Intro to Business - Ch 8: Accounting: Decision Making by the Numbers

Accounting: Who Does It? (8-1b)

Accountants work in a variety of positions to provide all of this information. Let's take a quick look at some of the roles accountants play: - Public accountants provide services such as tax preparation, external auditing (a process described later in the chapter), and management consulting to clients on a fee basis. - Management accountants work within a company and provide analysis, prepare reports, and financial statements, and assist managers in their own organization. Internal auditors also work within their organizations to detect internal problems such as waste, mismanagement, embezzlement, and employee theft. - Government accountants perform a variety of accounting functions for local, state, or federal government agencies. Some ensure that the government's own tax revenues and expenditures are recorded and reported in accordance with regulations and requirements. Others work for the IRS to audit tax returns or for other government agencies, such as the SEC or FDIC, to help ensure that our nation's banks and other financial institutions comply with the rules and regulations governing their behavior. Many jobs performed by accountants require expertise in complex subject areas. For this reason, accountants who want to move up in their profession often seek certification in a particular field. Becoming a CPA is a lot of work, you need: - 150 semester hours (5 years) of college - Pass a rigorous two-day, four-part exam (very few candidates pass all four parts on their first try) - Must complete at least one year of direct work experience in the field of accounting. Individuals seeking to become certified management accountants or certified fraud examiners must satisfy similarly challenging requirements.

Checking Out the Notes to Financial Statements: What's in the Fine Print? (8-4b)

Besides the usual notes that reports changes and differences that are notable to make, another important source of information is the section of the annual report usually titled "Management's Discussion and Analysis". As its name implies, this is where the top management team provides its take on the financial condition of the company. SEC guidelines require top management to disclose any trends, events, or risks likely to have a significant impact on the firm's financial condition in this section of the report.

Financial Accounting: Intended for Those on the Outside Looking In (8-2)

Financial accounting: the branch of accounting that prepares financial statements for use by owners, creditors, suppliers, and other external stakeholders These stakeholders are seldom interested in poring over detailed accounting information about the individual departments or divisions within a company. Instead, they're interested in the financial performance of the firm as a whole. They often want to know how a firm's financial condition has changed over a period of several years, or to compare its results to those of other firms in the same industry.

Budgeting: Planning for Accountability (8-5)

Management accountants also play an important role in the development of budgets. Budgeting is a management tool that explicitly shows how a firm will acquire and allocate the resources it needs to achieve its goals over a specific time period. If done well, budgeting: - Helps managers clearly specify how they intend to achieve the goals they set during the planning process. - Encourages communication and coordination among managers and employees in various departments within the organization. - Serves as a motivational tool. Good budgets clearly identify goals and demonstrate a plan of action for acquiring the resources need to achieve them. - Helps managers evaluate progress and performance. Managers can compare actual performance to budgeted figures to determine whether various departments and functional areas are making adequate progress toward achieving their organization's goals.

Inside Intelligence: The Role of Managerial Accounting (8-6 heading)

Managerial (or management) accounting: The branch of accounting that provides reports and analysis to managers to help them make informed business decisions. As its name implies, this branch of accounting is designed to meet the needs of a company's managers, though in recent years many firms have empowered other employees and given them access to some of this information as well. (View Exhibit 8.5 on pg. 144 to view the comparisons between financial and managerial accounting) It is impossible to describe all the functions performed by managerial accountants in a single chapter, but two functions will be selected and described below.

Financial Statements: Read All About Us (8-3)

One of the major responsibilities of financial accounting is the preparation of three basic financial statements: the balance sheet, income statement, and statement of cash flows. Taken together, these three financial statements provide external stakeholders with a broad picture of an organization's financial condition and its recent financial performance.

Looking for Trends in Comparative Statements (8-4c)

The SEC requires publicly traded corporations to provide comparative financial statements. This simply means that the balance sheet, income statement, and statement of cash flows must list two or more years of figures side by side, making it possible to see how account values have changed over a period of time. Using comparative statements to identify changes in key account values over time is called horizontal analysis (analysis of financial statements that compares account values reported on these statements over two or more years to identify changes and trends).

The Balance Sheet: What We Own and How We Got It (8-3a)

The balance sheet summarizes a firm's financial position at a specific point in time. It identifies and reports the value of the firm's assets, liabilities, and owner's equity. Through the balance sheets of different firms vary in specifics, all of them are organized to reflect the most famous equation in all of accounting--so famous that it is usually referred to simply as the accounting equation: Assets = Liabilities + Owner's Equity The logic behind the accounting equation is based on the fact that firms must finance the purchase of their assets, and owners and nonowners are the only two sources of funding.

Being Flexible: Clearing Up Problems with Static (8-5c)

The budget process, as described so far, results in a static budget, meaning that it is based on a single assumed level of sales. The problem with a static budget is that real-world sales can (and often do) vary considerably from their forecasted value--often for reasons that aren't under the control of the firm's management. One common way managerial accountants avoid this problem is to develop a flexible budget for control purposes. It is developed over a range of possible sales levels, and is designed to show the appropriate budgeted level of costs for each different level of sales. This flexibility enables managers to make more meaningful comparisons between actual costs and budgeted costs.

Developing the Key Budget Components: One Step at a Time (8-5b)

The budgeting process actually requires the preparation of several different types of budgets. But all of these individual budgets can be classified into two broad categories: operating budgets and financial budgets.

Interpreting Financial Statements: Digging Beneath the Surface (8-4 heading)

The financial statements we've just described contain a lot of important information. But they don't necessarily tell the whole story. In fact, the numbers they report can be misleading if they aren't put into proper context. Thus, in addition to looking at the statements, it's also important to check out the independent auditor's report and read the management discussion and footnotes that accompany these statements. It's also a good idea to compare the figures reported in current statements with those from earlier statements to see how key account values have changed.

The Income Statement: So, How Did We Do? (8-3b)

The income statement (the financial statement that reports the revenues, expenses, and net income that resulted from a firm's operations over an accounting period) summarizes the financial results of a firm's operations over a given period of time. Another name for the income statement is the profit and loss statement (or informally, the P&L). Just as with the balance sheet, we can use a simple equation to illustrate the logic behind the organization of the income statement: Revenue - Expenses = Net Income In this equation: - Revenues: represents the increase in the amount of cash and other assets (such as accounts receivable) the firm earns in a given time period as the result of its business activities. A firm normally earns revenue by selling goods or by charging fees for services (or both). - Accrual-basis accounting: the method of accounting that recognizes revenue when it is earned and matches expenses to the revenues they helped produce. - It is important to realize that this is not always when the firm receives cash from its sales. For example, if a firm sells goods on credit, it reports revenue before it receives cash. (The revenue would show up initially as an increase in accounts receivable rather than as an increase in cash.) - Expenses: indicates the cash a firm spends, or other assets it uses up, to carry out the business activities necessary to generate its revenue. - Under accrual-basis accounting, expenses aren't necessarily recorded when cash is paid. Instead, expenses are matched to the revenue they help generate. - Read pg. 135 for more info about expenses.

The Statement of Cash Flows: Show Me the Money (8-3c)

The last major financial statement is the statement of cash flows (the financial statement that identifies a firm's sources and uses of cash in a given accounting period). A firm must have enough cash to pay what it owes to workers, creditors, suppliers, and taxing authorities--hopefully, with enough left to pay a dividend to its owners! Cash flow statements commonly begin with net income. Why? Because it represents an increase (or decrease in the case of a loss) to the cash available to the company. The statement of cash flows identifies the amount of cash that flowed into and out of the firm from three types of activities: 1. Cash flows from operating activities 2. Cash flows from investing activities 3. Cash flows from financing activities

Preparing the Budget: Top-Down or Bottom-Up? (8-5a)

There are two broad approaches to budget preparation: 1. Top-down budgeting: Top management prepares the budget with little or no input from middle and supervisory managers 2. Bottom-up (or participatory) budgeting: Organizations allow middle and supervisory managers to participate actively in the creation of the budget. Proponents of this approach maintain that it has two major advantages. First, middle and supervisory managers are likely to know more about the issues and challenges facing their departments--and the resources it will take to address them--than top management. Second, middle and first-line managers are likely to be more highly motivated to achieve budgetary goals when they have a say in how those goals are developed. On the negative side, the bottom-up approach is more time-consuming and resource-intensive to carry out than the top-down approach. Also, some middle managers may be tempted to overstate their needs or set low-budget goals in order to make their jobs easier--an outcome known as budgetary slack.

Cost Concepts: A Cost for All Reasons (8-6a)

Without good information on costs, managers would be operating in the dark as they try to set prices, determine the most desirable mix of products, and locate areas where efficiency is lagging. Accountants define cost as the value of what is given up in exchange for something else.

Out-of-pocket costs (8-6a)

a cost that involves the payment of money or other resources E.g. the wages a company pays to its workers, the payments it makes to suppliers for raw materials, and the rent it pays for office space

Master budget (8-5b)

a presentation of an organization's operational and financial budgets that represents the firm's overall plan of action for a specified time period

qualified opinion (8-4a)

a report issued when the auditor believes that the overall financial statements are fairly stated but that either the scope of the audit was limited or the financial data indicated a failure to follow GAAP

adverse opinion (8-4a)

a report issued when the auditor believes the financial statements are so materially misstated or misleading as a whole that they do not present fairly the entity's financial position or the results of its operations and cash flows in conformity with GAAP An adverse opinion must include an explanation of the specific reasons for the opinion. Adverse opinions are very rare, so when an auditor renders one, it should set off alarm bells, warning stakeholders to view the information in the firm's financial statements with real skepticism. For CPA firms to perform audits with integrity, they must be independent of the firms they audit.

Accounting (8-1)

a system for recognizing, organizing, analyzing, and reporting information about the financial transactions that affect an organization

Activity-based costing (ABC) (8-6b)

a technique to assign product costs based on links between activities that drive costs and the production of specific products This approach is more complex and difficult to implement than the direct labor method (where the amount of direct labor used to produce a product dictates its cost). Basically, activity-based costing involves a two-stage process. - The first stage is to identify specific activities that create indirect costs, and then determine the factors that "drive" the costs of these activities. - The second stage is to tie these cost drivers to the production of specific goods (or other cost objects). - Once the relationships between cost drivers and specific products are identified, they can be used to determine how much of each indirect cost is assigned to each product.

Financial budgets (8-5b)

budgets that focus on the firm's financial goals and identify the resources needed to achieve these goals The two main financial budget documents are the cash budget and the capital expenditure budget. Cash budget: identifies short-term fluctuations in cash flows, helping managers identify times when the firms might face cash flow problems--or when it might have a temporary surplus of cash that it could invest. Capital expenditure budget: Identifies the firm's planned investments in major fixed assets and long-term projects. The information from these two financial budgets and the budgeted income statement are combined to construct the budgeted balance sheet (it shows how the firm's operations, investing, and financing activities are expected to affect all of the asset, liability, and owners' equity accounts).

Liabilities (8-3a)

claims that outsiders have against a firm's assets Balance sheets usually organize liabilities into two broad categories: 1. Current liabilities: debts that come due within a year of the date on the balance sheet. 2. Long-term liabilities: debts that don't come due until more than a year after the date on the balance sheet.

Indirect costs (8-6b)

costs that are the result of a firm's general operations and are not directly tied to any specific cost object E.g. plant maintenance, quality control, or depreciation on office equipment Unfortunately, indirect costs aren't tied in such a simple and direct way to the production of a specific product.

Fixed costs (8-6a)

costs that remain the same when the level of production changes within some relevant range E.g. interest on a bank loan, property insurance premiums, rent on office space, and other payments that are set by a contract or by legal requirements

Variable costs (8-6a)

costs that vary directly with the level of production E.g. payments for many types of labor, supplies, and utilities

Assets (8-3a)

resources owned by a firm Balance sheets usually classify assets into at least two major categories: 1. Current assets: consists of cash, and other assets that the firm expects to use up or convert into cash within a year. 2. Property, plant, and equipment: It lists the value of the company's land, buildings, machinery, equipment, and other long-term assets. With the exception of land, these assets have a limited useful life, so accountants subtract accumulated depreciation from the original value of these assets, to reflect the fact that these assets are being used up over time. 3 (extra). Intangible assets: Some companies lists a third category of assets called intangible assets. These are assets that have no physical existence--you can't see or touch them--but they still have value. E.g. Patents, copyrights, trademarks, and even the goodwill a company develops with its stakeholders

Cash flows from financing activities (8-3c)

the cash the firm received from issuing additional shares of its own stock or from taking out short-term and long-term loans E.g. paying off short-term loans (cash flowed out), getting cash from long-term bank loans (cash inflow increased), payments of dividends to shareholders (cash flowed out), repurchased shares of McDonald's stock (cash flowed out)

Owners' (or Stockholders') equity (8-3a)

the claims a firm's owners have against their company's assets (often called "stockholders' equity" on balance sheets of corporations) The specific accounts listed in the owners' equity section of a balance sheet depend on the form of business ownership. For corporations like McDonald's, the owners' equity is usually titled stockholders' equity. Also notice that retained earnings, which are the accumulated earnings reinvested in the company (rather than paid to owners), are another major component of the owners' equity section.

Net income (8-3b)

the difference between the revenue a firm earns and the expenses it incurs in a given time period If net income is: Positive - the firm has earned a profit Negative - the firm has suffered a loss Net income is called the "bottom line" because it is such an important measure of the firm's operating success.

Implicit costs (8-6a)

the opportunity cost that arises when a firm uses owner-supplied resources E.g. Suppose a couple of lawyers form a partnership and set up their office in a building one of the partners already owns. They feel good about their decision because they don't have to make any out-of-pocket payments for rent. But a good managerial accountant would point out to the partners that they still incur an implicit cost, because by using the building themselves they forgo the opportunity to earn income by renting the office space to someone else.

Financial Accounting Standards Board (FASB) (8-2a)

the private board that establishes the generally accepted accounting principles used in the practice of financial accounting The board consists of seven members appointed by the Financial Accounting Foundation. Each member serves a five-year term and can be reappointed to serve one additional term. In order to preserve independence and impartiality, the members are required to sever all ties with any firms or institutions they served prior to joining the board. Through GAAP, the FASB aims to ensure that financial statements are: - Relevant: They must contain information that helps the user understand the firm's financial performance and condition - Reliable: They must provide information that is objective, accurate, and verifiable. - Consistent: They must provide financial statements based on the same core assumptions and procedures over time; if a firm introduces any significant changes in how it prepares its financial statements, GAAP requires it to clearly identify and describe these changes. - Comparable: They must present accounting statements in a reasonably standardized way, allowing users to track the firm's financial performance over a period of years and compare its results with those for other firms

International Ethics Standards Boards for Accountants (IESBA) (8-4a)

"The standards clarify that professional accountants must be active and not turn a blind eye to noncompliance. It's trying to bring about early, early detection, if you will, but also early action by management or authorities".

Accounting: Who Uses It? (8-1a)

- Managers: Marketing managers, for instance, need information about sales in various regions and for various product lines. Financial managers need up-to-date facts about debt, cash, inventory, and capital - Stockholders: As owners of the company, most stockholders have a keen interest in its financial performance, especially as indicated by the firm's financial statements. Has management generated a strong-enough return on their investment? - Employees: Strong financial performance would help employees make their case for nice pay raises and hefty bonuses. But if earnings drop--especially multiple times--layoffs might be in the offing, so many employees might decide to polish their resumes. - Creditors: The late, great comedian Bob Hope once defined a bank as a place that would only lend you money if you could prove you didn't really need it. That's a bit of an exaggeration, but it is true that before granting a loan, responsible bankers and other lenders want to assess a firm's creditworthiness by looking at its financial statements. - Suppliers: Like bankers, companies that provide supplies want to know that the company can pay for the orders it places. - Government agencies: Accurate accounting information is crucial for meeting the reporting requirements of the Internal Revenue Service (IRS), the Securities and Exchange Commission (SEC), and other federal and state agencies.

Ethics in Accounting (8-2b)

Even clear and well-established accounting principles won't result in accurate and reliable information if managers and accountants don't use them. Example on pg. 132

Assigning Costs to Products: As (Not So) Simple as ABC? (8-6b)

Finally, accountants often want to assign costs to specific cost objects, such as one of the goods or services their firm produces. When they assign costs to specific cost objects, accountants distinguish between direct costs and indirect costs.

Other Statements: What Happened to the Owners' Stake (8-3d)

In addition to the three major statements just described, firms usually prepare either a statement of retained earnings or a stockholders' equity statement. - The statement of retained earnings is a simple statement that shows how retained earnings have changed from one accounting period to the next. - The change in retained earnings is found by subtracting dividends paid to shareholders from net income. - Firms that have more complex changes in the owners' equity section sometimes report these changes in notes to the financial statements in the annual report. But they often disclose these changes by providing a stockholder's equity statement. - Similar to the statement of retained earnings, this statement shows how net income and dividends affect retained earnings. But it also shows other changes in stockholders' equity, such as those that arise from the issuance of additional shares of stock.

Role of the Financial Standards Accounting Board (8-2a)

To reduce confusion (and frustration) and provide external stakeholders with consistent and accurate financial statements, the accounting profession has adopted a set of generally accepted accounting principles (GAAP) (a set of accounting standards that is used in the preparation of financial statements) that guide the practice of finance accounting.

The Independent Auditor's Report: Getting a Stamp of Approval (8-4a)

U.S securities laws require publicly traded corporations in the United States to have an independent CPA firm (an accounting firm that specializes in providing public accounting services) perform an annual external audit of their financial statements. And many companies that aren't publicly traded also obtain external audits even though they aren't legally required to do so. The purpose of an audit is to verify that a company's financial statements were properly prepared in accordance with GAAP and fairly present the financial condition of the firm. So external auditors don't just check the figures, they also examine the accounting methods the company used to obtain those figures. Read the rest on pg. 139. The results of the audit are presented in an independent auditor's report, which is included in the annual report the firm sends to its stockholders.

Operating budgets

budgets that communicate an organization's sales and production goals and the resources needed to achieve these goals These budgets are developed in a specific order, with the information from earlier budgets used in the preparation of later budgets.

Direct costs (8-6b)

costs that are incurred directly as the result of some specific cost object E.g. the wage payments made to workers directly involved in producing a good or service Direct costs for labor and materials are usually easy to measure and assign, since they have an easily identifiable link to the object.

unqualified opinion (clean opinion) (8-4a)

indicates that the auditor believes the statements are free from material omissions and errors (besides some minor concerns) The most common outcome

Cash flows from investing activities (8-3c)

the amount of cash received from the sale of fixed assets (such as land and buildings) and financial assets bought as long-term investments. It also shows any cash used to buy fixed assets or make long-term financial investments. E.g. sale of land and businesses, capital expenditures (primarily for building and opening new restaurants or remodeling existing restaurants), cash on equipment for new restaurants or to upgrade existing restaurants, and cash on "other" investing activities

Cash flows from operating activities (8-3c)

the amount of cash that flowed into the company from the sale of goods or services, as well as cash from dividends and interest received from ownership of the financial securities of other firms. It also shows the amount of cash used to cover expenses resulting from operations and any cash payments to purchase securities held for short-term trading purposes. E.g. cash payments from customers, inventory sold to restaurants, cash received from its restaurants

Sarbanes-Oxley Act (2002) (8-4a)

this law banned business relationships that might create conflicts of interest between CPA firms and the companies they audit It also established a private-sector nonprofit corporation known as the Public Company Accounting Oversight Board (PCAOB). It defines its mission as follows: "To protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports."