Accounting: The Language of Business (Part 6)

“Life is like a balance sheet. One wrong entry could change everything.” —Unknown

Introduction to Accounting and Business

(Part E)

by

Charles Lamson

Generally Accepted Accounting Principles

If the management of a company could record and report financial data as it saw fit, comparisons among companies would be difficult, if not impossible. Thus, financial accountants follow generally accepted accounting principles (GAAP) in preparing reports. These reports allow investors and other stakeholders to compare one company to another. 

To illustrate the importance of generally accepted accounting principles, assume that each sports conference in college football used different rules for counting touchdowns. For example, assume that the Pacific Athletic Conference (PAC 10) counted a touchdown as six points and the Atlantic Coast Conference (ACC) counted a touchdown as two points. It would be difficult to evaluate the teams under such different scoring systems. A standard set of rules and a standard scoring system help fans compare teams across conferences. Likewise, a standard set of generally accepted accounting principles allows for the comparison of financial performance and condition across companies.

Accounting principles and concepts develop from research, accepted accounting practices, and pronouncements of authoritative bodies. Currently, the Financial Accounting Standards Board (FASB) is the authoritative body having the primary responsibility for developing accounting principles. The FASB publishes Statements of Financial Accounting Standards and Interpretations to these Standards.

Because generally accepted accounting principles impact how companies report and what they report, all stakeholders are interested in the setting of these principles. For example, the setting of accounting standards for stock-based compensation or stock options has been especially controversial. Even the United States Senate has been involved in the debate. Many managers opposed an initial proposal by the FASB that would record the value of such options as a reduction of profits because doing so would negatively impact their financial results. The FASB issued a revised proposal, but investors, analysts, and other stakeholders criticized manager stock options in light of the poor financial performance of many companies and the financial failures of Enron, Tyco, and WorldCom. As the debate continues, some companies are voluntarily treating stock options as a reduction of profits.

Throughout this analysis, accounting principles and concepts are emphasized. It is through this emphasis on the "why" of accounting as well as the "how" that you will gain an understanding of the full significance of accounting. In the following paragraphs, we discuss the business entity concept and the cost concept.

Business Entity Concept

The individual business unit is the business entity for which economic data are needed.This entity could be an automobile dealer, a department store, or a grocery store. The business entity must be identified, so that the accountant can determine which economic data should be analyzed, recorded, and summarized in reports.

The business entity concept is important because it limits the economic data in the accounting system to data related directly to the activities of the business. In other words, the business is viewed as an entity separate from its owners, creditors, or other stakeholders. For example, the accountant for a business with one owner (a proprietorship) would record the activities of the business only, not the personal activities, property, or debts of the owner.

The Cost Concept

If a building is bought for $150,000, that amount should be entered into the buyer's accounting records. The seller may have been asking $170,000 for the building up to the time of the sale. The buyer may have initially offered $130,000 for the building. The building may have been assessed at $125,000 for property tax purposes. The buyer may have received an offer of $175,000 for the building the day after it was acquired. These later amounts have no effect on the accounting records because they did not result in an exchange of the building from the seller to the buyer. The cost concept is the basis for entering the exchange price, or cost, of $150,000 into the accounting records for the building.

Continuing the illustration, the $175,000 offer received by the buyer the day after the building was acquired indicates that it was a bargain purchase at $150,000. To use $175,000 in the accounting records, however, would record illusory or unrealized profit. If, after buying the building, the buyer accepts the offer and sells the building for $175,000, a profit of $25,000 is then realized and recorded. The new owner would record $175,000 as the cost of the building.

Using the cost concept involves two other important accounting concepts---objectivity and the unit of measure. The objectivity concept requires that the accounting records and reports be based upon objective evidence. In exchanges between a buyer and a seller, both try to get the best price. Only the final agreed-upon amount is objective enough for accounting purposes. If the amounts at which properties were recorded were constantly being revised upward and downward based on offers, appraisals, and opinions, accounting reports could soon become unstable and unreliable.

The unit of measure concept requires that economic data be recorded in dollars. Money is a common unit of measurement for reporting uniform financial data and reports. 

*WARREN, REEVE,& FESS, 2005, ACCOUNTING, 21ST ED., PP.12-13*

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Accounting: The Language of Business (Part 5)

Republicans and Democrats have used accounting gimmicks and competing government analyses to deceive the public into believing that 2 + 2 = 6. If our leaders cannot agree on the numbers, if 'facts' are fictional, how can they possibly have a substantive debate on solutions?

J. C. Watts

Introduction to Accounting and Business

(Part D)

by

 Charles Lamson

Profession of Accounting

Accountants engage in either private accounting or public accounting. Accountants employed by a business firm or a not-for-profit organization are said to be engaged in private accounting. Accountants and their staff who provide services on a fee basis are said to be employed in public accounting.

Because all functions within a business use accounting information, experience in private or public accounting provides a solid foundation for a career. Many positions in industry and in government agencies are held by individuals with accounting backgrounds.

Private Accounting

The scope of activities and duties of private accountants varies widely. Private accountants are frequently called management accountants. If they are employed by a manufacturer, they may be referred to as industrial or cost accountants. The chief accountant in a business may be called the controller. Various state and federal agencies and other not-for-profit agencies also employ accountants.

The Institute of Certified Management Accountants, an affiliate of the Institute of Management Accountants (IMA), sponsors the Certified Management Accountant (CMA) program. The CMA certificate is evidence of competence in management accounting. Becoming a CMA requires a college degree, two years of experience, and successful completion of a two-day examination. Continuing professional education is required for renewal of the CMA certificate. In addition, members of the IMA must adhere to standards of ethical conduct.

The Institute of Internal Auditors sponsors a similar program for internal auditors. Internal auditors are accountants who review the accounting and operating procedures prescribed by their firms. Accountants who specialize in internal auditing may be granted the Certified Internal Auditor (CIA) certificate.

Public Accounting

In public accounting, an accountant may practice as an individual or as a member of a public accounting firm. Public accountants who have met a state's education, experience, and examination requirements may become Certified Public Accountants (CPAs).

The requirements for obtaining a CPA certificate differ among the various states. All states require a college education in accounting, and most states require 150 semester hours of college credit. In addition, a candidate must pass an examination prepared by the American Institute of Certified Public Accountants (AICPA).

Most states do not permit individuals to practice as CPAs until they have had from 1 to 3 years experience in public accounting. Some states, however, accept similar employment in private accounting as equivalent experience. All states require continuing professional education and adherence to standards of ethical conduct. 

Specialized Accounting Fields

You may think that all accounting is the same. However, you will find specialized fields of accounting in practice. The two most common are financial accounting and managerial accounting. Other fields include cost accounting, environmental accounting, tax accounting, accounting systems, international accounting, not-for-profit accounting, and social accounting.

Financial accounting is primarily concerned with the recording and reporting of economic data and activities for a business. Although such reports provide useful information for managers, they are the primary reports for owners, creditors, governmental agencies, and the public. For example, if you wanted to buy some stock in PepsiCo, American Airlines, or McDonald's, how would you know in which company to invest? One way is to review financial reports and compare the financial performance and condition of each company. The purpose of financial accounting is to provide such reports.

Managerial accounting or management accounting, uses both financial accounting and estimated data to aid management in running day-to-day operations and in planning future operations. Management accountants gather and report information that is relevant and timely to the decision-making needs of management. For example, management might need information on alternative ways to finance the construction of a new building. Alternatively, management might need information on whether to expand its operations into a new product line. Thus, reports to management can differ widely in form and context.

*WARREN, REEVE,& FESS, 2005, ACCOUNTING, 21ST ED., PP. 10-12* 

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Accounting: The Language of Business (Part 4)

“Life is like accounting; everything must be balanced.” —Unknown

Introduction to Accounting and Business (Part C)

by

Charles Lamson

The Role of Accounting in Business

What is the role of accounting in business? The simplest answer to answer this question is that accounting provides information for managers to use in operating the business. In addition, accounting provides information to other stakeholders to use in assessing the economic performance and condition of the business.

In a general sense, accounting can be defined as an information system that provides reports to stakeholders about the economic activities and condition of a business. We will focus our discussions on accounting and its role in business. However, many of the concepts in this analysis will apply also to individuals, government, and other types of organizations. For example, individuals must account for activities such as hours worked, checks written, and bills due. Stakeholders for individuals include creditors, dependents, and the government. A main interest of the government is making sure that individuals pay the proper taxes. 

You may think of accounting as the "language of business." This is because accounting is the means by which business information is communicated to the stakeholders. For example, accounting reports summarizing the profitability of a new product help Coca-Cola's management decide whether to continue selling the product. Likewise, financial analysts use accounting reports in deciding whether to recommend the purchase of Coca-Cola stock. Banks use accounting reports in determining the amount of credit to extend to Coca-Cola. Suppliers use accounting reports in deciding whether to offer credit for Coca-Cola's purchases of supplies and raw materials. State and federal governments use the accounting reports as a basis for assessing taxes on Coca-Cola.

The process by which accounting provides information to business stakeholders is illustrated in Exhibit 3. A business must first identify its stakeholders. It must then assess the various informational needs of the stakeholders and design its accounting system to meet those needs. Finally, the accounting system records the economic data about business activities and events, which the business reports to the stakeholders according to their informational needs. 

Stakeholders use accounting reports as the primary source of information on which they base their decisions. They use other information as well. For example, in deciding whether to extend credit to an appliance store, a banker might use economic forecasts to assess the future demand for the store's products. During periods of economic downturn, the demand for consumer appliances normally declines. The banker might inquire about the ability and reputation of the managers of the business. For small corporations, bankers may require major stockholders to personally guarantee the loans of the business. Finally, bankers might consult industry publications that rank similar businesses as to their quality of products, customer satisfaction, and future prospects for growth.

Business Ethics

Individuals may have different views about what is "right" and "wrong" in a given situation. Unfortunately, business managers sometimes find themselves in situations where they feel pressure to violate personal ethics.

The moral principles that guide the conduct of individuals are called ethics. Regardless of differences among individuals proper ethical conduct implies a behavior that considers the impact of one's actions on society and others. In other words, proper ethical conduct implies that you not only consider what's in your best interest, but also what's in the best interest of others.

Ethical conduct is good business. For example, an automobile manufacturer that fails to correct a safety defect to save costs may later lose sales due to lack of consumer confidence. Likewise, a business that pollutes the environment may find itself the target of lawsuits and customer boycotts.

Business people should work within an ethical framework. Although an ethical framework is based on individual experiences and training, there are a number of sound principles that form the foundation for ethical behavior:

1. Avoid small ethical lapses. Small ethical lapses may appear harmless in and of themselves. Unfortunately such lapses can compromise your work. Small ethical lapses can build up and lead to larger consequences later.

2.  Focus on your long-term reputation. One characteristic of an ethical dilemma is that it places you under severe short-term pressure. The ethical dilemma is created by the stated or unstated threat that failure to "go along" may result in undesirable consequences. You should respond to ethical dilemmas by minimizing the short-term pressures and focusing on long-term reputation instead. Your reputation is very valuable. You will lose your effectiveness if your reputation becomes tarnished.

3.  You may suffer adverse personal consequences for holding to an ethical position. In some unethical organizations, managers have endured career setbacks for not budging from their ethical positions. Some managers have resigned because they were unable to support management in what they perceived as unethical behavior. Plus, in the short-term, ethical behavior can sometimes adversely affect your career. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 8-9*

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Accounting: The Language of Business (Part 3)

Don't ever let your business get ahead of the financial side of your business. Accounting, accounting, accounting. Know your numbers.

Tilman J. Fertitta

Introduction to Accounting and Business

(Part C)

by

Charles Lamson

Value Chain of a Business

Once a business has chosen between low cost, differentiation, or combination strategy (from last post), it must implement the strategy in its value chain. A value chain is the way a business adds value for its customers by processing inputs into a product or service as shown in Exhibit 2.

EXHIBIT 2 The Value Chain

To illustrate, Delta Air Lines' value chain consists of taking inputs, such as people, aircraft, and equipment, and processing these inputs into a service of transporting goods and passengers throughout the world. The extent to which customers value Delta's passenger service is reflected by the airfares Delta is able to charge as well as passenger load factors (percentage of seats occupied). For example, the extent to which Delta can, on average, charge higher fares than discount airlines, such as AirTran, implies that passengers value Delta's services more than AirTran's. These services may include newer, more comfortable aircraft, the ability to earn frequent flyer miles, more convenient passenger schedules, passenger lounges for frequent flyers, and international connections.

A business's value chain can be divided into primary and supporting processes. primary processes are those that are directly involved in creating value for customers. Examples of primary processes include manufacturing, selling, and customer service. supporting processes are those that facilitate the primary processes. Examples of support processes include purchasing and personnel. For Delta Airlines, primary processes would include purchasing and personnel. For Delta Airlines, primary processes would include aircraft maintenance, baggage handling, picketing, and flight operations. Secondary processes for Delta Airlines would include the accounting and finance functions, contracting for fuel deliveries, and investor relations.

Business Stakeholders

A business stakeholder is a person or entity having an interest in the economic performance of the business. These stakeholders normally include the owners, managers, employees, customers, creditors, and the government.

The owners who have invested resources in the business clearly have an interest in how well the business performs. To the extent that the business is profitable, owners will expect to share in the business profits. Since owners may eventually decide to sell their business, they also have an interest in the total economic worth of the business. This economic worth may reflect results of past profits as well as prospects for future profits.

The managers are those individuals who the owners have authorized to operate the business. Managers are primarily evaluated on the economic performance of the business. The managers of poor performing businesses are often fired by the owners. Thus, managers have an incentive to maximize the economic value of the business. Owners may offer managers salary contracts that are tied directly to how well the business performs. For example, a manager might receive a percent of the profits or a percent of the increase in profits. Such contracts are often referred to as profit-sharing plans.

The employees provide services to the business in exchange for a paycheck. The employees have an interest in the economic performance of the business because their jobs depend upon it. During business downturns, it is not unusual for a business to lay off workers for extended periods of time. Whenever a business fails, the employees will lose their jobs permanently. Employee labor unions often use the good economic performance of a business to argue for wage increases. In contrast, businesses often cite poor economic performance as a reason for decreasing wages or denying wage raises.

The customers may also have an interest in the continued success of a business. For example, if Apple Computer were to fail, customers might not be able to get hardware and software for their computers. Likewise customers who purchase advance tickets on Southwest Airlines have an interest in whether Southwest will continue in business. Frequent flyers on Eastern Airlines lost their accumulated frequent flyer points when Eastern went out of business.

Like the owners, the creditors invest resources in the business by extending credit, such as a loan. They, too, have an interest in how well the business performs. In order for the creditors to recover their investment, the business must generate enough cash to pay them back. In addition, creditors view the business as their customer and thus have a stake in the continued success of the business.

Various governments have an interest in the economic performance of businesses. City, county, state, and federal governments collect taxes from businesses within their jurisdictions. The better a business does, the more taxes the government can collect. In addition, workers are taxed on their wages. In contrast, workers who are laid off and are unemployed can file claims for unemployment compensation, which results in a financial burden for the government. City and state governments often provide incentives for businesses to locate in their jurisdictions. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, PP. 6-7*

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Accounting: The Language of Business (Part 2)

Capital isn't this pile of money sitting somewhere; it's an accounting construct.

Bethany McLean

Introduction to Accounting and Business

(Part B)

by

Charles Lamson

Business Strategy

How does a business decide which products or services to offer to consumers? For example, should Best Buy offer warranty and repair services to its customers? Many factors influence this decision, but ultimately the decision is made on the basis of whether it is consistent with the overall business strategy of the company.

A business strategy is an integrated set of plans and actions designed to enable the business to gain an advantage over its competitors, and in doing so, to maximize its profits. The two basic strategies a business may use are a low-cost strategy or a differentiation strategy.

Under a low-cost strategy, a business designs and produces products or services of acceptable quality at a cost lower than that of its competition. Walmart and Southwest Airlines are examples of businesses with a low-cost strategy. Such businesses often sell no frills, standardized products to the most typical customer in the industry. Following this strategy, businesses must continually focus on lowering costs.

Businesses may try to achieve lower costs in a variety of ways. For example, a business may employ strict budgetary controls, use sophisticated training programs, implement simple manufacturing technologies, or enter into cost-saving supplier relationships. Such supplier relationships may involve linking the supplier's production process directly to the client's production processes to minimize inventory costs, variations in raw materials, and record-keeping costs.

A primary concern of a business using a low-cost strategy is that a competitor may achieve even lower costs by replicating the low-costs or developing technological advances. Another concern is that the competitors may differentiate their products in such a way that customers no longer desire a standardized, no-frills product. For example, local pharmacies most often try to compete with Walmart on the basis of personalized service rather than cost.

Under a differentiation strategy, a business designs and produces products or services that possess unique attributes or characteristics for which customers are willing to pay a premium price. For the differentiation strategy to be successful, a product or service must be truly unique or perceived as unique in quality, reliability, image, or design. To illustrate, Maytag attempts to differentiate its appliances on the basis of reliability, while Tommy Hilfiger differentiates its clothing on the basis of image.

Businesses using a differentiation strategy often use information systems to capture and analyze customer buying habits and preferences. For example, many grocery stores such as Kroger and Safeway issue magnetic cards to preferred customers that allow the consumer to receive special discounts on purchases. In addition to establishing brand loyalty, the cards allow the stores to track consumer preferences and buying habits for use in purchasing and advertising campaigns.

Companies may enhance differentiation by investing in manufacturing and service technologies, such as flexible manufacturing methods that allow timely product design and delivery. Some companies use marketing and sales efforts to promote product differences. Other companies use unique credit granting arrangements, emphasize personal relationships with customers, or offer extensive training and after-sales service programs for customers.

A business using a differentiation strategy wants customers to pay a premium price for the differentiated features of its products. However, a business may provide features that exceed the customers needs. In this case, competitors may be able to offer customers less differentiated products at lower costs. Also, customers' perceptions of the differentiated features may change. As a result, customers may not be willing to continue to pay a premium price for the products. For example, as Tommy Hilfiger clothing becomes more commonplace, customers may be unwilling to pay a premium price for Hilfiger clothing. Over time, customers may also become better educated about the products and the value of the differentiated features. For example, IBM personal computers were once viewed as being differentiated on quality. However, as consumers have become better educated and more experienced with personal computers, Dell computers have also become perceived as being of high-quality.

A business may attempt to implement a combination strategy that includes elements of both the low cost and differentiation strategies. That is, a business may attempt to develop a differentiated product at competitive, low-cost prices. For example Andersen Windows allows customers to design their own windows through the use of its proprietary manufacturing software. By using flexible manufacturing, Andersen Windows can produce a variety of Windows in small quantities with a low or moderate cost. Thus, Andersen Windows sell at a higher price than standard low-cost windows but at a lower price than fully customized windows built on site.

As you might expect, a danger of a business using a combination strategy is that its products might not adequately satisfy either end of the market. That is, because its products are differentiated, it cannot establish itself as the low-cost leader, and at the same time, its products may not be differentiated enough that customers are willing to pay a premium price. In other words, the business may become "stuck in the middle."

A business may also attempt to implement different strategies for different markets. For example, Toyota segments the market for automobiles by offering the Lexus to image- and quality-conscious buyers. To reinforce this image, Toyota developed a separate dealer network. At the same time, Toyota offers a low-cost automobile, the Echo, to price-sensitive buyers. 

*WARREN, REEVE, AND FESS, 2005, ACCOUNTING, 21ST ED., PP. 4-6*

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Accounting: The Language of Business (Part 1)

• Accounting is the language of business.
• 
  
• Warren Buffett
• 
  

Introduction to Accounting and Business

(Part A)

by

Charles Lamson

Is accounting important to you? Yes, accounting is important in your personal life as well as your career, even though you may not be---or have any intention to become---an accountant. For example, assume that you are the owner/manager of a small Mexican restaurant and are considering opening another restaurant in a neighboring town. Accounting information about the restaurant will be a major factor in your deciding whether to open the new restaurant and the bank's deciding whether to finance the expansion.

The primary objective in this analysis is to illustrate basic accounting concepts that will help you to make good personal and business decisions. We begin by discussing what a business is, how it operates, and the role that accounting plays.

Nature of a Business

You can probably list some examples of companies with which you have recently done business. Your examples might be large large companies, such as Coca-Cola, Dell Computer, or Amazon. They might be local companies, such as gas stations or grocery stores, or perhaps employers. They might be restaurants, law firms, or medical offices. What do all of these examples have in common that identify them as businesses?

In general, 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 coffeehouse to an international automobile manufacturer. A business's customers are individuals or other businesses who purchase goods or services in exchange for money or other items of value. In contrast, a church is not a business because those who receive its services are not obliged to pay for them.

The objective of most businesses is to maximize profits. Profit is the difference between the amounts received from customers for goods or services provided and the amounts paid for the inputs used to provide the goods or services. Some businesses operate with an objective other than to maximize profits. The objective of such nonprofit businesses is to provide some benefit to society, such as medical research or conservation of natural resources. In other cases, governmental units such as cities operate waterworks or sewage treatment plants on a nonprofit basis. We will focus in this analysis on businesses operating to earn a profit. Keep in mind, though, that many of the same concepts and principles apply to nonprofit businesses as well.

Types of Businesses

There are three different types of businesses that are operated for profit: manufacturing, merchandising, and service businesses. Each type of business has unique characteristics.

• Manufacturing businesses change basic inputs into products that are sold to individual customers.
• Merchandising businesses also sell products to customers. However, rather than making the product, they purchase them from other businesses (such as manufacturers). In this sense, merchandisers bring products and customers together.
• Service businesses provide services rather than products to customers.

Types of Business Organizations

The common forms of business organization are proprietorship, partnership, corporation, or limited liability corporation. The following paragraphs, briefly describe each form and discuss its advantages and disadvantages.

A proprietorship is owned by an individual. More than 73 percent of the businesses in the United States are organized as proprietorships (taxfoundation.org). The popularity of this form is due to the ease and the low cost of organizing. The primary disadvantage of proprietorships is that the financial resources available to the businesses are limited to the individual owner's resources. Small local businesses such as hardware stores, repair shops, laundries, restaurants, and maid services are often organized as proprietorships.

As the business grows and more financial and managerial resources are needed, it may become a partnership. A partnership is owned by two or more individuals. Like proprietorships, small local businesses such as automotive repair shops, music stores, beauty salons, and clothing stores may be organized as partnerships. Currently, about 8 percent of the businesses in the United States are organized as partnerships (taxfoundation.org).

A corporation is organized under state or federal statutes as a separate legal taxable entity. The ownership of a corporation is divided into shares of stock. A corporation issues stock to individuals or other businesses, 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 stock. For this reason, most companies that require large investments in equipment and facilities are organized as corporations.

About 5 percent of businesses in the United States are organized as corporations (taxfoundation.org). Given that most large companies are organized as corporations, over 60 percent all of revenues are received by corporations. Thus, corporations have a major influence on the economy.

A limited liability corporation combines attributes of a partnership and a corporation in that it is organized as a corporation, but it can elect to be taxed as a partnership. Thus, its owners' (or members') liability is limited to their investment in the business, and its income is taxed when the owners report it on their individual tax returns.

The three types of businesses we discussed earlier---manufacturing, merchandising, and service---may be either proprietorships, partnerships, corporations, or limited liability corporations. However, because of the large amount of resources required to operate a manufacturing business, most manufacturing businesses are corporations. Likewise, most large retailers such as Wal-Mart, are corporations. 

*WARREN, REEVE, AND FESS, 2005, ACCOUNTING, 21ST ED., PP. 2-4*

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