Chapter 12 The Role of Accounting in Business

Financial Accounting

Figure 12.1

Financial statements provide a snapshot of a company’s performance over a specific period.

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Financial accountingBranch of accounting that furnishes information to individuals and groups both inside and outside the organization to help them assess the firm’s financial performance. is responsible for preparing the organization’s financial statementsFinancial reports—including the income statement, the balance sheet, and the statement of cash flows—that summarize a company’s past performance and evaluate its financial health.—including the income statement, the statement of owner’s equity, the balance sheet, and the statement of cash flows—that summarize a company’s past performance and evaluate its current financial condition. In preparing financial statements, financial accountants adhere to a uniform set of rules called generally accepted accounting principles (GAAP)Uniform set of rules for financial reporting issued by an independent agency called the Financial Accounting Standards Board (FASB).—the basic principles for financial reporting issued by an independent agency called the Financial Accounting Standards Board (FASB). Users want to be sure that financial statements have been prepared according to GAAP because they want to be sure that the information reported in them is accurate. They also know that they can compare the statements issued by one company to those of another company in the same industry.

While companies headquartered in the United States follow U.S.-based GAAP, many companies located outside the United States follow a different set of accounting principles called International Financial Reporting Standards (IFRS)A set of worldwide accounting rules and guidelines used by companies to prepare financial statements that can be compared with those of other countries.. These multinational standards, which are issued by the International Accounting Standards Board (IASB), differ from U.S. GAAP in a number of important ways. IFRS, for example, is a little stricter about the ways you can calculate the costs of inventory, but we’re not going to dwell unnecessarily on such fine distinctions. Bear in mind, however, that, according to most experts, a single set of worldwide standards will eventually emerge to govern the accounting practices of both U.S. and non-U.S. companies.

Owners and Managers

In summarizing the outcomes of a company’s financial activities over a specified period of time, financial statements are, in effect, report cards for owners and managers. They show, for example, whether the company did or didn’t make a profit and furnish other information about the firm’s financial condition. They also provide information that managers and owners can use in order to take corrective action.

Investors and Creditors

If you loaned money to a friend to start a business, wouldn’t you want to know how the business was doing? Investors and creditors furnish the money that a company needs to operate, and not surprisingly, they feel the same way. Because they know that it’s impossible to make smart investment and loan decisions without accurate reports on an organization’s financial health, they study financial statements to assess a company’s performance and to make decisions about continued investment.

According to the world’s most successful investor (and third-richest individual), Warren Buffett, the best way to prepare yourself to be an investor is to learn all the accounting you can. Buffett, chairman and CEO of Berkshire Hathaway, a company that invests in other companies, turned an original investment of $10,000 into a net worth of $35 billion in four decades, and he did it, in large part, by paying close attention to financial accounting reports.John Price, “The Return of the Buffetteers,” Investor Journal, August 1998, http://www.sherlockinvesting.com (accessed July 17, 2010).

Figure 12.2 Warren Buffet

Photo by Kevin Parry/WireImage/Getty Images

Government Agencies

Businesses are required to furnish financial information to a number of government agencies. Publicly owned companies, for example—the ones whose shares are traded on a stock exchange—must provide annual financial reports to the Securities and Exchange Commission (SEC), a federal agency that regulates stock trades. Companies must also provide financial information to local, state, and federal taxing agencies, including the Internal Revenue Service.

Other Users

A number of other external users have an interest in a company’s financial statements. Suppliers, for example, need to know if the company to which they sell their goods is having trouble paying its bills or may even be at risk of going under. Employees and labor unions are interested because salaries and other forms of compensation are dependent on an employer’s performance.

Figure 12.3 "Management and Financial Accounting" summarizes the main differences between the users of management and financial accounting and the types of information issued by accountants in the two areas. In the rest of this chapter, we’ll learn how to prepare a set of financial statements and how to interpret them. We’ll also discuss issues of ethics in the accounting communities and career opportunities in the accounting profession.

Figure 12.3 Management and Financial Accounting

Toying with a Business Idea

We know what you’re thinking: It’s nice to know that accounting deals with real-life situations, but while you wish Connie the best, you don’t know enough about the confectionary business to appreciate either the business decisions or the financial details. Is there any way to bring this lesson a little closer to home? Besides, while knowing what financial statements will tell you is one thing, you want to know how to prepare them.

Agreed. So let’s assume that you need to earn money while you’re in college and that you’ve decided to start a small business. Your business will involve selling stuff to other college students, and to keep things simple, we’ll assume that you’re going to operate on a “cash” basis: you’ll pay for everything with cash, and everyone who buys something from you will pay in cash.

A Word about Cash. You probably have at least a little cash on you right now—some currency, or paper money, and coins. In accounting, however, the term cash refers to more than just paper money and coins. It also refers to the money that you have in checking and savings accounts and includes items that you can deposit in these accounts, such as money orders and different types of checks.

Your first task is to decide exactly what you’re going to sell. You’ve noticed that with homework, exams, social commitments, and the hectic lifestyle of the average college student, you and most of the people you know always seem to be under a lot of stress. Sometimes you wish you could just lie back between meals and bounce a ball off the wall. And that’s when the idea hits you: Maybe you could make some money by selling a product called the “Stress-Buster Play Pack.” Here’s what you have in mind: you’ll buy small toys and other fun stuff—instant stress relievers—at a local dollar store and pack them in a rainbow-colored plastic treasure chest labeled “Stress-Buster.”

And here’s where you stand: You have enough cash to buy a month’s worth of plastic treasure chests and toys. After that, you’ll use the cash generated from sales of Stress-Buster Play Packs to replenish your supply. Each plastic chest will cost $1.00, and you’ll fill each one with a variety of five of the following toys, all of which you can buy for $1.00 each:

• A happy face stress ball
• A roomarang (an indoor boomerang)
• Some silly putty
• An inflatable beach ball
• A coil “slinky” spring
• A paddle-ball game
• A ball for bouncing off walls

You plan to sell each Stress-Buster Play Pack for $10 from a rented table stationed outside a major dining hall. Renting the table will cost you $20 a month. Because your own grades aren’t what your parents and the dean would like them to be, you decide to hire fellow students (trustworthy people with better grades than yours) to staff the table at peak traffic periods. They’ll be on duty from noon until 2:00 p.m. each weekday, and you’ll pay them $6 an hour. Wages, therefore, will cost you $240 a month (2 hours × 5 days × 4 weeks = 40 hours × $6). Finally, you’ll run ads in the college newspaper at a monthly cost of $40. Thus your total monthly costs will amount to $300 ($20 + $240 + $40).

Did You Make Any Money?

What does your income statement tell you? It has provided you with four pieces of valuable information:

1. You sold 100 units at $10 each, bringing in revenues or sales of $1,000.
2. Each unit that you sold cost you $6—$1 for the treasure chest plus 5 toys costing $1 each. So your cost of goods sold is $600 (100 units × $6 per unit).
3. Your gross profit—the amount left after subtracting cost of goods sold from sales—is $400 (100 units × $4 each).
4. After subtracting operating expenses of $300—the costs of doing business other than the cost of products sold—you generated a positive net income or profit of $100.

What If You Want to Make More Money?

You’re quite relieved to see that you made a profit during your first month, but you can’t help but wonder what you’ll have to do to make even more money next month. You consider three possibilities:

Breakeven Analysis

Playing these what-if games has started you thinking: is there some way to figure out the level of sales you need to avoid losing money—to “break even”? This can be done using breakeven analysisMethod of determining the level of sales at which the company will break even (have no profit or loss).. To break even (have no profit or loss), your total sales revenue must exactly equal all your expenses (both variable and fixed). For a merchandiser, like a hypothetical one called The College Shop, this balance will occur when gross profit equals all other (fixed) costs. To determine the level of sales at which this will occur, you need to do the following:

1. Determine your total fixed costsCosts that don’t change when the amount of goods sold changes., which are so called because the total cost doesn’t change as the quantity of goods sold changes):

   • Fixed costs = $240 salaries + $40 advertising + $20 table = $300

2. Identify your variable costsCosts that vary, in total, as the quantity of goods sold changes but stay constant on a per-unit basis.. These are costs that vary, in total, as the quantity of goods sold changes but stay constant on a per-unit basis. State variable costs on a per-unit basis:

   • Variable cost per unit = $6 ($1 for the treasure chest and $5 for the toys)

3. Determine your contribution margin per unitExcess of revenue per unit over variable cost per unit.: selling price per unit – variable cost per unit:

   • Contribution margin per unit = $10 selling price – $6 variable cost per unit = $4

4. Calculate your breakeven point in unitsNumber of sales units at which net income is zero.: fixed costs ÷ contribution margin per unit:

   • Breakeven in units = $300 fixed costs ÷ $4 contribution margin per unit = 75 units

Your calculation means that if you sell 75 units, you’ll end up with zero profit (or loss) and will exactly break even. To test your calculation, you can prepare a what-if income statement for 75 units in sales (which is your breakeven number of sales). The resulting statement is shown in Figure 12.8 "Proposed Income Statement Number Three for Stress-Buster Company".

Figure 12.8 Proposed Income Statement Number Three for Stress-Buster Company

What if you want to do better than just break even? What if you want to earn a profit of $200 next month? How many Stress-Buster Pack units would you need to sell? You can find out by building on the results of your breakeven analysis. Note that each additional sale will bring in $4 (contribution margin per unit). If you want to make a profit of $200—which is $200 above your breakeven point—you must sell an additional 50 units ($200 desired profit divided by $4 contribution margin per unit) above your breakeven point of 75 units. If you sell 125 units (75 breakeven units + the additional 50), you’ll make a profit of $200 a month.

As you can see, breakeven analysis is rather handy. It enables you to determine the level of sales that you must reach to avoid losing money and the level of sales that you have to reach to earn a profit of $200. Such information will help you plan for your business. For example, knowing you must sell 125 Stress-Buster Packs to earn a $200 profit will help you decide how much time and money you need to devote to marketing your product.

The Accounting Equation

The balance sheet is based on the accounting equationAccounting tool showing the resources of a business (assets) and the claims on those resources (liabilities and owner’s equity).:

This important equation highlights the fact that a company’s assets came from somewhere: either from loans (liabilities) or from investments made by the owners (owner’s equity). This means that the asset section of the balance sheet on the one hand and the liability and owner’s-equity section on the other must be equal, or balance. Thus the term balance sheet.

Let’s prepare two balance sheets for your company: one for the first day you started and one for the end of your first month of business. We’ll assume that when you started Stress-Buster, you borrowed $400 from your parents and put in $200 of your own money. If you look at your first balance sheet in Figure 12.9 "Balance Sheet Number One for Stress-Buster Company" you’ll see that your business has $600 in cash (your assets): Of this total, you borrowed $400 (your liabilities) and invested $200 of your own money (your owner’s equity). So far, so good: Your assets section balances with your liabilities and owner’s equity section.

Figure 12.9 Balance Sheet Number One for Stress-Buster Company

Now let’s see how things have changed by the end of the month. Recall that Stress-Buster earned $100 (based on sales of 100 units) during the month of September and that you decided to leave these earnings in the business. This $100 profit increases two items on your balance sheet: the assets of the company (its cash) and your investment in it (its owner’s equity). Figure 12.10 "Balance Sheet Number Two for Stress-Buster Company" shows what your balance sheet will look like on September 30. Once again, it balances. You now have $700 in cash: $400 that you borrowed plus $300 that you’ve invested in the business (your original $200 investment plus the $100 profit from the first month of operations, which you’ve kept in the business).

Figure 12.10 Balance Sheet Number Two for Stress-Buster Company

Beginning Balance Sheet

Your new beginning balance sheet contains the same items as the one that you created for Stress-Buster—cash, loans, and owner’s equity. But because you’ve already performed a broader range of transactions before you opened for business, you’ll need some new categories:

• You’ve bought furniture and equipment that you’ll use over the next five years. You’ll allocate the cost of these long-term assets by depreciating them. Because you estimate that this furniture and equipment will have a useful life of five years, you allocate one-fifth of the cost per year for five years.
• You’ve purchased an inventory of goods for later resale.
• You’ve taken out two types of loans: one that’s current because it’s payable in one year and one that’s long term because it’s due in five years.

Obviously, then, you need to prepare a more sophisticated balance sheet than the one you created for your first business. We call this new kind of balance sheet a classified balance sheetBalance sheet that totals assets and liabilities in separate categories. because it classifies assets and liabilities into separate categories.

Types of Liabilities

Liabilities are grouped in much the same manner as assets:

1. Current liabilitiesLiability that a business intends to pay off within a year.—liabilities that you’ll pay off within one year
2. Long-term liabilitiesLiability that a business need not pay off within the following year.—liabilities that don’t become due for more than one year

Recall that your liabilities come from your two loans: one which is payable in a year and considered current, and one which is long term and due in five years.

Now we’re ready to review your beginning balance sheet, which is shown in Figure 12.14 "Beginning Balance Sheet for The College Shop". Once again, your balance sheet balances: Your total assets of $275,000 equal your total liabilities plus owner’s equity of $275,000.

Figure 12.14 Beginning Balance Sheet for The College Shop

Liabilities and Owner’s Equity

Let’s begin our analysis of your beginning balance sheet with the liabilities and owner’s-equity sections. We’re assuming that, thanks to a strong business plan, you’ve convinced a local bank to loan you a total of $125,000—a short-term loan of $25,000 and a long-term loan of $100,000. Naturally, the bank charges you interest (which is the cost of borrowing money); your rate is 8 percent per year. In addition, you personally contributed $150,000 to the business (thanks to a trust fund that paid off when you turned 21).

Assets

Now let’s turn to the assets section of your beginning balance sheet. What do you have to show for your $275,000 in liabilities and owner’s equity? Of this amount, $50,000 is in cash—that is, money deposited in the company’s checking and other bank accounts. You used another $75,000 to pay for inventory that you’ll sell throughout the year. Finally, you spent $150,000 on several long-term assets, including a sign for the store, furniture, store displays, and computer equipment. You expect to use these assets for five years, at which point you’ll probably replace them.

Income Statement

Finally, let’s look at your income statement, which is shown in Figure 12.15 "Income Statement for The College Shop, Year Ended December 31". Like your College Shop balance sheet, your College Shop income statement is more complex than the one you prepared for Stress-Buster, and the amounts are much larger. In addition, the statement covers a full calendar year.

Figure 12.15 Income Statement for The College Shop, Year Ended December 31

Note, by the way, that the income statement that we prepared for The College Shop is designed for a merchandiser—a company that makes a profit by selling goods. How can you tell? Businesses that sell services (such as accounting firms or airlines) rather than merchandise don’t have lines labeled cost of goods sold on their statements.

The format of this income statement also highlights the most important financial fact in running a merchandising company: you must sell goods at a profit (called gross profit) that is high enough to cover your operating costs, interest, and taxes. Your income statement, for example, shows that The College Shop generated $225,000 in gross profit through sales of goods. This amount is sufficient to cover your operating expense, interest, and taxes and still produce a net income of $30,000.

A Few Additional Expenses

Note that The College Shop income statement also lists a few expenses that the Stress-Buster didn’t incur:

• Depreciation expense. Recall that before opening for business, you purchased some long-term assets (store sign, displays, furniture, and equipment) for a total amount of $150,000. In estimating that you would use these assets for five years (your estimate of their useful lives), you spread the cost of $150,000 over five years. For each of these five years, then, your income statement will show $30,000 in depreciation expense ($150,000 ÷ 5 years = $30,000).
• Interest expense. When you borrowed money from the bank, you agreed to pay interest at an annual rate of 8 percent. Your interest expense of $10,000 ($125,000 × 0.08) is a cost of financing your business and appears on your income statement after the subheading operating income.
• Income taxes. Your company has to pay income taxes at a rate of 25 percent of net income before taxes. This amount of $10,000 ($40,000 × 25%) appears on your income statement after the subheading net income before income taxes. It’s subtracted from income before income taxes before you arrive at your “bottom line,” or net income.

Statement of Owner’s Equity

Our next step is to prepare a statement of owner’s equity, which is shown in Figure 12.16 "Statement of Owner’s Equity for The College Shop". Note that the net income of $30,000 from the income statement was used to arrive at the year-end balance in owner’s equity.

Figure 12.16 Statement of Owner’s Equity for The College Shop

End-of-First-Year Balance Sheet

We’ll conclude with your balance sheet for the end of your first year of operations, which is shown in Figure 12.17 "End-of-Year Balance Sheet for The College Shop". First, look at your assets. At year’s end, you have a cash balance of $70,000 and inventory of $80,000. You also have an accounts receivable of $90,000 because many of your customers have bought goods on credit and will pay later. In addition, the balance sheet now shows two numbers for long-term assets: the original cost of these assets, $150,000, and an accumulated depreciation amount of $30,000, which reflects the amount that you’ve charged as depreciation expense since the purchase of the assets. The carrying value of these long-term assets is now $120,000 ($150,000 - $30,000), which is the difference between their original cost and the amount that they’ve been depreciated. Your total assets are thus $360,000.

Figure 12.17 End-of-Year Balance Sheet for The College Shop

The total of your liabilities of $180,000 plus owner’s equity of $180,000 also equals $360,000. Your liabilities consist of a long-term loan of $100,000 (which is now due in four years) and accounts payable of $80,000 (money that you’ll have to pay out later for purchases that you’ve made on credit). Your owner’s equity (your investment in the business) totals $180,000 (the $150,000 you originally put in plus the $30,000 in first-year earnings that you retained in the business).

Statement of Cash Flows

Owners, investors, and creditors can learn a lot from your balance sheet and your income statement. Indeed, each tells its own story. The balance sheet tells what assets your company has now and where they came from. The income statement reports earned income on an accrual basis (recognizing revenues when earned and expenses as incurred regardless of when cash is received or paid). But the key to surviving in business is generating the cash you need to keep it up and running. It’s not unusual to hear reports about companies with cash problems. Sometimes they arise because the products in which the firm has invested aren’t selling as well as it had forecast. Maybe the company tied up too much money in a plant that’s too big for its operations. Maybe it sold products to customers who can’t pay. Maybe management just overspent. Whatever the reason, cash problems will hamper any business. Owners and other interested parties need a financial statement that helps them understand a company’s cash flow.

The statement of cash flowsFinancial statement reporting on cash inflows and outflows resulting from operating, investing, and financing activities. tells you where your cash came from and where it went. It furnishes information about three categories of activities that cause cash either to come in (cash inflows) or to go out (cash outflows):

1. Cash flows from operating activitiesActivity that creates cash inflows or outflows through day-to-day operations. come from the day-to-day operations of your main line of business.
2. Cash flows from investing activitiesActivity that creates cash inflows or outflows through the selling or buying of long-term assets. result from buying or selling long-term assets.
3. Cash flows from financing activitiesActivity that creates cash inflows or outflows through the obtaining or repaying of borrowed or invested funds. result from obtaining or paying back funds used to finance your business.

A cash flow statement for The College Shop would look like the one in Figure 12.18 "Statement of Cash Flows for The College Shop". You generated $45,000 in cash from your company’s operations (a cash inflow) and used $25,000 of this amount to pay off your short-term loan (a cash outflow). The net result was an increase in cash of $20,000. This $20,000 increase in cash agrees with the change in your cash during the year as it’s reported in your balance sheets: You had an end-of-the-year cash balance of $70,000 and a beginning-of-the-year balance of $50,000 ($70,000 − $50,000 = $20,000). Because you didn’t buy or sell any long-term assets during the year, your cash flow statement shows no cash flows from investing activities.

Figure 12.18 Statement of Cash Flows for The College Shop

Vertical Percentage Analysis

What does this statement tell us about your second year in business? Some things look good and some don’t. Your sales went up from $500,000 to $600,000 (a 20 percent increase—not bad). But your profit was down—from $30,000 to $18,000 (a bad sign). As you stare at the statement, you’re asking yourself the question: Why did my profit go down even though my sales went up? Does this result make sense? Is there some way of comparing two income statements that will give me a more helpful view of my company’s financial health? One way is called vertical percentage analysisAnalysis of an income statement treating the relationship of each item as a percentage of a base (usually sales).. It’s useful because it reveals the relationship of each item on the income statement to a specified base—generally sales—by expressing each item as a percentage of that base.

Figure 12.20 "Comparative Income Statement Using Vertical Percentage Analysis" shows what comparative income statements look like when you use vertical percentage analysis showing each item as a percentage of sales. Let’s see if this helps clarify things. What do you think accounted for the company’s drop in income even though The College Shop sales went up?

Figure 12.20 Comparative Income Statement Using Vertical Percentage Analysis

The percentages help you to analyze changes in the income statement items over time, but it might be easier if you think of the percentages as pennies. In year 1, for example, for every $1.00 of sales, $0.55 went to pay for the goods that you sold, leaving $0.45 to cover your other costs and leave you a profit. Operating expenses (salaries, rent, advertising, and so forth) used up $0.35 of every $1.00 of sales, while interest and taxes took up $0.02 each. After you covered all your costs, you had $0.06 profit for every $1.00 of sales.

Asking the Right Questions

Now, compare these figures to those for year 2. Where is the major discrepancy? It’s in Cost of goods sold. Instead of using $0.55 of every $1.00 of sales to buy the goods you sold, you used $0.64. As a result, you had $0.09 less ($0.64 – $0.55) to cover other costs. This is the major reason why you weren’t as profitable in year 2 as you were in year 1: your Gross profit as a percentage of sales was lower in year 2 than it was in year 1. Though this information doesn’t give you all the answers you’d like to have, it does, however, raise some interesting questions. Why was there a change in the relationship between Sales and Cost of goods sold? Did you have to pay more to buy goods for resale and, if so, were you unable to increase your selling price to cover the additional cost? Did you have to reduce prices to move goods that weren’t selling well? (If your costs stay the same but your selling price goes down, you make less on each item sold.) Answers to these questions require further analysis, but at least you know what the useful questions are.

Profit Margin Ratios

We’ve already determined the two most common profit margin ratios—gross profit margin and net profit margin—when we used vertical percentage analysis to determine the relationship to Sales of each item on The College Shop’s income statement. We were examining gross profit when we found that Gross profit for year 1 was 45 percent of Sales and that, in year 2, it had declined to 36 percent. We can express the same relationships as ratios:

We can see that gross profit margin declined (a situation that, as we learned earlier, probably isn’t good). But how can you tell whether your gross profit margin for year 2 is appropriate for your company? For one thing, we can use it to compare The College Shop’s results to those of its industry. When we make this comparison, we find that the specialized retail industry (in which your company operates) reports an average gross profit margin of 41 percent. For year 1, therefore, we had a higher ratio than the industry; in year 2, though we had a lower ratio, we were still in the proverbial ballpark.

It’s worthwhile to track gross profit margin, whether for your company or for companies that you might invest in or lend money to. In particular, you’ll gain some insight into changes that might be occurring in a business. For instance, what if you discover that a firm’s gross profit margin has declined? Is it because it’s costing more for the company to buy or make its products, or is it because its competition is forcing it to lower its prices?

Net Profit Margin

Net profit is the money that a company earns after paying all its expenses, including the costs of buying or making its products, running its operations, and paying interest and taxes. Look again at Figure 12.20 "Comparative Income Statement Using Vertical Percentage Analysis". Using vertical percentage analysis, we found that for The College Shop, net profit as a percentage of sales was 6 percent in year 1 but declined to 3 percent in year 2. Expressed as ratios, these relationships would look like this:

You realize that a declining net profit margin isn’t good, but you wonder how you compare with your industry. A little research informs you that average net profit margin in the industry is 7 percent. You performed nearly as well as the industry in year 1 but fell further from your target in year 2. What does this information tell you? That a goal for year 3 should be trying to increase your net profit margin.

Management Efficiency Ratios

These ratios reveal the way in which assets (shown on the balance sheet) are being used to generate income (shown on the income statement). To compute this group of ratios, therefore, you must look at both statements. In Figure 12.19 "Comparative Income Statement for The College Shop", we produced a comparative income statement for The College Shop’s first two years. Figure 12.21 "Comparative Balance Sheet for The College Shop" is a comparative balance sheet for the same period.

Figure 12.21 Comparative Balance Sheet for The College Shop

As you can see from Figure 12.21 "Comparative Balance Sheet for The College Shop", running even a small business entails a substantial investment in assets. Even if you rent space, for example, you must still buy furniture and equipment. To have products on hand to sell, you need to tie up money in inventory. And once you’ve sold them, you may have money tied up in accounts receivable while you’re waiting for customers to pay you. Thus, investing in assets is a normal part of doing business. Managing your assets efficiently is a basic requirement of business success. Let’s look at a representative management efficiency ratio. The inventory turnover ratioFinancial ratio that shows how efficiently a company turns over its inventory. measures a firm’s efficiency in selling its inventory.

You don’t make money from unsold inventory. You make money when you sell inventory, and the faster you sell it, the more money you make. To determine how fast your inventory is “turning,” you need to examine the relationship between sales and inventory.Another way to calculate inventory turnover is to divide Cost of goods sold by inventory (rather than dividing Sales by inventory). We don’t discuss this method here because the available industry data used for comparative purposes reflect Sales rather than Cost of goods sold. Let’s see how well The College Shop is doing in moving its inventory:

For year 1, The College Shop converted its inventory into sales 6.25 times: on average, your entire inventory was sold and replaced 6.25 times during the year. For year 2, however, inventory was converted into sales only 5.45 times. The industry did better, averaging turnover of 6.58 times. Before we discuss possible reasons for the drop in The College Shop’s inventory turnover ratio, let’s look at an alternative way of describing this ratio. Simply convert this ratio into the average number of days that you held an item in inventory. In other words, divide 365 days by your turnover ratio:

The College Shop was doing fine in year 1 (relative to the industry), but something happened in year 2 to break your stride. Holding onto inventory for an extra 9 days (67 days for year 2 minus 58 days for year 1) is costly. What happened? Perhaps inventory levels were too high because you overstocked. It’s good to have products available for customers, but stocking too much inventory is costly. Maybe some of your inventory takes a long time to sell because it’s not as appealing to customers as you thought. If this is the case, you may have a problem for the next year because you’ll have to cut prices (and reduce profitability) in order to sell the same slow-moving inventory.

Optimal inventory turnover varies by industry and even by company. A supermarket, for example, will have a high inventory turnover because many of its products are perishable and because it makes money by selling a high volume of goods (making only pennies on each sale). A company that builds expensive sailboats, by contrast, will have a low inventory turnover: it sells few boats but makes a hefty profit on each one. Some companies, such as Dell Computer, are known for keeping extremely low inventory levels. Because computers are made to order, Dell maintains only minimal inventory and so enjoys a very high ratio of sales to inventory.

Management Effectiveness Ratios

“It takes money to make money,” goes the old saying, and it’s true. Even the smallest business uses money to grow. Management effectiveness ratios address the question: how well is a company performing with the money that owners and others have invested in it?

These ratios are widely regarded as the best measure of corporate performance. You can give a firm high marks for posting good profit margins or for turning over its inventory quickly, but the final grade depends on how much profit it generates with the money invested by owners and creditors. Or, to put it another way, that grade depends on the answer to the question: is the company making a sufficiently high return on its assets?

Like management efficiency ratios, management effectiveness ratios examine the relationship between items on the income statement and items on the balance sheet. From the income statement you always need to know the “bottom line”—net profit. The information that you need from the balance sheet varies according to the ratio that you’re trying to calculate, but it’s always some measure of the amount of capital used in the business. Common measures of capital investment include total equity, total assets, or a combination of equity and long-term debt. Let’s see whether The College Shop made the grade. Did it generate a reasonable profit on the assets invested in the company?

Because the industry average return on assets is 7.9 percent, The College Shop gets an “A” for its first year’s performance. It slipped in the second year but is probably still in the “B” range.

Financial Condition Ratios

Financial condition ratios measure the financial strength of a company. They assess its ability to pay its current bills; and to determine whether its debt load is reasonable, they examine the proportion of its debt to its equity.

Accounting “Strategy,” Ethics, and the Law

Unfortunately, you may also be well on your way to becoming the Bernie Ebbers of the small-business set. In 2002, when the giant telecom company WorldCom collapsed under the weight of an $11 billion fraud scheme, CEO Ebbers, who was convicted of securities fraud and conspiracy, got twenty-five years in a federal penitentiary (“I don’t know accounting,” he told the judge). And Ebbers wasn’t the only person on the WorldCom payroll who was charged with illegal activities: Accounting department managers went down with him. Betty Vinson, for example, a forty-seven-year-old midlevel accountant who’d followed orders to falsify accounting records, was sentenced to five months in jail. And she was lucky—she got minimal jail time because she cooperated with federal prosecutors.See Susan Pulliam, “How Following Orders Can Hurt Your Career,” CFO.com, October 3, 2003, http://www.cfo.com (accessed July 22, 2010).

The damage done at WorldCom spread to innocent employees as well, not to mention investors, creditors, and business partners. In 2001, when Enron, the seventh-largest company in America, melted down in the heat of an investigation into its financial-reporting practices, it took down an entire accounting firm with it—eighty-nine-year-old Arthur Andersen, then one of the “Big Five” public accounting firms. Volumes have been written about what went wrong, but we can pretty much boil it down to this: Enron executives behaved unethically and illegally, and Andersen auditors looked the other way. Instead of performing its role as public watchdog, Andersen was watching its own pocketbook: The accounting firm protected the revenues generated by lucrative consulting contracts with its client instead of protecting the client’s stakeholders. In so doing, Andersen not only shirked its responsibilities as a public auditor but also covered up evidence of its own inappropriate actions.

In 2002, Andersen gave up its licenses to practice as certified public accountants in the United States, and a company that had employed 85,000 people only 10 years earlier now employs about 200, most of them to deal with lawsuits and to oversee the process of shutting down the company for good.See Michael Moffett, What Happened at Enron? (Cambridge, MA: Harvard Business Review, July 2004); and Barbara Ley Toffler with Jennifer Reingold, Final Accounting: Ambition, Greed, and the Fall of Arthur Andersen (New York: Broadway Books, 2003), http://books.google.com (accessed July 22, 2010).

Who Can You Trust?

In a very real sense, the issue at the bottom of all this financial misconduct is trustworthiness. As we’ve seen, accountants are supposed to provide users with financial reports that are useful because they’re relevant, timely, and, most important, accurate. It should go without saying that if users—whether internal or external—can’t trust these reports to be accurate, they can’t rely on them to be as useful as they should be. Would you, for instance, invest in or loan money to a company whose financial reports you can’t trust?

Which—appropriately—brings us back to you and your little foray into falsifying accounting records. Let’s say that in February of your second year of operations, you have an unexpected opportunity to expand into the vacated store right next to The College Shop. It’s too good to pass up, but you’ll need quite a bit of money to outfit the space and expand your inventory. First, you go to the friend for whose benefit you “adjusted” your financial statements, but he’s just lost a bundle in the stock market and can’t help you out. Your only option, then, is to get a bank loan. So you go to your banker, and some version of the following exchange occurs early in the conversation:

She means, of course, the first-year statements that you falsified, and if you’re offered and accept a loan under these circumstances, you could be guilty of a financial crime that, according to the FBI, is normally characterized by “deceit, concealment, or violation of trust” and committed “to obtain personal or business advantage.” The maximum you could get under federal law is twenty years, although your case no doubt calls for a sentence measured in mere months.Federal Bureau of Investigations, Financial Crimes Report to the Public (Washington, D.C.: U.S. Dept. of Justice, 2005), http://www.fbi.gov (accessed July 22, 2010).

Are You Ethical?

We could give you the benefit of the doubt and agree that you wouldn’t have gotten yourself into this mess had you known the legal ramifications. We must assume, however, that you knew what you did was ethically wrong. Ethics refers to the ability and willingness to distinguish right from wrong and to know when you’re doing one or the other. Ethical and trustworthy behavior is critical in both business and accounting, and although the vast majority of businesspeople and accountants behave ethically, all of them—especially providers of financial information—constantly face ethical dilemmas in the course of their work.

Sarbanes-Oxley Act (SOX)

It will be helpful to remember that both the law and the accounting profession have taken steps to remind you of your responsibilities when you’re reporting financial information. In the wake of corporate scandals like the ones we described above, Congress passed the Sarbanes-Oxley Act (SOX)A federal law enacted to encourage ethical corporate behavior and discourage fraud and other wrongdoing. of 2002, which was designed to encourage ethical corporate behavior and to discourage fraud and other forms of corporate wrongdoing. Among other things, SOX requires its top executives to take responsibility for a company’s financial statements and subjects them to criminal penalties for falsely certifying its financial reports. SOX also set up the Public Company Accounting Oversight Board (PCAOB) to regulate accounting professionals, especially in the area of auditing standards.

The Profession’s Code of Ethics

Finally, you can always turn to the Code of Professional Ethics of the American Institute of Certified Public Accountants (AICPA), which sets down two hallmarks of ethical behavior:American Institute of Certified Public Accountants, AICPA Code of Professional Conduct—Current and Historical Versions (2006-2010), http://www.aicpa.org (accessed July 22, 2010.

• Integrity. An accountant should be “honest and candid” and should never subordinate the “public trust…to personal gain and advantage.”
• Objectivity and independence. An accountant should be “impartial, intellectually honest, and free of conflicts of interest.” He or she is “scrupulous in [the] application of generally accepted accounting principles and candid in all…dealings with members in public practice.”

Job Descriptions

If you choose a career in accounting, you have two career options:

• Work as a public accountant, whether for a “Big Four” public accounting firm or for a midsize or smaller company
• Work as a private accountant for a business, not-for-profit organization, or government agency

Let’s take a closer look at these options. Public accounting firms provide clients with accounting and tax services in return for fees. Most members of such firms are certified public accountants (CPAs)Accountant who has met state-certified requirements for serving the general public rather than a single firm. who have met educational and work requirements set by the state and passed a rigorous exam. Although public accounting firms offer consulting and tax services, the hallmark of the profession is performing external auditsAccountant’s examination of and report on a company’s financial statements.: the public accountant examines a company’s financial statements and submits an opinion on whether they’ve been prepared in accordance with GAAP. This “stamp of approval” provides the investing public with confidence that a firm’s financial reports are accurate. Typically, public accountants are self-employed, work for small, sometimes regional firms, or are associated with one of the “Big Four” public accounting firms—Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers—or one of the large second-tier public accounting firms, such as BDO Seidman or Grant Thornton.

Often called management or corporate accountants, private accountantsAccountant who works for a private organization or government agency. may work for specific companies, nonprofit organizations, or government agencies. A firm’s chief accounting officer is called a controller. As a rule, the controller reports to the organization’s chief financial officer (CFO), who’s responsible for all of its accounting and other financial activities. The jobs of private accountants vary according to the company or industry in which they’re employed. Most private accountants record and analyze financial information and provide support to other members of the organization in such diverse areas as marketing, strategic planning, new product development, operations, human resources, and finance. Private accountants also conduct internal audits. In this capacity, they ensure that accounting records are accurate, company policies are adhered to, assets are safeguarded, and operations are efficiently conducted. Finally, they may also provide a variety of specialized services:

• Develop and prepare financial reports
• Prepare tax returns
• Perform cost accounting functions (that is, determine the cost of goods or services)
• Prepare and supervise budgets
• Manage such functions as payroll, accounts payable, and receivables

Accountants who pass a special exam and meet other professional requirements in the field of management accounting are designated certified management accountants (CMAs). CMAs often have greater job responsibilities and receive higher compensation than other accountants.

The Job and Its Prospects

So, what’s the job like? For that matter, what’s the professional life of an accountant like? Or perhaps even more important, what are your prospects for getting a job in accounting, and what kind of income can you expect if you’re able to make a career for yourself in the field? “If you’re looking for a career that’s challenging and for which the dynamics change constantly…then this is where its at,” advises one practicing CPA.“Ask a CPA,” Start Here Go Places, http://www.startheregoplaces.com (accessed July 27, 2010). Beatrice Sanders, former director of Academic and Career Development for the American Institute of Certified Public Accountants, agrees: “Whatever form of practice you choose, accounting provides a challenging and rewarding career in which there are no limits on where you can go, or how far.”Gloria A. Gaylord and Glenda E. Reid, Careers in Accounting, 4th ed. (New York: McGraw-Hill, 2006), http://books.google.com (accessed July 27, 2010).

The Job Market Today

“The one great benefit of choosing accounting as your career is that you will always have a job when you graduate.” Or so says one accountant CPA (in fact, the same CPA who promises a challenging career in a dynamic profession). Obviously, we can’t make any guarantees, but in order to help you better assess your prospects for a satisfying career in accounting, we can offer you some relevant facts and figures.

First of all, we can confirm that accounting graduates have always faced a favorable job market and that, according to a survey conducted by the National Association of Colleges and Employers (NACE), the year 2010 is no different. In the June edition of its Salary Survey, NACE reported that accounting employers extended the largest number of offers to new college graduates.National Association of Colleges and Employers, “Top Employers for the Class of 2010,” Knowledge Center, www.naceweb.org (accessed July 26, 2010).And what about the area that probably interests you most right now—salary? For the most part, we can report good news. The NACE survey, for example, reports that, with average salary offers of just over $50,000, 2010 accounting graduates could expect to be among the highest-paid entrants into the workforce.