WGU_C213_Accounting_Study_Info - Copy.pdf - Accounting for MBAs AUTHORS Kay Stice Brigham Young University Jim Stice Brigham Young University This book

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Unformatted text preview: Accounting for MBAs AUTHORS Kay Stice Brigham Young University Jim Stice Brigham Young University This book was downloaded by Kaden Comadena ([email protected]) for individual use. Topic 1: The Nature and Purpose of Financial Accounting This video can be viewed online. KEY POINTS 1 2 3 4 5 6 Accounting is the recording of the day-to-day financial activities of a company and the organization of that information into summary reports used to evaluate the company’s financial status. The focus of financial accounting is the three primary financial statements: the balance sheet, the income statement, and the statement of cash flows. Among the users of financial accounting information are lenders, investors, company management, suppliers, customers, employees, competitors, government agencies, politicians, and the press. The practice of accounting involves adherence to duplicate the system throughout the United States. established accounting rules as well as the use of judgment. U.S. accounting rules are established by the FASB. In addition to the FASB, other important accounting-related organizations are the SEC, the AICPA, the PCAOB, the IRS, and the IASB. Three factors have combined to make right now a time of significant change in accounting. The three factors are the rapid advance in information technology, the international integration of worldwide business, and the increased scrutiny associated with the large corporate accounting scandals. FYI In its first decade of operation, McDonald’s Corporation spent over $3 million on research to perfect its french fries. Ray Kroc, a 51-year-old milkshake machine distributor, first visited the McDonald brothers’ drive-in in San Bernardino, California, in 1954—because he wanted to know why a single “hamburger stand” needed ten milkshake machines. That first day, Kroc spent the lunch rush hour watching the incredible business volume the small drive-in was able to handle. Before leaving town, Kroc had received a personal briefing on the McDonald’s Speedee System by Dick and Mac McDonald and had secured the rights to duplicate the system throughout the United States. Ray Kroc soon discovered that duplicating the McDonald’s system in his first outlet in Chicago involved more than just signing a licensing agreement. Kroc’s french fries, for example, were mushy even though he closely copied the McDonald brothers’ process. Feverish detective work finally revealed that Dick and Mac McDonald had been storing their potatoes in an outside bin before turning them into french fries. This aging process allowed some of the natural sugars in the potatoes to turn into starch, resulting in fries that would cook all the way through without burning. Further research revealed the optimal temperature for the cooking oil, the best type of potato to use, and how to make frozen french fries that taste as good as fresh. The end product, the McDonald’s french fry, was instrumental in establishing the McDonald’s reputation for consistent quality. FYI If the McDonald brothers had renewed the original licensing agreement instead of selling their interest for $2.7 million in 1961, their 2012 licensing fee alone, equal to 0.5 percent of McDonald’s sales, would have been $441 million. By 1961, the friendly relations between Ray Kroc and the McDonald brothers had soured. The original licensing agreement had stipulated that Kroc could make no changes to the McDonald’s Speedee System without written approval from the brothers. However, in order to adapt the single-location, Southern California operating procedure for use on a nationwide scale, Kroc made hundreds of unapproved changes, such as changing the approved building design by adding a furnace and enclosing service window areas to protect workers and customers from the cold. These changes were merely technical violations of the licensing agreement, but they put Kroc’s growing McDonald’s network on shaky legal ground. Therefore, Kroc was pleased in 1961 when the McDonald brothers proposed that he buy them out. At least he was pleased until he heard their price—$2.7 million. This was a huge amount, completely dwarfing the $77,000 in profit that Kroc’s McDonald’s Corporation had reported the year before. The only way to complete the buyout was for Kroc’s company to borrow the $2.7 million. A group of lenders (headed by the endowment fund of Princeton University) was found, but the lenders were nervous about making such a large loan to an upstart company in the volatile restaurant business. Kroc had to agree to a loan contract that resulted in an effective annual interest rate on the loan of nearly 50 percent. But when the buyout was completed, Kroc was free to expand and adapt the McDonald’s system in any way he saw fit. As the number of McDonald’s locations expanded (to 34,480 at the end of 2012), so did the menu. Originally, the McDonald’s menu contained just hamburgers (15¢), french fries (12¢), milkshakes (20¢), cheeseburgers, soft drinks (three flavors), milk, coffee, potato chips, and pie. The first addition to this menu was the Filet-O-Fish sandwich in the early 1960s. The Big Mac started in Pittsburgh in 1967, and the Egg McMuffin debuted in Santa Barbara in 1971. Not all of the McDonald’s menu innovations caught on—among the items that have died a merciful death are the McLean Deluxe (a low-fat hamburger held together with a seaweed-based filler) and the Hulaburger, one of Ray Kroc’s favorites (a cheeseburger with a big slice of pineapple). The essence of McDonald’s business seems fairly simple: Revenues come from selling Big Macs, Happy Meals, Chicken McNuggets, and so on.1 Operating costs are the costs of the raw materials to produce the food items plus labor costs, building rentals, income taxes, and so forth. But the following three accounting facts illustrate that the world of business is a bit more complex and interesting than you might have thought, and that an understanding of the language of accounting used to describe that world is essential: Sales at all McDonald’s restaurants in 2012 (see Figure 1.1) totaled $88.3 billion. However, McDonald’s Corporation reported less than one- third of this amount in its income statement for the year. Actual net cash income (accountants call this “cash from operations”) for 2012 was $6.966 billion. However, application of accounting rules resulted in reported net income of only $5.465 billion. By the way, this is the income reported to the stockholders—the income reported to the IRS and to foreign tax authorities is computed differently. The economic value of the McDonald’s brand name and reputation has been estimated at $40.1 billion, and this reputation is by far the corporation’s most valuable resource. However, U.S. accounting rules require that the total brand name and reputation value reported in McDonald’s financial statements be $0.2 Figure 1.1: Time Line of McDonald’s Sales: 1986-2012 In this introductory course in financial accounting, you will learn to speak and understand accounting—the language of business. You will become comfortable with accounting terminology such as “cash flow,” “off-balancesheet,” and “return on equity.” Also, discussion of the business environment in which accounting is used will increase your understanding of general business concepts such as corporation, lease, annuity, leverage, derivative (the financial kind, not the calculus kind), and so forth. You will see how accountants organize and condense the economic activity of a company into summary reports called financial statements: the balance sheet, the income statement, and the statement of cash flows. You will also become skilled at interpreting these financial statements in order to analyze the financial status of a company. You will become convinced that accounting is not “bean counting.” Time after time you will see that accountants must exercise judgment about how to best summarize and report the results of business transactions. As a result, you will gain a respect for the complexity of accounting as well as a skepticism about the precision of any financial reports you see. Finally, you will see the power of accounting. Financial statements are not just paper reports that get filed away and forgotten. You will see that financial statement numbers and, indirectly, the accountants who prepare them determine who receives loans and who does not, which companies attract investors and which do not, which managers receive salary bonuses and which do not, and which companies are praised in the financial press and which are not. So let’s get started. 1.1What is Accounting and Why Does it Exist? This video can be viewed online. Imagine a long-distance telephone company with no system in place to document who calls whom and how long they talk. Or a manager of a 300unit apartment complex who has forgotten to write down which tenants have and which have not paid the current month’s rent. Or an accounting professor who, the day before final grades are due, loses the only copy of the disk containing the spreadsheet of all homework, quiz, and exam scores. Each of these hypothetical situations illustrates a problem with bookkeeping— the least glamorous aspect of accounting. Bookkeeping is the preservation of a systematic, quantitative record of an activity. Bookkeeping systems can be very primitive— making marks in a stick to tally how many sheep you have or moving beads on a string to track the score in a billiards game. The doubleentry bookkeeping system used by businesses today has been in existence for over 500 years. But the importance of routine bookkeeping cannot be overstated; without bookkeeping, business is impossible. FYI In the novel “Debt of Honor,” techno-thriller author Tom Clancy describes a catastrophic meltdown of the U.S. economy when one day’s worth of U.S. stock exchange trading records are destroyed in an act of war. To evaluate the importance of bookkeeping records, we’ll use a thought experiment. Suppose that sometime during the night, all college professors were to disappear from the face of the earth. Could life proceed normally the next day? Unfortunately, yes— except for those of us who disappear. Now, what if every copy of every novel ever written were to disappear during the night? The cultural loss would be incalculable, but the normal activities of the next day would not be noticeably affected. But what if we woke up tomorrow morning to find the bookkeeping records of all businesses worldwide destroyed during the night? Businesses that rely on up-to-the-minute customer account information, such as banks, simply could not open their doors. Retailers would have to insist on cash purchases, because no credit records could be verified. Manufacturers would have to do a quick count of existing inventories of raw materials and components to find out whether they could keep their production lines running. Suppliers would have to call all their customers, if they could remember who they were, to renegotiate purchase orders. Attorneys would find themselves in endless arguments about their fees because they would have no record of billable hours. Routine and dry as it may seem, the world simply could not function without bookkeeping. This video can be viewed online. Rudimentary bookkeeping is ancient (probably predating both language and money), but the modern system of double-entry bookkeeping still in use today (described later in our discussion of “The Accounting Information System”) was developed in the 1300s and 1400s in Italy by the merchants in the trading and banking centers of Florence, Venice, and Genoa. The key development in1 accounting in the last 500 years has been the use of bookkeeping data, not just to keep track of things, but to evaluate the performance and status of a business. Using bookkeeping data as an evaluation tool may seem like an obvious step to you, but it is a step that is often not taken. Let’s consider a bookkeeping system that most of us are familiar with—a checking account. Your checking account bookkeeping system involves (or should involve) careful recording of the dates and amounts of all checks written and all deposits made and the maintenance of a running account total that is reconciled monthly with the amount that the bank statement says is in the account. Now, assume that you have a perfect checking account bookkeeping system. Will your system answer the following questions? Are you spending more for groceries this year than you did last year? What proportion of your monthly expenditures are fixed, meaning that you can’t change them except through a drastic change in lifestyle? You plan to travel abroad next year; will you be able to save enough between now and then to pay for it? This video can be viewed online. In order to answer these kinds of evaluation questions, your checks must be coded by type of expenditure, the data must be broken down into summary reports, and past data must be used to forecast future patterns. How many of us use our checking account data like this? Most of us do the bookkeeping (usually), but we don’t structure the information to make it useful for evaluating our spending habits. In sum, an accounting system is used by a business (1) to handle routine bookkeeping tasks and (2) to structure the information so it can be used to evaluate the performance and status of the business. These two functions of an accounting system are shown in Figure 1.2. A number of specific uses of accounting data for evaluation purposes are outlined in a later section of this chapter. Figure 1.2: Dual Function of an Accounting System Accounting is formally defined as a system of providing “quantitative information, primarily financial in nature, about economic entities that is intended to be useful in making economic decisions.”2 The key features of this definition are the following: Numbers: Accounting is quantitative. This is a strength because numbers can be easily tabulated and summarized. It is a weakness because some important business events, such as a toxic waste spill and the associated lawsuits and countersuits, cannot be easily described by one or two numbers. A financial dimension: The status and performance of a business is affected by and reflected in many dimensions—financial, personal relationships, community and environmental impact, and public image. Accounting focuses on just the financial dimension. Usefulness: The practice of accounting is supported by a long tradition of theory; U.S. accounting rules in fact have a theoretical conceptual framework, and some people actually make a living as accounting theorists. However, in spite of its theoretical beauty, accounting exists only because it is useful. Future decisions based on past information: Although accounting is the structured reporting of what has already occurred, this past information can only be useful if it impacts decisions about the future. This assessment can be taken online. 1.2Financial Statements This video can be viewed online. Users of accounting information can be divided into two major groups: internal users, such as managers and executives who actually work in the company, and external users, such as potential lenders and investors. This textbook focuses on financial accounting, which is the name given to accounting information provided for and used by external users. Managerial accounting is the name given to accounting systems designed for internal users. From an accounting standpoint, the crucial difference between internal users and external users is that internal users, because they work within the company, have the power to custom design accounting reports to meet their specific needs. External users typically must rely on general purpose financial information provided by the company. The general purpose information provided by financial accounting is summarized in the financial statements: the balance sheet, income statement, and statement of cash flows. Balance Sheet This video can be viewed online. The balance sheet reports the resources of a company (the assets), the company’s obligations (the liabilities), and the owners’ equity, which represents how much money has been invested in the company by its owners. A condensed illustration of McDonald’s 2012 balance sheet is shown below. All numbers are in millions of U.S. dollars.1 Assets Liabilities Cash $2,336 Long-term loans $13,633 Land 5,613 Other liabilities 6,460 Buildings and equipment 19,064 Other assets 8,374 Equity Owners’ investment 15,294 Total $35,387 Total $35,387 McDonald’s reports total assets in excess of $35 billion. Notice that the total of the assets is exactly equal to the total of the liabilities and the equity. Is this exact equality a coincidence? You’ll find out later when we discuss the balance sheet in more detail. The $35 billion asset total is also interesting in light of the statement made earlier that the value of the McDonald’s brand name and reputation is over $40 billion, but accounting rules prohibit including that value in the balance sheet. Could it be true that more than half of McDonald’s economic assets are actually not listed in its balance sheet ($35 billion listed and $40 billion not listed)? We’ll address that question later when we discuss long-term assets in detail. Income Statement This video can be viewed online. The income statement reports the amount of net income earned by a company during a period, with annual and quarterly income statements being the most common. Net income is the excess of a company’s revenues over its expenses; if the expenses are more than the revenues, then the company has suffered a loss for the period. The income statement represents the accountant’s best effort at measuring the economic performance of a company. A simplified version of McDonald’s 2012 income statement is given below (in millions of U.S. $): Revenues: $27,567 Expenses: Food and paper: $6,318 Payroll and benefits 4,710 Interest 517 Income taxes 2,614 Other expenses 7,943 Total expenses 22,102 Net income $5,465 Overall, during 2012 McDonald’s made over $5.4 billion. Later we will learn how to use its detailed revenue and expense data, coupled with an understanding of how a franchise business like McDonald’s works, to estimate how much profit McDonald’s makes each time it sells you a Big Mac. Statement of Cash Flows This video can be viewed online. The statement of cash flows reports the amount of cash collected and paid out by a company in the following three types of activities: operating, investing, and financing. The types of activities that fall in each of these three categories will be explained later when we discuss the financial statements in detail. The statement of cash flows is the most objective of the financial statements because, as you will see in subsequent chapters, it involves a minimum of accounting estimates and judgments. A summary of McDonald’s 2012 statement of cash flows is given below (in millions of U.S. $): Cash from operations $6,966 Cash used for investing activities: (3,049) Purchases of property and equipment (118) (3,167) Cash from financing activities: New loans received 2,285 Repayment of old loans (1,081) Payment of cash dividends (2,897) Other (2,106) (3,799) Net increase in cash during the year $0 McDonald’s cash balance increased by just $400,000 (rounded to $0 when reporting in millions) during the year. Notice that no detail about cash from operations is given. The reason is that because of some traditional accounting reporting practices, companies are not required to report cash expenditures by category, such as cash paid to employees, cash paid for rent, and the like. You will have to wait until later to find out more about this. The three primary financial statements will be more formally introduced in our “Overview of the Financial Statements.” We cover the basics of how to analyze the financial statements when we provide an ...
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