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Unformatted text preview: Accounting for MBAs AUTHORS
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.
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.
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
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.
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
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
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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