase orders for the materials
and parts used to add value to a company’s products, measure the costs of various units,
functions, and departments in the company. Depreciation is the expense method used to
reduce the value of a company’s assets used in production over time.
3. Preparing tax returns and other financial reports for local, state, and federal
governments.
4. Preparing reports on whether a company is meeting goals and objectives on costs,
inventory control, and cash balances.
5. Preparing information and reports of a company’s financial statements that show a
company’s profitability over time, the success of its business model, and its current
financial situation.

C. GAAP Accounting Rules

The generally accepted accounting principles (GAAP) is a set of rules and
procedures developed over time by accounting experts to ensure a clear and accurate
picture of a company’s financial standing. They are legally enforceable and companies or
accountants who break them can be punished with fines and/or imprisonment.
1. The use of GAAP allows stakeholders to evaluate a company’s performance relative to
others.
2. Managers may try to manipulate this information to increase the value of a company’s
stock or prospects, enhancing their own interests. Well-established accounting rules and
guidelines greatly reduce the opportunities for fraudulent behavior.
3. In the U.S., independent accountants are required to review a company’s financial
statements and make a statement that they have been prepared according to GAAP
guidelines, representing a true and fair account of the company’s position.

D. Types of Accountants
Accountants can be divided into two groups: inside or outside (independent)
accountants. Most of them have passed the stringent professional exams developed by the
American Institute of Certified Public Accountants required to become a certified public
accountant (CPA).
1. External accountants work in the Big Four accounting firms such as Ernst & Young or
KPMG, LLP that specialize in auditing large companies or in small independent public
companies or partnerships to provide services to medium or small companies and
individuals.
2. The Sarbanes-Oxley Act, passed in 2002, requires a company’s CEO and CFO, as well
as its external auditors, to sign off that their company’s financial statements accurately
reflect its situation.

3. Internal accountants are employed by a company to scrutinize internal data to ensure

that transactions are properly recorded, accounting rules have been followed, reports are
accurate, that employees are not deliberately defrauding the company, or stealing its
assets.
4. Internal accountants may be either managerial accountants with Certified Managerial
Accountant (CMA) who prepare information for managerial analysis, or Chartered
Financial Analysts (CFA) who prepare financial information for use by outside
stakeholders. Protecting the confidentiality of a company’s business model and
competitive advantage is an important requirement for internal accountants.
5. Managerial accountants may specialize in financial analysis which provides
information for company decisions about the components of its business model such as
product lines and acquisitions, tax accounting, or cost accounting which analyzes costs of
acquisition of materials, inventory, and physical work arrangements.

E. Accounting and ERP Systems

Today, IT software has transformed the way accountants work. They are able to
use ERP, transaction recording, and CRM systems to develop more and better data than
ever before. It can flow freely between different levels, functions, and groups within a
company to provide more useful, timely, and accurate information for decisions that will
add value and profitability.

II. ACCOUNTING CONCEPTS AND FINANCIAL STATEMENTS

The strengths and weaknesses of a company’s business model and its functions
can be identified from information in its financial statements. Managers at all levels need
to understand them and the methods used to prepare them. Investors should be able to
read and analyze them using financial ratios to assess potential future risks and returns.
A. The Balance Sheet
The balance sheet is the summary of the financial condition of a business on the
day at the end of the specific reporting period, such as December 31, 2003. It reports the
main assets, what it owns, and liabilities, what it owes, and its stockholder’s equity, or
what it’s worth. Its purpose is to track the relationship between capital and assets to see
how well a company is using them.
1. Liabilities are the sums of money a company borrows from creditors, which is a
major source of capital to build its business model, including money owed to employees
and suppliers.
2. Stockholder’s equity or equity is the money obtained from its founders and
stockholders over time, and all of the profit that has been retained in its business.
3. Together, liabilities and equity make up the total capital a company has invested in its
business. It is used to buy the assets and resources needed to fund its business model.
4. The Accounting Equation is designed so the two sides balance, to show managers and
investors how their capital is being used. The basic concept is that what a company owns
minus what it owes is what it is worth.
Assets-Liabilities= Owner’s Equity, or
Assets= Liabilities and Owners’ Equity

5. Double-entry bookkeeping involves recording the dual effects of a financial

transaction on a company’s assets and liabilities.
6. Investors are able to evaluate the company’s ability to pay its creditors. Should a
company fail, its creditors are paid in an established order.
7. Assets are listed on the balance sheet in order of liquidity, which measures how fast
they can be converted to cash. Inventory is the stock of finished products on hand and
pre-paid expenses include insurance premiums, rent, salary advances, or equipment
maintenance contracts that have already been paid.
8. Current assets or working assets are constantly used to make products that are sold
to generate revenue and still more cash.
9. Non-current assets include property, plant, and equipment.
10. Liabilities include current liabilities, due in less than one year, and long-term debt
borrowed for more than one year. Total liabilities are listed on the right hand side of the
Balance Sheet.
11. Stockholders’ Equity includes the different types of stock issued, such as preferred,
common, or capital stock, the original stock used to start the company. .
12. Total equity includes the value of all of the capital stock invested and retained
earnings.

B. The Income Statement

Although the balance sheet shows financial status at a given time, it does not
explain how its assets are used. The income statement, or profit and loss statement,
summarizes and reports the results of a company’s profit-making activities in a specific
time period. The “bottom line” on this statement shows profit or loss for the period.
1. The income statement shows
Sales revenue-Expenses= Profit (or loss)
2. To calculate net income, companies deduct the cost of goods sold (COGS) from sales
revenue.
3. The GAAP matching principle requires that the expenses incurred in making and
selling a company’s products be deducted from the revenues generated by the sale of the
company’s products during the same accounting period. The accrual basis of accounting
records income when a company makes a sale or provides a service, not when the
company actually gets paid.
4. Gross profit or gross margin is left after cost of goods sold is deducted.
5. Net profit, the bottom line, is the total profit or earnings that reflect adjustments for
cost of goods sold, all other expenses, interest, and taxes.

C. Statement of Cash Flows

The cash flow statement shows how much cash a company generates during a
period, where it comes from, and how it was used. Cash refers to assets that can be
turned into cash immediately, such as money in checking accounts, stocks and bonds that
can be sold quickly.
1. Cash flows are divided into three basic categories:
a. Cash flows from operating activities
b. Cash flows from investing
c. Cash flows from financing
2. Working capital is the amount of cash left after current liabilities are subtracted from
current assets on the Balance Sheet.
3. Companies may have positive or negative cash flows depending on how they are re-
investing in the business, as well as the success of their operations.

III. ANALYZING A COMPANY’S FINANCIAL STATEMENTS

Financial ratios are measures of a company’s performance and profitability.
They provide useful information to benchmark a company’s performance to study
changing performance over time and to compare a company to others in its industry.
Managers use financial ratios to understand how profitability will be affected by
decisions about pricing, product development, and HRM policies.

A. Liquidity Ratios
Liquidity ratios measure a company’s ability to pay its bills when they are due.
1. Current ratio is a test of solvency that tests ability to pay liabilities due within one
year.
Current assets/Current liabilities = Current Ratio
2. Quick ratio is a more stringent test, excluding inventory.
Cash + Receivables/ Current Liabilities = Quick Ratio

B. Asset Management Ratios

Asset Management Ratios measure how efficiently and effectively managers are using
assets to generate revenue and profit.
1. Inventory turnover ratio measures how quickly it is shipped and sold in a given
period.
Cost of Goods Sold/Inventory = Inventory Turnover

2. Asset turnover measures how well a company’s assets are used to generate sales.
Sales/Total Assets = Asset Turnover

C. Profitability Ratios
Many different profitability ratios are used to relate a company’s performance to
different pieces of financial information such as sales, equity, or total capital to measure
how effectively a company’s business model is generating profit and cash.
1. Gross margin indicates how much of each sales dollar is left after paying the cost of
goods sold.
Gross profit (or COGS)/ Sales X 100 = Gross Margin

Relatively small improvements in gross margin can lead to major increases in the bottom
line.
2. Profit margin or return on sales measures how much profit is generated from sales.
Net Income/Sales X 100 = Return on Sales

3. Return on Equity (ROE or ROI) and Earnings Per Share measure tells managers
how much profit has been earned on each $100 of stockholders’ equity invested in the
business. The higher the Return on Equity, the more a company’s managers are adding to
the value of its owners’ investment, so it is sometimes called Return on Investment.
Net Income/ Owner’s Equity X 100 = Return on Equity

Earning’s per share is another measure used to examine how much profit has been
earned for each share of its stock.
Net Income/ Total Number of Shares = Earnings Per Share

4. Return on Invested Capital (ROIC) is believed by financial analysts to be the best

measure of a company’s profitability. It measures profit for each dollar invested in the
business. The more cash generated, the more efficiently and effectively, it is being used.
Net Income/Total Capital = Return on Invested Capital

D. Changes in the Sporting Goods Industry

The value of financial ratios is to analyze the results within a company and to
compare it to that of its competitors.

How could it improve earnings?

REVIEW OF LEARNING OBJECTIVES

1. Explain how the success of a company’s business model can be measured by

financial accounts and describe the various kinds of activities that accountants
perform.
The primary goal of a company is to make a profit, and it can only do this if the
revenues it earns from the sales of its profits exceed the costs and expenses of making
them. Accounting makes its functional contribution by providing the tools a company
needs to accurately measure its revenues, assets, costs, money, expenses, and capital so
managers can evaluate whether the profit their business model is earning is a profitable
return on the capital invested in it. Accounting activities include (a) collecting, measuring
and recording raw financial data; (b) organizing this data using agreed-upon accounting
rules and methods to create useful information about a company’s financial performance;
(c) analyzing this information and reporting and communicating the results in financial
reports and statements.

2. Analyze a company’s balance sheet and describe how it balances the assets a
company owns against the capital owed to its creditors and stockholders.
The balance sheet is the summary of the financial condition of a business on the
day at the end of the specific reporting period, such as December 31, 2003. It reports the
main assets, what it owns, and liabilities, what it owes, and its stockholder’s equity, or
what it’s worth. Its purpose is to track the relationship between capital and assets to see
how well a company is using them. The basic equation of accounting is what a company
owns minus what it owes is what it is worth., or Assets – Liabilities = Owners’ Equity

3. Explain how the income statement is used to measure a company’s bottom line
profit and the various costs and expenses that must be deducted to arrive at this
total.
The income statement, or profit and loss statement, summarizes and reports the
results of a company’s profit-making activities in a specific time period. The “bottom
line” on this statement shows profit or loss for the period. To calculate net income,
companies deduct the cost of goods sold (COGS) from sales revenue. Gross profit or
gross margin is left after cost of goods sold is deducted. Net profit, the bottom line, is the
total profit or earnings that reflect adjustments for cost of goods sold, all other expenses,
interest, and taxes. The income statement shows
Sales revenue-Expenses= Profit (or loss)

4. Explain why the need for cash, as well as profit, affects a company’s business
model, and how the cash flow statement measures the cash that flows into and out of
a company.
A company’s business model requires both profit and cash flow objectives to
ensure its long-term and short-term survival. It needs cash to pay its bills and invest in
new materials, labor, and other resources on a regular basis. The statement of cash flows
shows how much a company generates during a specific period, where it came from, and
how it was used.

5. Explain how financial ratios can be used to analyze the information in a

company’s financial statements and how they help both managers and investors
evaluate a company’s current and future profitability.
Financial ratios are measures of a company’s performance and profitability. They
provide useful information to benchmark a company’s performance to study changing
performance over time and to compare a company to others in its industry. Managers use
financial ratios to understand how profitability will be affected by decisions about
pricing, product development, and HRM policies.