Using Accounting & Financial Information

Mark S. Bettner

• Publisher: Business Expert Press
• Year: 2018
• ISBN:
  9781947098695
• Topic: Business
• Subtopic: Financial Accounting
• Index: Business

Accounting is often referred to as the language of business. Unfortunately, many business professionals lack the required fluency in this unique language to perform basic financial analysis, prepare budgetary forecasts, or to compare competing capital investment alternatives. This book targets individuals with limited exposure to—or formal training in—accounting and related finance disciplines. These individuals include—but certainly are not limited to—engineers, information technology specialists, retail managers, entrepreneurs, marketing directors, construction contractors, attorneys, and bankers who are making career transitions from consumer lending positions to become commercial loan officers. The primary purpose of this book is to help managers and business owners from diverse professional and educational backgrounds to (1) converse more effectively with their accounting and finance colleagues; (2) understand the structure and the elements of general purpose financial statements; (3) identify both the usefulness and the limitations of accounting information; (4) prepare budgets and financial forecasts; and (5) make sense of commonly used decision-making models.

CHAPTER 1

Users of Accounting and Financial Information

Accounting is often referred to as the language of business; unfortunately, many business professionals lack fluency in this unique language, making it difficult for them to perform basic financial analysis, prepare budgetary forecasts, or compare competing capital investment alternatives. Although there is no shortage of well-written accounting textbooks, budgeting handbooks, or finance publications, most require that readers have educational backgrounds and/or professional experience in accounting and financial management.

This book targets individuals in management positions with limited exposure to—or formal training in—the disciplines of accounting and finance. These professionals include engineers, information technology specialists, entrepreneurs, marketing managers, construction contractors, attorneys, and even bankers who have transitioned from consumer-lending positions to become commercial loan officers.

Throughout this book, accounting and financial reporting subjects are addressed from a user’s perspective. Thus, topics such as transaction analysis, journal entries, and numerous other recordkeeping procedures associated with financial statement preparation are avoided. Its purpose is to help managers from diverse professional and educational backgrounds to: (1) converse more effectively with their accounting and finance colleagues, (2) appreciate the usefulness and limitations of general purpose financial statements, (3) use accounting information in decision-making processes, (4) develop short- and long-term financial forecasts, and (5) make sense of commonly used decision-making models.

The Role of Accounting in Organizations and Society

A primary objective of accounting is to communicate relevant and reliable information to decision makers that is useful in managing economic resources. This book addresses the role of accounting as it relates to for-profit corporations; however, accounting plays an important role in all types of enterprises—including partnerships, family-owned businesses, nonprofit organizations, and governmental entities.

Users of accounting information include investors, creditors, managers, regulatory agencies, tax authorities, and anyone else interested in financial issues related to a company’s efficiency, performance, competitive advantage, and sustainability. When accounting information is prepared for users external to an organization (such as investors, creditors, and regulators), it is often referred to as financial accounting or financial reporting. When it is prepared for users inside of an organization (including managers, chief financial officers, board members, and controllers), it is generally referred to as managerial accounting. Chapters 2 through 4 devote coverage to external reporting topics, whereas Chapters 5 through 8 focus on internal accounting issues.¹

Financial Management Systems

It is useful to frame a preliminary discussion of accounting in the context of financial management systems.² Figure 1.1 illustrates the function of a financial management system as it relates to external and internal decision makers.

Figure 1.1 Financial management systems

Organizations engage in a multitude of economic events and transactions every day. Most of these activities result in the creation of what is referred to in Figure 1.1 as unprocessed “raw” financial data. This information often takes the form of source documents such as sales receipts, utility bills, property tax notices, employee timecards, bank statements, purchase orders, insurance policies, and lease contracts. Financial management systems convert raw financial data into relevant and reliable information useful to external and internal decision makers.

Financial management systems are composed of numerous modules and reporting applications unique to the environments in which they function; however, common to all financial information systems is general ledger software. General ledger software is used to record economic events, accumulate activities in specific accounts, analyze accounts receivable, manage payments to creditors, track inventory, maintain depreciation schedules, and streamline financial reporting processes.

Most financial management systems also include payroll software for distributing paychecks, transferring withholdings to tax authorities, and performing the year-end filings of required IRS forms, such as W-2s and 1099s. Other components may include cost accounting software, budgeting applications, simulation packages, and forecasting modules. Functioning as an integrated set of specialized subroutines, these components convert raw data into uniquely formatted reports for dissemination to a diverse group of stakeholders and decision makers.

As Figure 1.1 illustrates, the users of accounting information are both internal and external to the reporting entity. The needs and characteristics of each user group are discussed next.

Internal Users of Accounting Information

Accounting information provided to internal users can be highly confidential and company-specific. Thus, internal accounting reports are often custom-designed and uniquely tailored for specific user groups. For instance, the following internal decision makers rely upon accounting information for very specific purposes:

• Boards of directors and CEOs use accounting information to support strategic planning decisions, such as acquiring subsidiaries, distributing dividends, and shifting manufacturing operations abroad.
• Treasurers and CFOs use accounting information to make financial management decisions, such as investing excess cash reserves, determining annual bonuses, and financing expansion with debt or with equity.
• Controllers use accounting information to analyze cost behaviors, to measure operating efficiency, and to determine breakeven points.
• Human resources officers use accounting information to make hiring decisions, to measure health care costs, and to forecast retirement fund requirements.
• Engineers and researchers use accounting information to estimate the cost of improving quality, to measure manufacturing efficiency, and to prepare budgets supporting the R&D pipeline.
• Marketing and sales managers use accounting information to forecast sales, to make product mix decisions, and to support brand management decisions.

The second half of this book is devoted entirely to the use of accounting information by internal decision makers. Chapter 5 discusses long-term forecasting, whereas Chapter 6 addresses short-term forecasting and operational budgeting. Chapter 7 examines cost behavior and its impact on profitability, and Chapter 8 focuses on the importance of accounting information for evaluating capital investment decisions. The remaining portion of this chapter and the three chapters that follow pertain to accounting information used by external decision makers, in particular the investors and creditors of publicly owned, for-profit corporations.

External Users of Accounting Information

Investors and creditors are generally considered the primary external users of accounting information. Other external users include regulatory bodies (such as the Federal Trade Commission and the Public Utilities Commission), tax authorities (including the Internal Revenue Service and the Social Security Administration), and a host of other stakeholders with vested interests in the financial affairs of a particular business entity (common examples include labor unions, suppliers, and customers).

Investors (Shareholders)

Investors are the owners of for-profit corporations. Many privately owned corporations are so small that there is no separation between owners and management—in other words, they are one and the same. Publicly owned corporations can have millions of external shareholders, few of whom actually take part in managing the daily operations of the company whose shares they own. Thus, in publicly owned corporations, a separation exists between owners and managers.³ The shareholders of these corporations are on the outside looking in, and they depend heavily upon financial accounting information to keep them informed.

Existing and potential investors require a basic level of financial literacy in order for accounting information to be useful to them. As their financial literacy improves, so does their ability to measure their return on investment, compare performances among competing firms in the same industry, and assess whether a company will continue as a going concern. Perhaps most importantly, financial literacy enables investors to formulate sensible valuations of stock prices and to become more adept at predicting changes in investment values over time.

Creditors (Lenders)

Unlike investors, creditors rarely have an ownership stake in publicly owned corporations. As the term implies, creditors extend credit to companies with an expectation of being repaid and they are often compensated with interest for doing so. Creditors include bankers, bondholders, suppliers, venture capitalists, and numerous other providers of debt financing.

Creditors rely heavily upon financial accounting information to evaluate the credit risk associated with a borrower’s likelihood of default. As such, they are especially interested in a borrower’s ability to generate enough cash flow to satisfy debt service obligations over the term of a loan agreement. High-credit-risk borrowers are charged higher rates of interest than low-credit-risk borrowers.

Investors and creditors both rely upon accounting reports to assess the amount, the timing, and the uncertainty associated with a company’s future cash flows.⁴ Given the importance of accounting information to both user groups, it is important that access to reliable information be readily available. The remainder of this chapter discusses the financial reporting requirements of publicly owned corporations and the integrity of the information that they provide.

Reporting Requirements of Publicly Owned Corporations

Publicly owned corporations are those whose stock is listed and traded on organized exchanges, such as the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations (NASDAQ). The Securities and Exchange Commission (SEC) mandates by law that all publicly owned corporations make information freely available to everyone, including investors and creditors. The EDGAR link on the SEC website (www.sec.gov) provides open access to more than 20 million filings submitted by publicly owned entities. These enterprises are required to submit dozens of reports to the SEC on a regular basis. Of these reports, two are of primary importance to this book—the 10-Q and the 10-K. The 10-Q is a required quarterly report, whereas the 10-K is a much longer and more detailed annual report. Both provide valuable information about a corporation’s products, markets, employees, executive competition packages, and risk factors.⁵

At the heart of every 10-Q and 10-K is a rather lengthy section devoted to financial accounting and financial reporting. It is in this section that a corporation’s general purpose financial statements are presented. These statements typically include comparative balance sheets, income statements, statements of cash flows, and statements of retained earnings.⁶ Each of these reports is discussed in detail throughout this book. For now it is important to be aware of two things. First, they are called general purpose financial statements because their structure and content are somewhat generic and boilerplate across all reporting entities—in short, they provide a one size fits all function. Second, each statement has a unique purpose that makes it useful to investors, creditors, and other decision makers in assessing the amount, timing, and uncertainty of future cash flows.

A balance sheet reveals a corporation’s financial position at a point in time, meaning that it reports the resources of an entity (its assets), and the claims to those resources by investors and creditors, at a specific date. An income statement reports a corporation’s results of operations over a ...

Table of contents

• Cover
• Half Title Page
• Title Page
• Copyright Page
• Dedication
• Contents
• Acknowledgments
• Chapter 1 Users of Accounting and Financial Information
• Chapter 2 Corporate Financial Statements
• Chapter 3 Accrual and Deferral Timing Differences
• Chapter 4 Financial Statement Analysis
• Chapter 5 Long-Term Financial Forecasting
• Chapter 6 Operating Budgets
• Chapter 7 Cost–Volume–Profit Relationships
• Chapter 8 Capital Budgeting
• About the Author
• Index