Chapter 1 - ACCT 2810

A business is an organization in which basic resources (inputs), such as materials and labor, are assembled and processed to provide goods or services (outputs) to customers. Businesses come in all sizes, from a local coffee house to Starbucks (SBUX), which sells over $22 billion of coffee and related products each year.

The objective of most businesses is to earn a profit. Profit is the difference between the amounts received from customers for goods or services and the amounts paid for the inputs used to provide the goods or services. In this text, we focus on businesses operating to earn a profit. However, many of the same concepts and principles also apply to not-for-profit organizations such as hospitals, churches, and government agencies.

Three types of businesses operated for profit include service, merchandising, and manufacturing businesses. Each type of business and some examples are described below.

• Service businesses provide services rather than products to customers.

  • Delta Air Lines (DAL) (transportation services)

  • The Walt Disney Company (DIS) (entertainment services)

• Merchandising businesses sell products they purchase from other businesses to customers.z

  • Walmart (WMT) (general merchandise)

  • Amazon.com (AMZN) (books, music, videos)

• Manufacturing businesses change basic inputs into products that are sold to customers.

  • General Motors Corporation (GM) (cars, trucks, vans)

  • Intel Corp (INTC) (computer microprocessors)

A business is normally organized in one of the following four forms:

• proprietorship

• partnership

• corporation

• limited liability company

A proprietorship is owned by one individual. More than 70% of the businesses in the United States are organized as proprietorships. The frequency of this form is due to the ease and low cost of organizing. The primary disadvantage of proprietorships is that the financial resources are limited to the individual owner’s resources. In addition, the owner has unlimited liability to creditors for the debts of the company.

A partnership is owned by two or more individuals. About 10% of the businesses in the United States are organized as partnerships. Like a proprietorship, a partnership may outgrow the financial resources of its owners. Also, the partners have unlimited liability to creditors for the debts of the company.

A corporation is organized under state or federal statutes as a separate legal entity. The ownership of a corporation is divided into shares of stock. A corporation issues the stock to individuals or other companies, who then become owners or stockholders of the corporation. A primary advantage of the corporate form is the ability to obtain large amounts of resources by issuing shares of stock. In addition, the stockholders’ liability to creditors for the debts of the company is limited to their investment in the corporation.

A limited liability company (LLC) combines attributes of a partnership and a corporation. The primary advantage of the limited liability company form is that it operates similar to a partnership, but its owners’ (or members’) liability for the debts of the company is limited to their investment. Many professional practices such as lawyers, doctors, and accountants are organized as limited liability companies.

In addition to the ease of formation, ability to raise capital, and liability for the debts of the business, other factors such as taxes and legal life of the business should be considered when forming a business. For example, corporations are taxed as separate legal entities, while the income of sole proprietorships, partnerships, and limited liability companies is passed through to the owners and taxed on the owners’ tax returns. As separate legal entities, corporations also continue on, regardless of the lives of the individual owners. In contrast, sole proprietorships, partnerships, and limited liability companies may terminate their existence with the death of an individual owner.

The characteristics of sole proprietorships, partnerships, corporations, and limited liability companies are summarized below.

The objective of a business is to earn a profit by providing goods or services to customers. How does a company decide which products or services to offer its customers? Many factors influence this decision. Ultimately, however, the decision is based on how the company plans to gain an advantage over its competitors and, in doing so, maximize its profits.

Companies try to maximize their profits by generating high revenues while maintaining low costs, which results in high profits. However, a company’s competitors are also trying to do the same, and thus, a company can only maximize its profits by gaining an advantage over its competitors.

Generally, companies gain an advantage over their competitors by using one of the following strategies:

• A low-cost strategy, where a company designs and produces products or services at a lower cost than its competitors. Such companies often sell no-frills, standardized products and services.

• A premium-price strategy, where a company tries to design and produce products or services that serve unique market needs, allowing it to charge premium prices. Such companies often design and market their products so that customers perceive their products or services as having a unique quality, reliability, or image.

Walmart (WMT) and Southwest Airlines (LUV) are examples of companies using a low-cost strategy. John Deere (DE) and Tiffany (TIF) are examples of companies using a premium-price strategy.

Since business is highly competitive, it is difficult for a company to sustain a competitive advantage over time. For example, a competitor of a company using a low-cost strategy may copy the company’s low-cost methods or develop new methods that achieve even lower costs. Likewise, a competitor of a company using a premium-price strategy may develop products that are perceived as more desirable by customers.

Examples of companies utilizing low-cost and premium-price strategies include:

• Local pharmacies who develop personalized relationships with their customers. By doing so, they are able to charge premium (higher) prices. In contrast, Walmart’s pharmacies use the low-cost emphasis and compete on cost.

• Grocery stores such as Kroger (KR) develop relationships with their customers by issuing preferred customer cards. These cards allow the stores to track consumer preferences and buying habits for use in purchasing and advertising campaigns.

• Honda (HMC) promotes the reliability and quality ratings of its automobiles and thus charges premium prices. In contrast, Kia Motors (KRX) uses a low-cost strategy.

• Harley-Davidson (HOG) emphasizes that its motorcycles are “Made in America” and promotes its “rebel” image as a means of charging higher prices.

Companies sometimes struggle to find a competitive advantage. For example, JCPenney (JCP) and Macy’s (M) have difficulty competing on low costs against Walmart (WMT), Kohl’s (KSS), T.J. Maxx (TJX), and Target (TGT). At the same time, JCPenney and Macy’s have difficulty charging premium prices against competitors such as The GAP (GPS) and Urban Outfitters (UOF). Likewise, Delta Air Lines (DAL) and United Airlines (UA) have difficulty competing against low-cost airlines such as Southwest (LUV). At the same time, Delta and United don’t offer any unique services for which their passengers are willing to pay a premium price.

A business stakeholder is a person or entity with an interest in the economic performance and well-being of a company. For example, owners, suppliers, customers, and employees are all stakeholders in a company.

Capital market stakeholders provide the financing for a company to begin and continue its operations. Banks and other long-term creditors have an economic interest in receiving the amount loaned plus interest. Owners want to maximize the economic value of their investments.

Product or service market stakeholders purchase the company’s products or services or sell their products or services to the company. Customers have an economic interest in the continued success of the company. For example, customers who purchase advance tickets on Delta Air Lines (DAL) are depending on Delta continuing in business. Likewise, suppliers depend on continued success of their customers. For example, if a customer fails or cuts back on purchases, the supplier’s business will also decline.

Government stakeholders, such as federal, state, county, and city governments, collect taxes from companies. The better a company does, the more taxes the government collects. In addition, workers who are laid off by a company can file claims for unemployment compensation, which results in a financial burden for the state and federal governments.

Internal stakeholders, such as managers and employees, depend upon the continued success of the company for keeping their jobs. Managers of companies that perform poorly are often fired by the owners. Likewise, during economic downturns companies often lay off workers.

All companies engage in the following three business activities:

• Financing activities to obtain the necessary funds (monies) to organize and operate the company

• Investing activities to obtain assets such as buildings and equipment to begin and operate the company

• Operating activities to earn revenues and profits

Financing activities involve obtaining funds to begin and operate a business. Companies obtain financing through the use of capital markets by:

• borrowing

• issuing shares of ownership

When a company borrows money, it incurs a liability. A liability is a legal obligation to repay the amount borrowed according to the terms of the borrowing agreement. When a company borrows from a vendor or supplier, the liability is called an account payable. In such cases, the company promises to pay according to the terms set by the vendor or supplier. Most vendors and suppliers require payment within a relatively short time, such as 30 days.

A company may also borrow money by issuing bonds. Bonds are sold to investors and require repayment normally with interest. The amount of the bonds, called the face value, usually requires repayment several years in the future. Thus, bonds are a form of long-term financing. The interest on the bonds, however, is normally paid semiannually. Bond obligations are reported as bonds payable, and any interest that is due is reported as interest payable.

Many companies borrow by issuing notes payable. A note payable requires payment of the amount borrowed plus interest. Notes payable are similar to bonds except that they may be issued on either a short-term or a long-term basis.

A company may finance its operations by issuing shares of ownership. For a corporation, shares of ownership are issued in the form of shares of stock. Although corporations may issue a variety of different types of stock, the basic type of stock issued to owners is called common stock. Investors who purchase the stock are referred to as stockholders.

The claims of creditors and stockholders on the assets of a corporation are different. Assets are the resources owned by a corporation (company). Creditors have first claim on the company’s assets. Only after the creditors’ claims are satisfied do the stockholders have a right to the corporate assets.

Creditors normally receive timely payments, which may include interest. In contrast, stockholders are not entitled to regular payments. However, many corporations distribute earnings to stockholders on a regular basis. These distributions of earnings to stockholders are called dividends.

Investing activities involve using the company’s assets to obtain additional assets to start and operate the business. Depending upon the nature of the business, a variety of different assets must be acquired.

Most businesses need assets such as machinery, buildings, computers, office furnishings, trucks, and automobiles. These assets have physical characteristics and as such are tangible assets. Long-term tangible assets such as machinery, buildings, and land are reported separately as property, plant, and equipment. Short-term tangible assets such as cash and inventories are reported separately.

A business may also need intangible assets. For example, a business may obtain patent rights to use in manufacturing a product. Long-term assets such as patents, goodwill, and copyrights are reported separately as intangible assets.

A company may also prepay for items such as insurance or rent. Such items, which are assets until they are consumed, are reported as prepaid expenses. In addition, rights to payments from customers who purchase merchandise or services on credit are reported as accounts receivable.

Operating activities involve using assets to earn revenues and profits. The management of a company does this by implementing one of the business strategies discussed earlier.

Revenue is the increase in assets from selling products or services. Revenues are normally identified according to their source. For example, revenues received from selling products are called sales. Revenues received from providing services are called fees earned.

To earn revenue, a business incurs costs, such as wages of employees, salaries of managers, rent, insurance, advertising, freight, and utilities. Costs used to earn revenue are called expenses and are identified and reported in a variety of ways. For example, the cost of products sold is referred to as the cost of goods sold, cost of merchandise sold, or cost of sales. Other expenses are normally classified as either selling expenses or administrative expenses. Selling expenses include those costs directly related to the selling of a product or service. For example, selling expenses include such costs as sales salaries, sales commissions, freight, and advertising costs. Administrative expenses include other costs not directly related to the selling such as officer salaries and other costs of the corporate office.

By comparing the revenues for a period to the related expenses, it can be determined whether the company has earned net income or incurred a net loss. Net income results when revenues exceed expenses. A net loss results when expenses exceed revenues.

The role of accounting is to provide information about the financing, investing, and operating activities of a company to its stakeholders. For example, accounting provides information for managers to use in operating the business. In addition, accounting provides information to other stakeholders, such as creditors, for assessing the economic performance and condition of the company.

Accounting is often called the “language of business.” In a general sense, accounting is defined as an information system that provides reports to stakeholders about the economic activities and condition of a business. This text focuses on accounting and its role in business. However, many of the concepts discussed also apply to individuals, governments, and not-for-profit organizations. For example, individuals must account for their hours worked, checks written, and bills paid. Stakeholders for individuals include creditors, dependents, and the government.

A primary purpose of accounting is to summarize the financial performance of a business for external stakeholders, such as banks and governmental agencies. The branch of accounting that is associated with preparing reports for users external to the business is called financial accounting. Accounting also can be used to guide management in making financing, investing, and operations decisions for the company. This branch of accounting is called managerial accounting. Financial and managerial accounting may overlap. For example, financial reports for external stakeholders are often used by managers in assessing the potential impact of their decisions on the company. The head of the accounting department in a company is called comptroller or chief financial officer (CFO).

The two major objectives of financial accounting are:

• To report the financial condition of a business at a point in time

• To report changes in the financial condition of a business over a period of time

Financial statements report the financial condition of a business at a point in time and changes in the financial condition over a period of time. The four basic financial statements and their relationship to the objectives of financial accounting are listed below.

The income statement reports the change in financial condition due to the operations of the company. The time period covered by the income statement may vary depending upon the needs of stakeholders. Public corporations are required to file quarterly and annual income statements with the Securities and Exchange Commission (SEC). The income statement for a year ending December 31 for The Hershey Company is shown in Exhibit 6.

Since the objective of business operations is to generate revenues, the income statement begins by listing the revenues for the period. During the year, Hershey generated sales of $7,791 million. These sales are listed under “Revenues.” The numbers shown in Exhibit 6 are expressed in millions of dollars. It is common for large companies to express their financial statements in thousands or millions of dollars.

Following the revenues, the expenses used in generating the revenues are listed. For Hershey, these expenses include cost of sales, selling and administrative, interest, income taxes, and other expenses. By reporting the expenses and the related revenues for a period, the expenses are said to be matched against the revenues. This is known in accounting as the matching concept, which is discussed later in this chapter.

When revenues exceed expenses for a period, the company has net income. If expenses exceed revenues, the company has a net loss. Net income means that the business increased its net assets through its operations. That is, the assets created by the revenues exceeded the assets used in generating those revenues.

The objective of most companies is to maximize net income or profit. A net loss means that the business decreased its net assets through its operations. While a business might survive in the short run by reporting net losses, in the long run a business must earn net income to survive.

Exhibit 6 shows that Hershey earned net income of $1,178 million. Is this good or bad? Certainly, net income is better than a net loss. However, the stakeholders must assess net income according to their objectives. For example, a creditor might be satisfied that the net income is sufficient to ensure that it will be repaid. In contrast, a stockholder might assess the corporation’s profitability as less than its competitors’ profits and thus be disappointed. Throughout this text, various methods of assessing corporate performance will be described and illustrated.

The statement of stockholders’ equity reports the changes in financial condition due to changes in stockholders’ equity for a period. Changes to stockholders’ equity normally involve common stock and retained earnings. Retained earnings are the portion of a corporation’s net income retained in the business. A corporation may retain all of its net income for expanding operations, or it may pay a portion or all of its net income as dividends. For example, high-growth companies often do not distribute dividends but instead retain profits for future expansion. In contrast, more mature corporations normally pay a regular dividend.

Since retained earnings depend upon net income, the period covered by the statement of stockholders’ equity is the same period as the income statement. The statement of stockholders’ equity for Hershey for the year ended December 31 is shown in Exhibit 7.

There was no change in common stock during the year. During the year, Hershey earned net income of $1,178 million and distributed (declared) dividends of $564 million. Dividends are reported in the statement of stockholders’ equity rather than the income statement. This is because dividends are not an expense but a distribution of net income to stockholders. In addition to net income and dividends, Hershey reported an unusual (other) item of $47 million as an addition to its retained earnings. This other item is related to the effects of a 2017 Congressional reform of the U.S. corporate taxes, which were allowed to be reclassified into retained earnings. Thus, during the year, Hershey’s retained earnings increased from $6,371 to .

Exhibit 7 includes a column for other equity items. Items in this category include paid-in capital (amounts contributed in excess of the par value of stock) and treasury stock (repurchased common stock) that will be discussed in a later chapter.

The balance sheet reports the financial condition as of a point in time. This is in contrast to the income statement, statement of stockholders’ equity, and statement of cash flows, which report changes in financial condition for a period of time. The financial condition of a business as of a point in time is measured by its total assets and claims or rights to those assets.

The claims on a company’s assets consist of rights of creditors and stockholders. The rights of creditors are liabilities. The rights of stockholders are referred to as stockholders’ equity or owners’ equity. Thus, the financial condition of a business can be expressed in equation form as:

This equation is called the accounting equation. This equation is the foundation of accounting information systems, which are discussed in later chapters.

The balance sheet, sometimes called the statement of financial condition, is prepared using the accounting equation. The balance sheet is prepared by listing the accounting equation in vertical rather than horizontal form as follows:

1. Step 1

   Each asset is listed and added to arrive at total assets.

2. Step 2

   Each liability is listed and added to arrive at total liabilities.

3. Step 3

   Each stockholders’ equity item is listed and added to arrive at total stockholders’ equity.

4. Step 4

   Total liabilities and total stockholders’ equity is added to arrive at total liabilities and stockholders’ equity.

5. Step 5

   Total assets must equal total liabilities and stockholders’ equity.

The accounting equation must balance in Step 5; hence, the name balance sheet. The balance sheet for The Hershey Company as of December 31 is shown in Exhibit 8.

Exhibit 8 reports total assets of $7,703 million equal its total liabilities of $6,296 million plus its total stockholders’ equity of $1,407 million.

The statement of cash flows reports the change in financial condition due to the changes in cash during a period. The statement of cash flows is organized around the three business activities of financing, investing, and operating. Any changes in cash must be related to one or more of these activities.

The net cash flows from operating activities is reported first. This is because cash flows from operating activities is a primary focus of the company’s stakeholders. In the short term, creditors use cash flows from operating activities to assess whether the company’s operating activities are generating enough cash to repay them. In the long term, a company cannot survive unless it generates positive cash flows from operating activities. Thus, cash flows from operating activities is also a focus of employees, managers, suppliers, customers, and other stakeholders who are interested in the long-term success of the company.

The net cash flows from investing activities is reported second. This is because investing activities directly impact the operations of the company. Cash receipts from selling property, plant, and equipment are reported in this section. Likewise, any purchases of property, plant, and equipment are reported as cash payments. Companies that are expanding rapidly, such as start-up companies, normally report negative net cash flows from investing activities. In contrast, companies that are downsizing or selling segments of the business may report positive net cash flows from investing activities.

The net cash flows from financing activities is reported third. Any cash receipts from issuing debt or stock are reported in this section as cash receipts. Likewise, cash payments of debt and dividends are reported in this section.

The statement of cash flows is completed by adding the net cash flows from operating, investing, and financing activities to determine the net increase or decrease in cash for the period. This net increase or decrease in cash is then added to the cash at the beginning of the period to arrive at the cash at the end of the period.

The statement of cash flows for The Hershey Company for the year ended December 31 is shown in Exhibit 9.

During the year, Hershey’s operating activities generated a positive net cash flow of $1,600 million. Hershey’s investing activities used $1,503 million of cash to purchase property, plant, equipment, and other long-term assets. Hershey’s financing activities generated $111 million of cash. This cash was used to pay dividends, pay debt, and purchase its own stock. A company may purchase its own common stock if the corporate management believes its stock is undervalued or for providing stock to employees or managers as part of an incentive (stock option) plan. Hershey also received cash by borrowing from creditors.

During the year, Hershey increased its cash by $208 million. This increase is added to the cash at the beginning of the period of $380 million to arrive at net cash at the end of the period of $588 million.

Overall, Hershey’s statement of cash flows indicates that Hershey generated $1,600 million in cash flows from its operations. It used this cash to expand its operations and pay dividends to stockholders. Thus, Hershey appears to be in a strong operating position.

The financial statements are prepared in the following order:

1. income statement

2. statement of stockholders’ equity

3. balance sheet

4. statement of cash flows

Preparing the financial statements in the preceding order is important because the financial statements are integrated as follows:

1. The income statement and statement of stockholders’ equity are integrated. The net income or net loss reported on the income statement also appears on the statement of stockholders’ equity as either an addition (net income) to or deduction (net loss) from the beginning retained earnings.

2. The statement of stockholders’ equity and the balance sheet are integrated. The common stock and retained earnings at the end of the period on the statement of stockholders’ equity also appear on the balance sheet.

3. The balance sheet and statement of cash flows are integrated. The cash on the balance sheet also appears as the end-of-period cash on the statement of cash flows.

To illustrate, The Hershey Company’s financial statements in Exhibits 6, 7, 8, and 9 are integrated as follows:

1. Net income of $1,178 million is also reported on the statement of stockholders’ equity as an addition to the beginning retained earnings.

2. Retained earnings of $7,032 million and common stock of $299 as of December 31 are also reported on the balance sheet.

3. Cash of $588 million on the December 31 balance sheet is also reported as the end-of-period cash on the statement of cash flows.

The preceding integrations are shown in Exhibit 10. These integrations are important in analyzing (1) financial statements and (2) the impact of transactions on the financial statements. In addition, these integrations serve as a check on whether the financial statements have been prepared correctly. For example, if the ending cash on the statement of cash flows doesn’t agree with the balance sheet cash, then an error has occurred.

Exhibit 10Integrated Financial Statements

The four corporate financial statements described and illustrated in the preceding section were prepared using accounting “rules,” called generally accepted accounting principles (GAAP). Generally accepted accounting principles (GAAP) are necessary so that stakeholders can compare companies across time. If the management of a company could prepare financial statements as they saw fit, the comparability between companies and across time would be impossible.

Accounting principles and concepts develop from research, accepted accounting practices, and pronouncements of regulators. Within the United States, the Financial Accounting Standards Board (FASB) has the primary responsibility for developing accounting principles. The FASB publishes Statements of Financial Accounting Standards as well as interpretations of these Standards.

The Securities and Exchange Commission (SEC), an agency of the U.S. government, also has authority over the accounting and financial disclosures for corporations whose stock is traded and sold to the public. The SEC normally accepts the accounting principles set forth by the FASB. However, the SEC may issue Staff Accounting Bulletins on accounting matters that may not have been addressed by the FASB.

Many countries outside the United States use generally accepted accounting principles adopted by the International Accounting Standards Board (IASB). The IASB issues International Financial Reporting Standards (IFRS). Significant differences currently exist between FASB and IASB accounting principles. However, the FASB and IASB are working together to reduce and eliminate these differences toward the goal of developing a single set of accounting principles. Such a set of worldwide accounting principles would help facilitate investment and business in an increasingly global economy.

Generally accepted accounting principles (GAAP) rely upon eight supporting accounting concepts, as shown in Exhibit 11. Throughout this text, emphasis is on accounting principles and concepts. In this way, you will gain an understanding of “why” as well as “how” accounting is applied in business. Such an understanding is essential for analyzing and interpreting financial statements.

The business entity concept limits the economic data recorded in an accounting system to data related to the activities of that company. In other words, the company is viewed as an entity separate from its owners, creditors, or other companies. For example, a company with one owner records the activities of only that company and does not record the personal activities, property, or debts of the owner. A business entity may take the form of a proprietorship, partnership, corporation, or limited liability company (LLC).

To illustrate, the accounting for The Hershey Company, a corporation, is separate from the accounting of its stakeholders. In other words, the accounting for transactions and events of individual stockholders, creditors, or other Hershey stakeholders is not included in The Hershey Company’s financial statements. Only the transactions and events of the corporation are included.

The cost concept initially records assets in the accounting records at their cost or purchase price. To illustrate, assume that Aaron Publishers purchased the following land on August 3, 20Y4, for $150,000:

Under the cost concept, Aaron Publishers records the purchase of the land on August 3, 20Y4, at the purchase price of $150,000. The other amounts listed above have no effect on the accounting records.

The fact that the land has an estimated selling price of $220,000 on December 31, 20Y8, indicates that the land has increased in value. However, to use the $220,000 in the accounting records would be to record an illusory or unrealized profit. If Aaron Publishers sells the land on January 9, 20Y9, for $240,000, a profit of is then realized and recorded. The new owner would record $240,000 as its cost of the land.

The going concern concept assumes that a company will continue in business indefinitely. This assumption is made because the amount of time that a company will continue in business is not known.

The going concern concept justifies the use of the cost concept for recording purchases, such as land. For example, in the preceding illustration Aaron Publishers plans to build a plant on the land. Since Aaron Publishers does not plan to sell the land, reporting changes in the market value of the land is irrelevant. That is, the amount Aaron Publishers could sell the land for if it went out of business is not important. This is because Aaron Publishers plans to continue its operations.

If, however, there is strong evidence that a company is planning on discontinuing its operations, then the accounting records are revised. To illustrate, the assets and liabilities of businesses in receivership or bankruptcy are valued from a quitting concern or liquidation point of view, rather than from the going concern point of view.

The matching concept reports the revenues earned by a company for a period with the expenses incurred in generating the revenues. That is, expenses are matched against the revenues they generated.

Revenues are normally recorded at the time a product is sold or a service is rendered, which is referred to as the revenue recognition principle. At the point of sale, the sale price has been agreed upon, the buyer acquires ownership of the product or acquires the service, and the seller has a legal claim against the buyer for payment.

The expenses incurred in generating revenue should be reported in the same period as the related revenue. This is called the expense recognition principle. By matching revenues and expenses, net income or loss for the period can properly be determined and reported.

The objectivity concept requires that entries in the accounting records and the data reported on financial statements be based on verifiable or objective evidence. For example, invoices, bank statements, and a physical count of supplies on hand are all objective and verifiable. Thus, they can be used for entering amounts in the accounting system. In some cases, judgments, estimates, and other subjective factors may have to be used in preparing financial statements. In such situations, the most objective evidence available is used.

In the United States, the unit of measure concept requires that all economic data be recorded in dollars. Other relevant, nonfinancial information may also be recorded, such as terms of contracts. However, it is only through using dollar amounts that the various transactions and activities of a business can be measured, summarized, reported, and compared. Money is common to all business transactions and thus is the unit of measurement for financial reporting.

The adequate disclosure concept requires that the financial statements, including related notes, contain all relevant data a stakeholder needs to understand the financial condition and performance of the company. Nonessential data are excluded to avoid clutter.

The accounting period concept requires that accounting data be recorded and summarized in financial statements for periods of time. For example, transactions are recorded for a period of time such as a month or a year. The accounting records are then summarized and updated before preparing the financial statements.

The reliability of the financial reporting system is important to the economy and for the ability of businesses to raise money from investors. That is, stockholders and creditors require accurate financial reporting before they will invest their money. Scandals and financial reporting frauds threaten the confidence of investors. Exhibit 13 is a list of some financial reporting frauds and abuses.

Exhibit 13

Accounting Frauds

The companies listed in Exhibit 13 were caught in the midst of ethical lapses that led to fines, firings, and criminal or civil prosecution. The second column of Exhibit 13 identifies the accounting concept that was violated in committing these unethical business practices. For example, the WorldCom (WCOME) fraud involved reporting various expense items as though they were assets. This is a violation of the matching concept and resulted in overstating income and assets. The third column of the exhibit identifies some of the results of these events. In most cases, senior and mid-level executives lost their jobs and were sued by upset stakeholders. In some cases, the executives also were criminally prosecuted and are serving prison terms.

In analyzing and assessing a company’s financial condition and performance, a variety of quantitative measures may be used. Quantitative measures are referred to as metrics. Throughout this text, we use a variety of metrics to assess a company’s financial condition and performance. In addition, the effects of management’s decisions on metrics are also described and illustrated. We call this use of metrics to assess financial condition, performance, and decisions metric-based analysis.

The two basic types of metrics used in this text are ratios and amounts. For example, the return on assets ratio is described and illustrated in this chapter. An example of a metric amount is passenger miles flown by an airline or grade point average of a student.

We apply metric analysis at the following three levels:

1. Financial statement level

2. Transaction level

3. Managerial decision level

Financial Statement Level

Metric-based analysis is commonly applied at the financial statement level. At this level, various financial ratios are computed and analyzed. In the next section, we apply metric-based analysis at the financial statement level using the ratio return on assets (net income divided by average total assets).

Transaction Level

We also apply metric-based analysis at the transaction level. When a company enters into a transaction, it changes the company’s assets, liabilities, and stockholders’ equity. Since we assume companies operate to maximize their profits, we assess the effects of a transaction on one or more of a company’s profitability metrics.

Companies also attempt to maintain a minimum degree of liquidity so they can pay their liabilities and respond quickly to new opportunities to expand or enhance their operations. Liquidity refers to the degree to which a company has cash or assets that can be readily converted to cash. For example, investments in marketable securities can readily be converted to cash. In contrast, property, plant, and equipment are less liquid and could take months or years to convert to cash.

Liquidity differs from solvency. Solvency refers to the ability of a company to pay its long-term debts. Companies that cannot pay their debts are said to be insolvent, which usually involves filing for bankruptcy. Liquidity affects a company’s ability to pay its debts. However, a company may have a large portion of assets that cannot be readily converted to cash but still be profitable and solvent.

In addition to assessing the effects of a transaction on one or more of a company’s profitability metrics, we also assess the effects on one or more of a company’s liquidity metrics. In Chapter 2, we begin our metric-based analysis of transactions by assessing the effects of each transaction on cash and net income. In later chapters, we expand this analysis to include a variety of profitability and liquidity metrics.

Managerial Decision Level

In the managerial chapters of this text, metric-basis analysis assesses the effects of decisions on a variety of operating metrics. For example, a managerial decision to increase selling prices (assuming no decrease in units sold) would decrease its break-even point, which is the level at which operations may neither profit nor experience a loss. In this case, the metric being assessed is the break-even point.

In the remainder of this chapter, we describe and illustrate metric-based analysis at the financial statement level using return on assets. The return on assets is a profitability metric often used to compare a company’s performance over time and with competitors.

Return on assets is normally expressed as a percent such as 12%. However, it may also be expressed as an amount per dollar invested. For example, a 12% return on assets could also be expressed as $0.12 return per $1 invested. In other words, the company is earning 12 cents per dollar invested.

The return on assets percentage is computed as follows:

To illustrate, return on assets is computed for Apple Inc. (AAPL) and HP Inc. (HPQ) (formerly Hewlett-Packard). The computations use data (in millions) from recent financial statements.

1. Describe the types and forms of businesses, how businesses make money, and business stakeholders.

2. The three types of businesses operated for profit include manufacturing, merchandising, and service businesses. Such businesses may be organized as proprietorships, partnerships, corporations, and limited liability companies. A business may make money (profits) by gaining an advantage over its competitors using a low-cost or a premium-price emphasis. Under a low-cost emphasis, a business designs and produces products or services at a lower cost than its competitors. Under a premium-price emphasis, a business tries to design products or services that possess unique attributes or characteristics for which customers are willing to pay more. A business’ economic performance is of interest to its stakeholders. Business stakeholders include four categories: capital market stakeholders, product or service market stakeholders, government stakeholders, and internal stakeholders.

3. Describe the three business activities of financing, investing, and operating.

4. All businesses engage in financing, investing, and operating activities. Financing activities involve obtaining funds to begin and operate a business. Investing activities involve obtaining the necessary resources to start and operate the business. Operating activities involve using the business’s resources according to its business emphasis.

5. Define accounting and describe its role in business.

6. Accounting is an information system that provides reports to stakeholders about the economic activities and condition of a business. Accounting is the “language of business.”

7. Describe and illustrate the basic financial statements and how they are integrated.

8. The principal financial statements of a corporation are the income statement, the statement of stockholders’ equity, the balance sheet, and the statement of cash flows. The income statement reports a period’s net income or net loss, which also appears on the statement of stockholders’ equity. The ending reported on the statement of stockholders’ equity is also reported on the balance sheet. The ending cash balance is reported on the balance sheet and the statement of cash flows.

9. Describe eight accounting concepts underlying financial reporting.

10. The eight accounting concepts discussed in this chapter include the business entity, cost, going concern, matching, objectivity, unit of measure, adequate disclosure, and accounting period concepts.

11. Describe types of metrics and analyze a company’s performance using return on assets.

12. A metric is any quantitative measure. Metric analysis may be performed at the financial statement, transaction, or managerial decision level. At the financial statement level, return on assets is computed by dividing net income by average total assets. Return on assets is useful in assessing the percentage (rate) that a company is earnings on its invested assets. Return on assets can also be expressed as dollars earned for each dollar invested.