CHAPTER 17 Using Management and Accounting Information 17.1 A WORD FROM THE AUTHORS We begin this chapter by describing why employees need information. The first three major sections in this chapter answer the following questions: (1) How can information reduce risk when making a decision? (2) What is a management information system? (3) How do employees use a management information system? Next, we look at why accounting information is important, attempts to improve financial reporting, and careers in the accounting industry. Then we examine the basic accounting equation and the three most important financial statements: the balance sheet, the income statement, and the statement of cash flows. Finally, we take a look at how managers evaluate the firm’s financial health. 17.2 TRANSITION GUIDE New in Chapter 17: Using Management and Accounting Information • In this edition of Business, this chapter combines management information (formerly in Chapter 16 in the eleventh edition) with material in the accounting chapter. The first three learning objectives in the revised chapter are as follows: 1. Examine how information can reduce risk when making a decision. 2. Discuss management’s information requirements. 3. Outline the five functions of an information system. • The accounting information in the revised chapter has been reduced to make room for the material on management information—more specific information on accounting coverage is provided below. • A new Inside Business feature describes how PricewaterhouseCoopers (PwC) motivates employees to think creatively while providing information to its clients. • Information in the introductory paragraph for Chapter 17 has been changed and now includes material for both management and accounting information. • A new Personal Apps feature explains how students can use information to reduce risk when making a decision. • Figure 17.1, “The Relationship Between Information and Risk” (formerly Figure 16.1 in the eleventh edition) is now in the first major section How Can Information Reduce Risk When Making a Decision? • Figure 17.2, “Management Information Systems (MIS),” (formerly Figure 16.2 in the eleventh edition) is now in the second major section “What Is a Management Information System?” • In the section “What Is a Management Information System,” the material on how administrative managers use a management information system has been revised and expanded. • Figure 17.3, “Five Management Information System Functions,” (formerly Figure 16.3 in the eleventh edition) is now in the third major section “How Do Employees Use a Management Information System?” • A new Going for Success feature explains how executives, managers, and employees are using technology and tablet computers to increase productivity. • In the section “Making Smart Decisions,” new information has been included about how three software programs (decision support systems, executive information systems, and expert systems) are helping employees at all levels within an organization make better decisions. • The material in the “Recent Accounting Scandals” section has been deleted. • The Sustaining the Planet feature, “The Global Reporting Initiative,” has been deleted. • The “Who Uses Accounting Information?” section has been deleted. A portion of this material is now covered in the material on management information. • Updated information about employment opportunities is presented in the section “Careers in Accounting.” Also, the term certified management accountant has been deleted from this section. • A new Social Media feature describes how the Big Four accounting firms are using social media to reach out to potential job candidates. • The information in “The Accounting Cycle” section has been deleted. • The section, “The Accounting Equation and the Balance Sheet,” has been revised to show how the accounting equation provides the foundation for a firm’s balance sheet. • The Career Success feature, “More Accountants and Auditors Needed!,” has been deleted. • Figure 17.5, “Personal Balance Sheet,” has been revised to show assets on the left side and liabilities and net worth (owners’ equity) on the right side. This revision helps to illustrate that the accounting equation (Assets = Liabilities + Owners’ equity) is still in balance. • Figure 17.6, “Business Balance Sheet,” has been revised to show assets on the left side and liabilities and owners’ equity on the right side. This revision helps to illustrate that the accounting equation (Assets = Liabilities + Owners’ equity) is still in balance. • In Figure 17.6, “Business Balance Sheet,” the line item for goodwill has been deleted, and the amount for patents has been increased to $21,000. Also, the material on goodwill has been deleted from the section “Intangible Assets.” • A new Personal Apps feature encourages students to look at a firm’s financial statements before accepting a job offer. • The concept of a personal budget is introduced in the section “The Income Statement.” • The Ethical Challenges & Successful Solutions feature has been deleted. • A new Entrepreneurial Success feature describes common mistakes made by first-time entrepreneurs. • The section, “Evaluating Financial Statements,” has been shortened. • The section, “Using Accounting Information to Evaluate a Potential Investment,” has been revised and is now included in Chapter 20, “Understanding Personal Finances and Investments.” • Figure 17.10, “Comparisons of Present and Past Financial Statements for Microsoft Corporation,” has been revised and now includes data for 2009, 2010, and 2011. • The “Financial Ratios” section now includes calculations for three different ratios that are used to measure a firm’s profitability (return on sales), its ability to pay its debts (current ratio), and how often it sells its inventory (inventory turnover). For more information about ratio analysis and additional ratios, students are encouraged to read an accounting or finance text or use the Internet. • Table 17.3, “Financial Ratios of Northeast Art Supply Compared with Average Ratios for All Businesses,” has been deleted. • A new Return to Inside Business about PricewaterhouseCoopers (Pwc) has been provided at the end of the chapter. • The Summary, Key Terms, Review Questions, and Discussion Questions reflect the material on information and accounting contained in the revised chapter. • Questions for Video Case 17.1, “Information Helps Level the Playing Field for The Little Guys,” have been revised and ask students to consider how this firm could use information to improve operations and solve cash flow problems. • The Building Skills for Career Success section contains a new Social Media Exercise. • The Exploring the Internet feature in Building Skills for Career Success has been deleted. • The Researching Different Careers feature in the Building Skills for Career Success section now asks students to evaluate their ability to use different software programs and develop a plan to improve their ability to use each type of software. 17.3 QUICK REFERENCE GUIDE Instructor Resource Location Transition Guide IM, p. 649 Learning Objectives Textbook, p. 486; IM, p. 653 Brief Chapter Outline IM, pp. 653–654 Comprehensive Lecture Outline IM, pp. 654–669 At Issue: Should a business value its human assets and include them on its balance sheet? IM, p. 665 Going for Success Information Technology and the Tablet Textbook, p. 496 Social Media The Big Four Go Social Textbook, p. 499 Entrepreneurial Success Accounting for First-Time Entrepreneurs Textbook, p. 507 Inside Business PricewaterhouseCoopers Innovates Through PowerPitch Textbook, p. 487 Return to Inside Business Textbook, p. 511 Questions and Suggested Answers, IM, p. 670 Marginal Key Terms List Textbook, p. 513 Review Questions Textbook, p. 513 Questions and Suggested Answers, IM, pp. 670–672 Discussion Questions Textbook, p. 513 Questions and Suggested Answers, IM, p. 673 Video Case 17.1 (Information Helps Level the Playing Field for The Little Guys) and Questions Textbook, p. 514 Questions and Suggested Answers, IM, p. 674 Case 17.2 (Making the Numbers or Faking the Numbers?) and Questions Textbook, pp. 514–515 Questions and Suggested Answers, IM, pp. 675–676 Building Skills for Career Success Textbook, pp. 515–516 Suggested Answers, IM, pp. 676–677 IM Quiz I & Quiz II IM, pp. 678–680 Answers, IM, p. 680 Classroom Exercises IM, pp. 681–682 17.4 LEARNING OBJECTIVES After studying this chapter, students should be able to: 1. Examine how information can reduce risk when making a decision. 2. Discuss management’s information requirements. 3. Outline the five functions of an information system. 4. Explain why accurate accounting information and audited financial statements are important. 5. Read and interpret a balance sheet. 6. Read and interpret an income statement. 7. Describe business activities that affect a firm’s cash flow. 8. Summarize how managers evaluate the financial health of a business. 17.5 BRIEF CHAPTER OUTLINE I. How Can Information Reduce Risk When Making a Decision? A. Information and Risk B. Information Rules C. The Difference Between Data and Information D. Knowledge Management II. What Is a Management Information System? A. A Firm’s Information Requirements B. Size and Complexity of the System III. How Do Employees Use a Management Information System? A. Step 1: Collecting Data 1. Internal Sources of Data 2. External Sources of Data B. Step 2: Storing Data C. Step 3: Updating Data D. Step 4: Processing Data E. Step 5: Presenting Information 1. Business Reports 2. Visual Displays and Tables F. Making Smart Decisions IV. Why Accounting Information Is Important A. Why Audited Financial Statements Are Important B. Reform: The Sarbanes-Oxley Act of 2002 C. Different Types of Accounting D. Careers in Accounting V. The Accounting Equation and the Balance Sheet A. The Accounting Equation B. The Balance Sheet C. Assets 1. Current Assets 2. Fixed Assets 3. Intangible Assets D. Liabilities and Owners’ Equity 1. Current Liabilities 2. Long-Term Liabilities 3. Owners’ or Stockholders’ Equity VI. The Income Statement A. Revenues B. Cost of Goods Sold C. Operating Expenses D. Net Income VII. The Statement of Cash Flows VIII. Evaluating Financial Statements A. Comparing Financial Data B. Financial Ratios 1. Measuring a Firm’s Ability to Earn Profits 2. Measuring a Firm’s Ability to Pay Its Debts 3. Measuring How Well a Firm Manages Its Inventory 17.6 COMPREHENSIVE LECTURE OUTLINE I. HOW CAN INFORMATION REDUCE RISK WHEN MAKING A DECISION? Information is one of the four major resources (along with material, human, and financial) managers must have to operate a business. Information helps managers reduce risk when making a decision. A. Information and Risk. To improve the decision-making process and reduce risk, the information used by individuals and business firms must be relevant or useful to meet a specific need. 1. Better intelligence and knowledge that lead to better decisions are especially important because they can provide a competitive edge over competitors and improve a firm’s profits. 2. Theoretically, with accurate and complete information, there is no risk whatsoever; a decision made without any information is a gamble. For the most part, business decision makers see themselves located someplace between the extremes. 3. Figure 17.1 illustrates that, when the amount of available information is high, there is less risk; when the amount of available information is low, there is more risk. 4. Information, when understood properly, produces knowledge and empowers managers and employees to make better decisions. B. Information Rules. An information rule emerges when research confirms the same results each time that it studies the same or a similar set of circumstances. 1. Businesspeople try to accumulate information rules to shorten the time they spend analyzing choices. 2. Information rules are the “great simplifiers” for all decision makers. Business research is continuously looking for new rules that can be put to good use and looking to discredit old ones that are no longer valid. C. The Difference Between Data and Information. Many people use the terms data and information interchangeably, but the two differ in important ways. 1. Data are numerical or verbal descriptions that usually result from some sort of measurement. (The word data is plural; the singular form is datum.) 2. Information is data presented in a form that is useful for a specific purpose. For a manager, information presented in a practical, useful form such as a graph simplifies the decision-making process. D. Knowledge Management. The average company maintains a great deal of data that can be transformed into information. 1. A database is a single collection of data and information stored in one place that can be used by people throughout an organization to make decisions. 2. Although databases are important, the way the data and information are used is even more important and valuable to a firm. As a result, management information experts now use the term knowledge management (KM) to describe a firm’s procedures for generating, using, and sharing the data and information. II. WHAT IS A MANAGEMENT INFORMATION SYSTEM? A management information system (MIS) is a system that provides managers and employees with the information they need to perform their jobs as effectively as possible. The purpose of an MIS (sometimes referred to as an information technology system or simply IT system) is to distribute timely and useful information from both internal and external sources to the managers and employees who need it. (See Figure 17.2.) Today, most medium-sized to large business firms have an information technology (IT) officer at the executive level who is responsible for ensuring that a firm has the equipment necessary to provide the information the firm’s employees and managers need to make effective decisions. Today’s typical MIS is built around a computerized system of record-keeping and communication software so that it can provide information based on a wide variety of data. A. A Firm’s Information Requirements. Today, many firms are organized into five areas of management: finance, operations, marketing, human resources, and administration. Managers in each of these areas need specific information to make decisions. 1. Financial managers must ensure that the firm’s managers and employees, lenders and suppliers, stockholders and potential investors, and government agencies have the information they need to measure the financial health of the firm. Of equal importance is information about the present state of the economy, interest rates, and predictions of business conditions in the future. 2. Operations managers are concerned with present and future sales levels, current inventory levels of work in process and finished goods, and the availability and cost of the resources used to produce products and services. They must also keep abreast of any innovative production technology that might be useful to the firm. 3. Marketing managers need to have detailed information about a firm’s products and services and those offered by competitors, including pricing strategies, new promotional campaigns, and products that competitors are test marketing. Information concerning the firm’s customers, current and projected market share, and new and pending product legislation is also important. 4. Human resources managers must be aware of anything that pertains to a firm’s employees, such as current wage levels and benefit packages both within the firm and in firms that compete for valuable employees, current legislation and court decisions that affect employment practices, union activities, and the firm’s plans for growth, expansion, or mergers. 5. Administrative managers are responsible for the overall management of the organization. Administrators must ensure that all employees have access to the information they need to do their jobs and that the information is used in a consistent manner throughout the firm. a) Administrative managers must make sure that all managers and employees are able to use the IT that is available, and that they receive the skills training required to use the firm’s MIS. b) Administrative managers must commit to the costs of updating the firm’s MIS and providing additional training when necessary. B. Size and Complexity of the System. An MIS must be tailored to the needs of the organization it serves. 1. In some firms, a tendency to save on initial costs may result in a system that is too small or simple. a) Such a system generally ends up serving only one or two management levels or a single department. b) Managers in the other departments “give up” on the system as soon as they find that it cannot accept or process their data. c) They look elsewhere for information, process their own data, or do without. 2. Almost as bad is an MIS that is too large or too complex for the organization. a) Unused capacity and complexity increase the cost of owning and operating the system. b) A system that is difficult to use may not be used at all. Teaching Tip: Ask students to work with a partner to identify all the information that needs to be in an individual instructor’s database to track student performance. If possible, show students the systems the college provides for instructors (the ability to send warning letters, withdraw students, etc.). III. HOW DO EMPLOYEES USE A MANAGEMENT INFORMATION SYSTEM? To provide information, an MIS must perform five specific functions. It must collect data, store the data, update the data, process the data into information, and present information to users. (See Figure 17.3.) A. Step 1: Collecting Data. A firm’s employees, with the help of an MIS system, must gather the data needed to establish the firm’s data bank. The data bank should include all past and current data that may be useful in managing the firm. Only useful information should be entered into the data bank. The data entered into the system must be relevant to the needs of the firm’s managers. Perhaps most important, the data must be accurate. 1. Internal Sources of Data. Typically, most of the data gathered for an MIS come from internal sources. The most common internal sources of information are managers and employees, company records, and reports and minutes of meetings. a) Past and present accounting data can also provide information about the firm’s customers, creditors, and suppliers. b) Sales reports are a source of data on sales, pricing strategies, and the effectiveness of promotional campaigns. c) Human resources records are useful as a source of data on wage and benefits levels, hiring patterns, employee turnover, and other personnel variables. d) Present and past production forecasts should also be included in the firm’s data bank along with data indicating how well these forecasts predicted actual events. e) Specific plans and management decisions should be incorporated into the MIS system. 2. External Sources of Data. External sources of data include customers, suppliers, bankers, trade and financial publications, industry conferences, online computer services, and firms that specialize in gathering data. These data take various forms, depending on the requirements of the firm and its managers. a) Suppliers are an excellent source of information about the future availability and costs of raw materials and component parts. b) Bankers can often provide valuable economic insights and projections. c) Information furnished by trade publications and industry conferences usually is concerned as much with future projections as with present conditions. d) Legal issues and court decisions that may affect the firm are discussed occasionally in local newspapers and, more often, in specialized publications. e) Whether the source of the data is internal or external, it is good to remember the following cautions: (1) The cost of obtaining data from external sources can be quite high. (2) Outdated or incomplete data usually yield inaccurate information. (3) Although computers generally do not make mistakes, the people who use them can. When data/information and your judgment disagree, check the data. B. Step 2: Storing Data. An MIS must be capable of storing data until they are needed. 1. The method chosen to store data depends on the size and needs of the organization. a) Small businesses may enter data and then store them directly on the hard drive inside an employee’s computer. b) Medium-sized to large businesses store data in a larger computer system and provide access to employees through a computer network. Networks take on many configurations and are designed by specialists who work with a firm’s information technology personnel to decide on what’s best for the company. C. Step 3: Updating Data 1. An MIS must be able to update stored data regularly to ensure that the information presented to managers and employees is accurate, complete, and up to date. 2. The frequency with which data are updated depends on how fast they change and how often they are used. a) When it is vital to have current data, updating may occur as soon as the new data are available. b) Data and information may be updated according to a predetermined time schedule. D. Step 4: Processing Data. Some data are used in the form in which they are stored. Other data require processing to extract, highlight, or summarize the information they contain. Data processing is the transformation of data into a form useful for a specific purpose. For verbal data, the process consists mainly of extracting pertinent material from storage and combining it into a report. A statistic is a measure that summarizes a particular characteristic of an entire group of numbers. E. Step 5: Presenting Information. An MIS must be capable of presenting the information in a usable form and be appropriate for the information itself and for the uses to which it will be put. 1. Business Reports. Verbal information may be presented in list or paragraph form. A typical business report includes four parts: a) The introduction sets the stage for the remainder of the report, describes the problem to be studied in the report, identifies the research techniques that were used, and previews the material that will be presented in the report. b) The body of the report describes the facts that were discovered in the process of completing the report. It should also provide a foundation for the conclusions and the recommendations. c) The conclusions summarize the report’s findings. d) Suggestions on how the problem might be solved are presented in the recommendations section. 2. Visual Displays and Tables. A visual display (see Figure 17.4) is a diagram that represents several items of information in a manner that makes a comparison easier. Typical visual displays include graphs, bar charts, and pie charts. A tabular display is used to present verbal or numerical information in columns and rows. It is most useful in presenting information about two or more related variables. (See Table 17.1.) Tabular displays generally have less impact than visual displays. The data contained in most two-column tables can be displayed visually. However, displaying the information in a table with more than two columns would require several bar or pie charts. Teaching Tip: Ask students how many of them have used visual displays in their papers. Follow up with a discussion of when graphs, bar charts, and pie charts are most appropriate. F. Making Smart Decisions. In addition to the steps described, three different software applications can actually help to improve and speed the decision-making process for people at different levels within an organization. 1. A decision-support system (DSS) is a type of software program that provides relevant data and information to help a firm’s employees make decisions. a) It can also be used to determine the effect of changing different variables and to answer “what if” type questions. 2. Similar to a DSS, an executive information system (EIS) is a computer-based system that facilitates and supports the decision-making needs of top managers and senior executives by providing easy access to both internal and external information. 3. An expert system is a type of computer program that uses artificial intelligence to imitate a human’s ability to think. a) An expert system uses a set of rules that analyze information supplied by a user about a particular activity or problem. b) Based on the information supplied, the expert system then provides recommendations or suggests specific actions in order to help make decisions. IV. WHY ACCOUNTING INFORMATION IS IMPORTANT. Accounting is the process of systematically collecting, analyzing, and reporting financial information. Although accounting information can be used to answer questions about what has happened in the past, it can also be used to help make decisions about the future. To improve the accuracy of a firm’s accounting information and its financial statements, businesses rely on audits conducted by accountants employed by public accounting firms. A. Why Audited Financial Statements Are Important. An audit is an examination of a company’s financial statements and the accounting practices that produced them. The purpose is to make sure that a firm’s financial statements have been prepared in accordance with generally accepted accounting principles (GAAPs). 1. GAAPs have been developed to provide an accepted set of guidelines and practices for U.S. companies reporting financial information and the accounting profession. 2. The Financial Accounting Standards Board (FASB), which establishes accounting standards for U.S. companies, is working toward establishing a new set of standards that combines GAAPs with the International Financial Reporting Standards (IFRS) to create one set of accounting standards that can be used by both U.S. and multinational firms. a) Created by the International Accounting Standards Board, IFRS are now used in more than 100 different countries around the world. b) For multinational firms, the benefits of global accounting standards are huge because preparing financial statements and accounting records that meet global standards saves both time and money. 3. Although an audit and the resulting report do not guarantee that a company has not cooked the books, it does imply that the company has followed GAAPs. Teaching Tip: Lots of students have heard the term “cooking the books” but may not have a real appreciation of what it means. Consider showing this brief (2-minute) video that explains ways in which companies manipulate financial information. The Web site for this Investopedia video is http://www.investopedia.com/video/play/understanding-cook-the-books#axzz214qRTCws. 4. Bankers, creditors, investors, and government agencies are willing to rely on an auditor’s opinion because of the historically ethical reputation and independence of auditors and accounting firms. 5. Without the audit function and GAAPs, there would be very little oversight or supervision and the validity of a firm’s financial statements and its accounting records would drop quickly. a) Firms would find it difficult to obtain debt financing, acquire goods and services from suppliers, find investor financing, or prepare documents requested by government agencies. B. Reform: The Sarbanes-Oxley Act of 2002 1. To help ensure that corporate financial information is accurate, Congress enacted the Sarbanes-Oxley Act in 2002. Key components include the following: a) The Securities and Exchange Commission (SEC) is required to establish a full-time, five-member federal oversight board that will police the accounting industry. b) Chief executive and financial officers are required to certify periodic financial reports and are subject to criminal penalties for violations of securities reporting requirements. c) Accounting firms are prohibited from providing many types of consulting services to the companies they audit. d) Auditors must maintain financial documents and audit work papers for five years. e) Auditors and accountants can be imprisoned for up to 20 years for destroying financial documents and willful violations of the securities laws. f) A public corporation must change its lead auditing firm every five years. g) There is added protection for whistle-blowers who report violations of the Sarbanes-Oxley Act. 2. While most people welcome the Sarbanes-Oxley Act, complex rules make compliance more expensive and time consuming for corporate management and more difficult for accounting firms. Teaching Tip: The primary complaints about Sarbanes-Oxley revolve around Section 404, which requires that companies have to report the effectiveness of their internal control systems. This requires significant monitoring and internal audit analysis on the part of business. Ask students how they feel about Section 404. C. Different Types of Accounting. Accounting usually is broken down into two broad categories: managerial accounting and financial accounting. 1. Managerial accounting provides managers and employees with the information needed to make decisions about a firm’s financing, investing, and operating activities. 2. Financial accounting generates financial statements and reports for people outside of an organization (stockholders, financial analysts, bankers, lenders, suppliers, government agencies, and other interested groups). 3. Additional special areas of accounting include the following: a) Cost accounting—Determining the cost of producing specific products or services. b) Tax accounting—planning tax strategy and preparing tax returns. c) Government accounting—Providing basic accounting services to ensure that tax revenues are collected and used to meet the goals of state, local, and federal agencies. d) Not-for-profit accounting—Helping not-for-profit organizations to account for all donations and expenditures. D. Careers in Accounting 1. Accounting can be an exciting and rewarding career—one that offers higher-than-average starting salaries. To be successful in the accounting industry, employees must: a) Be responsible, honest, and ethical. b) Have a strong background in financial management. c) Know how to use a computer and software to process data into accounting information. d) Be able to communicate with people who need accounting information. 2. Accountants are generally classified as private or public accountants. a) A private accountant is employed by a specific organization. b) A public accountant works on a fee basis for clients and may be self-employed or be the employee of an accounting firm. (1) Typically, public accounting firms include on their staffs at least one certified public accountant (CPA), an individual who has met state requirements for accounting education and experience and has passed a rigorous two-day accounting examination prepared by the American Institute of Certified Public Accountants (AICPA). State requirements usually include a college degree or a specified number of hours of college coursework and from one to three years of on-the-job experience. Details regarding specific state requirements for practice as a CPA can be obtained by contacting the state’s board of accountancy. (2) Publicly traded corporations must hire an independent certified public accountant to audit their financial statements. In addition to auditing a corporation’s financial statements, services performed by CPAs include planning and preparing tax returns, determining the true cost of producing and marketing a firm’s goods or services, and compiling the financial information needed to make major management decisions. V. THE ACCOUNTING EQUATION AND THE BALANCE SHEET. Financial data are transformed into financial information and reported on three very important financial statements—balance sheet, income statement, and statement of cash flows. A. The Accounting Equation. The accounting equation shows the relationship between the firm’s assets, liabilities, and owners’ equity. 1. Assets are the resources a business owns—cash, inventory, equipment, and real estate. 2. Liabilities are the firm’s debts—what it owes to others. 3. Owners’ equity is the difference between total assets and total liabilities—what would be left for the owners if the firm’s assets were sold and the money used to pay off its liabilities. 4. The relationship between assets, liabilities, and owners’ equity is shown by the accounting equation: Assets Liabilities + Owners’ equity. This is the basis for the accounting process. 5. To use this equation, a firm’s accountants must record raw data—the firm’s day-to-day financial transactions—using the double-entry bookkeeping system, a system that uses two separate accounting entries for each financial transaction to maintain the balances shown in the accounting equation. 6. The financial transactions are summarized in the firm’s financial statements, and information is presented in a standardized format to make the statements as accessible as possible to the various people who may be using it. a) A firm’s financial statements are prepared at least once a year and included in the firm’s annual report—a report distributed to stockholders and other interested parties that describes a firm’s operating activities and its financial condition. b) Most firms also have financial statements prepared semiannually, quarterly, or monthly. B. The Balance Sheet. A balance sheet (sometimes referred to as a statement of financial position) is a summary of the dollar amounts of a firm’s assets, liabilities, and owners’ equity accounts at the end of a specific accounting period. 1. The balance sheet must demonstrate that assets are equal to liabilities plus owners’ equity. 2. Most people think of a balance sheet as a statement that reports the financial condition of a business firm, but balance sheets apply to individuals, too. Figure 17.5 shows Marty Campbell’s current personal balance sheet. 3. Figure 17.6 shows the balance sheet for Northeast Art Supply, Inc. C. Assets. On a balance sheet, assets are listed in order from the most liquid to the least liquid. The liquidity of an asset is the ease with which it can be converted into cash. 1. Current Assets. Current assets are assets that can be converted quickly into cash or that will be used in one year or less. a) Because cash is the most liquid asset, it is listed first. b) Next are marketable securities—stocks, bonds, and other investments—that can be easily converted into cash in a matter of days. c) Next are the firm’s receivables. (1) Its accounts receivable, which result from allowing customers to make credit purchases, are generally paid within 30 to 60 days. (2) However, the firm expects that some of these debts will not be collected. Thus, it has reduced its accounts receivable by a 5 percent allowance for doubtful accounts. (3) The firm’s notes receivable are receivables for which customers have signed promissory notes. They are generally repaid over a longer period of time than accounts receivable. d) Merchandise inventory represents the value of goods on hand for sale to customers. e) Prepaid expenses are assets that have been paid for in advance but have not yet been used. f) As shown in Figure 17.6, for Northeast Art, current assets total $182,000. 2. Fixed Assets. Fixed assets are assets that will be held or used for a period longer than one year. a) Fixed assets generally include land, buildings, and equipment. b) Note that the values of Northeast’s delivery equipment and furniture and store equipment are decreased by their accumulated depreciation. (1) Depreciation is the process of apportioning the cost of a fixed asset over its useful life. (2) The depreciation amount allotted to each year is an expense for that year, and the value of the asset must be reduced by the amount of depreciation expense. c) For Northeast Art, fixed assets total $137,000. 3. Intangible Assets. Intangible assets do not exist physically but have a value based on rights or privileges they confer on a firm. a) Intangible assets include patents, copyrights, trademarks, franchises, and goodwill. b) Intangible assets are long-term assets—they are of value to the firm for a number of years. c) Goodwill is the value of a firm’s reputation, location, earning capacity, and other intangibles that make the business a profitable concern. d) Goodwill is not normally listed on a balance sheet unless the firm has been purchased from previous owners. e) For Northeast Art, intangible assets total $21,000. 4. All three types of assets for Northeast Art total $340,000. Teaching Tip: Use the “Sell It Off, Sell It All Off!” group exercise here. This activity will take 30 to 40 minutes. D. Liabilities and Owners’ Equity. The firm’s liabilities are separated into two categories—current and long-term liabilities. 1. Current Liabilities. A firm’s current liabilities are debts that will be repaid in one year or less. a) Accounts payable are short-term obligations that arise as a result of making credit purchases. b) Notes payable are obligations that have been secured with promissory notes. Only those that must be paid within the year are listed under current liabilities. c) Figure 17.6 lists salaries payable and taxes payable as current liabilities. These are expenses that have been incurred during the current accounting period but will be paid in the next accounting period. d) For Northeast Art, current liabilities total $70,000. 2. Long-Term Liabilities. Long-term liabilities are debts that need not be repaid for at least one year. Northeast lists only a $40,000 mortgage payable in this group. Northeast’s current and long-term liabilities total $110,000. 3. Owners’ or Stockholders’ Equity. For a sole proprietorship or partnership, the owners’ equity is the difference between assets and liabilities. For a corporation, the owners’ equity (usually referred to as stockholders’ equity) is the total value of stock plus retained earnings that have accumulated to date. Retained earnings are the portion of a business’s profits not distributed to stockholders. a) The original investment by the owners of Northeast Art Supply was $150,000. b) In addition, $80,000 of Northeast’s earnings has been reinvested in the business since it was founded. c) Thus, owners’ equity totals $230,000. 4. As the two grand totals in Figure 17.6 show, Northeast’s assets and the sum of its liabilities and owners’ equity are equal—at $340,000. VI. THE INCOME STATEMENT. An income statement is a summary of a firm’s revenues and expenses during a specified accounting period. The income statement is sometimes called the earnings statement or the statement of income and expenses. Figure 17.7 shows a personal income statement for Marty Campbell. Although the difference between income and expenses is referred to as profit or loss for a business, it is normally referred to as a cash surplus or cash deficit for an individual. Figure 17.8 shows the income statement for Northeast Art Supply. For a business, revenues less cost of goods sold less operating expenses equals net income. Teaching Tip: Encourage students to develop personal income statements. See the “Income and Outgo Statement.” This can be handed out for homework or simply as a suggestion to students. A. Revenues. Revenues are the dollar amounts earned by a firm from selling goods, providing services, or performing business activities. 1. Gross sales are the total dollar amount of all goods and services sold during the accounting period. 2. From gross sales, the following amounts are deducted. a) Sales returns—Merchandise returned to the firm by customers b) Sales allowances—Price reductions offered to customers who accept slightly damaged or soiled merchandise c) Sales discounts—Price reductions offered to customers who pay their bills promptly 3. The remainder is the firm’s net sales. Net sales are the actual dollar amount received by the firm for the goods and services it has sold after adjustment for returns, allowances, and discounts. 4. For Northeast Art, net sales are $451,000. B. Cost of Goods Sold. The standard method of determining the cost of goods sold by a retailing or wholesaling firm during an accounting period is summarized as follows: 1. Cost of goods sold Beginning inventory Net purchases Ending inventory 2. According to Figure 17.8, Northeast Art Supply began its accounting period with a merchandise inventory of $40,000. a) It purchased merchandise valued at $346,000 but after deducting purchase discounts, it paid only $335,000 for this merchandise. b) Thus, during the year, it had total goods available for sale valued at $40,000 + $335,000, for a total of $375,000. 3. Twelve months later, Northeast had sold all but $41,000 worth of the available goods. The cost of goods sold was therefore $375,000 less ending inventory of $41,000, or $334,000. 4. A firm’s gross profit is its net sales less the cost of goods sold. a) For Northeast Art, gross profit was $117,000. C. Operating Expenses. A firm’s operating expenses are all business costs other than the cost of goods sold. They are generally divided into two categories: selling expenses or general expenses. 1. Selling expenses are costs related to the firm’s marketing activities. For Northeast, selling expenses total $37,000. 2. General expenses are costs incurred in managing a business. For Northeast, general expenses total $42,500. Teaching Tip: Use the “Operating Expenses Brainstorming” exercise here. It takes no more than five minutes plus discussion. D. Net Income. When revenues exceed expenses, the difference is called net income. When expenses exceed revenues, the difference is called net loss. 1. In Figure 17.8, Northeast’s net income from operations is computed as gross profit on sales ($117,000) less total operating expenses ($79,500). 2. For Northeast Art, net income from operations totals $37,500. 3. Interest expense of $2,000 is deducted from net income to obtain a net income before taxes of $35,500. The interest expense is deducted in this section of the income statement because it is not an operating expense. Rather, it is an expense that results from financing the business. 4. Northeast’s federal income taxes are $5,325. Although these taxes may or may not be payable immediately, they are an expense that must be deducted from income. 5. This leaves Northeast with a net income after taxes of $30,175. a) This amount may be used to pay a dividend to stockholders, retained or reinvested by the firm, used to reduce the firm’s debts, or all three. VII. THE STATEMENT OF CASH FLOWS. In 1987, the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) required all publicly traded companies to include a statement of cash flows in their annual report. The statement of cash flows illustrates how the operating, investing, and financing activities of a company affect cash during an accounting period. This information is used in many different ways by different people: (1) By executives and managers to determine how much cash is available to pay dividends to stockholders and evaluate decisions related to the firm’s future investments and financing needs; (2) By investors to know if a firm can pay dividends in the future; (3) By lenders and suppliers to evaluate the firm’s ability to repay its debts. A statement of cash flows for Northeast Art Supply is illustrated in Figure 17.9. The cash flows statement is organized around three different activities: operating, investing, and financing. • Cash flows from operating activities—The first section addresses the firm’s primary revenue source: providing goods and services. Typical adjustments include adding the amount of depreciation to a firm’s net income. Other adjustments for increase or decrease in amounts for accounts receivable, inventory, accounts payable, and income taxes payable are also required to reflect a true picture of cash flows from operating activities. • Cash flows from investing activities—The second section is concerned with cash flow from investments. This includes the purchase and sale of land, equipment, and other long-term assets and investments. • Cash flows from financing activities—The third section deals with cash flow from all financing activities. It reports changes in debt obligation and owners’ equity accounts. The totals of all three activities are added to the beginning cash balance to determine the ending cash balance. The cash flows statement, balance sheet, and income statement illustrate the results of past business decisions and the firm’s ability to pay debts and dividends and finance new growth. VIII. EVALUATING FINANCIAL STATEMENTS. The balance sheet, the income statement, and the statement of cash flows can provide answers to a variety of questions about the firm’s ability to do business and stay in business, its profitability, and its value as an investment. A. Comparing Financial Data. Many firms also compare their financial results with those of competing firms and with industry averages. 1. Comparisons are possible as long as accountants follow GAAPs. 2. Competitors’ financial statements can be obtained from their annual reports—if they are public corporations. 3. Industry averages are published by reporting services like Dun & Bradstreet and Standard & Poor’s, as well as by some industry trade associations. 4. Most corporations include in their annual reports comparisons of the important elements of their financial statements for recent years. (See Figure 17.10.) B. Financial Ratios. A financial ratio is a number that shows the relationship between two elements of a firm’s financial statements. Like the individual elements in financial statements, these ratios can be compared with those of competitors, with industry averages, and with the firm’s past ratios from previous accounting periods. 1. Measuring a Firm’s Ability to Earn Profits. A firm’s net income after taxes indicates whether the firm is profitable. It does not, however, indicate how effectively the firm’s resources are being used. For this purpose, three ratios can be computed. a) Return on sales (or profit margin) is a financial ratio calculated by dividing net income after taxes by net sales. b) It indicates how effectively the firm is transforming sales into profits. A higher return on sales is better than a low one. c) Today, the average return on sales for all business firms is between 4 and 5 percent. d) A low return on sales can be increased by reducing expenses, by increasing sales, or both. 2. Measuring a Firm’s Ability to Pay Its Debts. A firm’s current ratio can be used to evaluate a firm’s ability to pay its current liabilities. It is computed by dividing current assets by current liabilities. a) The average current ratio for all industries is 2.0, but it varies greatly from industry to industry. b) A high current ratio indicates that a firm can pay its current liabilities. c) A low current ratio can be improved by repaying current liabilities, by reducing dividend payments to stockholders to increase the firm’s cash balance, or by obtaining additional cash from investors. Teaching Tip: In the class prior to the coverage of ratios, instruct students to investigate financial ratios for the company of their choice as a homework assignment. 3. Measuring How Well a Firm Manages Its Inventory. A firm’s inventory turn-over is the number of times the firm sells its merchandise inventory in one year. a) It is approximated by dividing the cost of goods sold in one year by the average value of the inventory. b) The average value of the inventory can be found by adding the beginning inventory value and the ending inventory values and dividing the sum by two. c) The average inventory turnover for all firms is about nine times a year, but turnover rates vary widely from industry to industry. d) The quickest way to improve inventory turnover is to order merchandise in smaller quantities at more frequent intervals. Teaching Tip: Ask students to identify industries where the maintenance of relatively slow-moving inventories might be an issue. Examples might be first edition book or expensive jewelry. Both require significant investment. Instructor Manual for Business William M. Pride, Robert J. Hughes, Jack R. Kapoor 9781133595854, 9780538478083, 9781285095158, 9781285555485, 9781133936671, 9781305037083
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