Chapter 2.1: Accounting and Financial Information

The Role of Accounting

Accounting is often called “the language of business” because it communicates so much of the information that owners, managers, and investors need to evaluate a company’s financial performance. These people are stakeholders in the business—they’re interested in its activities because they’re affected by them. The financial futures of owners and other investors may depend heavily on strong financial performance from the business, and when performance is poor, managers may be replaced or laid off in a downsizing.

In fact, a key purpose of accounting is to help stakeholders make better business decisions by providing them with financial information. You shouldn’t try to run an organization or make investment decisions without accurate and timely financial information, and it is the accountant who prepares this information. More importantly, accountants make sure that stakeholders understand the meaning of financial information, and they work with both individuals and organizations to help them use financial information to deal with business problems. Actually, collecting all the numbers is the easy part. The hard part is analyzing, interpreting, and communicating the information. Of course, you also have to present everything clearly while effectively interacting with people from every business discipline. In any case, we’re now ready to define accounting as the process of measuring and summarizing business activities, interpreting financial information, and communicating the results to management and other decision makers.

Fields of Accounting

Accountants typically work in one of two major fields. Management accountants provide information and analysis to decision makers inside the organization in order to help them run it. Financial accountants furnish information to individuals and groups both inside and outside the organization in order to help them assess its financial performance. Their primary focus, however, is on external parties. In other words, management accounting helps you keep your business running while financial accounting tells the outside world how well you’re running it.

Management Accounting

Management accounting, also known as managerial accounting, plays a key role in helping managers carry out their responsibilities. Because the information that it provides is intended for use by people who perform a wide variety of jobs, the format for reporting information is flexible. Reports are tailored to the needs of individual managers, and the purpose of such reports is to supply relevant, accurate, timely information that will aid managers in making decisions. In preparing, analyzing, and communicating such information, accountants work with individuals from all the functional areas of the organization—human resources, operations, marketing, etc.

Financial Accounting

Financial accounting is responsible for preparing the organization’s financial statements—including the income statement (also called the profit/loss 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. If a company is traded publicly on a stock market such as the TSX (Toronto Stock Exchange), these financial statements must be made public, which is not true of the internal reports produced by management accountants. In preparing financial statements, Canadian financial accountants adhere to a uniform set of rules called international financial reporting standards (IFRS)—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 IFRS because they want to be sure that the information reported in them is accurate. They also know that when financial statements have been prepared by the same rules, they can be compared from one company to another.

Financial Accounting Information Users

The users of managerial accounting information are pretty easy to identify—basically, they’re a club’s managers. We need to look a little more closely, however, at the users of financial accounting information, and we also need to know a little more about what they do with the information that accountants provide them. Publicly Traded companies will provide their financial accounting information to a wider set of stakeholders, including shareholders, potential investors, etc., than compared to a privately held company that will generate a single set of financial statements according to the International Financial Reporting Standards. Publicly Traded companies will also provide their financial accounting information to the general public in order to showcase to potential investors the company’s performance. Therefore, Publicly Traded companies will typically generate two sets of financial statements, one set of detailed statements in accordance with Canadian International Financial Reporting Standards (IFRS) and another set of simplified financial statements that can be more easily consumed by the general public. 

Understanding Financial Statements

We hope that, so far, at least one thing is clear: If you’re in business, you need to understand financial statements. The law no longer allows high-ranking executives to plead ignorance or fall back on delegation of authority when it comes to responsibility for a firm’s financial reporting. In a business environment tainted by episodes of fraudulent financial reporting and other corporate misdeeds, top managers are now being held responsible for the financial statements issued by the people who report to them. Top managers need to know how well the company is performing. Financial information helps managers identify signs of impending trouble before it is too late.

The Function of Financial Statements

• Income Statement = Shows sales, expenses, and whether or not a profit was made.
• Balance Sheet = Show assets and liabilities, the amount invested in the business.
• Statement of Cash Flows = Show how much cash is coming in and going out.

Since this book is for an introductory course, attention is on the income statement, balance sheet, and cash flow statement only, even though other financial statements are mentioned.

“Bob’s Re-Gripping”

You decide that you want to start a home-based re-gripping business.  You have gained some knowledge on how to re-grip golf clubs and think you can do a good job soliciting customers.

One of the basic steps is understanding the material costs and how much to sell your service.

The Income Statement

Let’s say that during your first month, you sell one hundred re-grips. Not bad, you say to yourself, but did I make a profit? To find out, you prepare an income statement showing revenues, or sales, and expenses—the costs of doing business. You divide your expenses into two categories:

• Cost of goods sold: the total cost of the goods that you’ve sold
• Operating expenses: the costs of operating your business except for the costs of things that you’ve sold.

Now you need to do some subtracting:

• The difference between sales and cost of goods sold is your gross profit, also known as gross margin.
• The difference between gross profit and operating expenses is your net income or profit, which is the proverbial “bottom line.” Note we’ve assumed you’re making money, but businesses can also have a net loss.

Below is your income statement for the first month. (Remember that we’ve made things simpler by handling everything in cash.)

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 (grip) that you sold cost you $6.  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. Because this is a small business, you can either keep this money as income or reinvest in equipment for the business

The Balance Sheet

A balance sheet reports the following information:

• Assets: the resources from which it expects to gain some future benefit
• Liabilities: the debts that it owes to outside individuals or organizations
• Owner’s equity: the investment in the business

Whereas your income statement tells you how much income you earned over some period of time, your balance sheet tells you what you have at a specific point in time.

Companies prepare financial statements on at least a twelve-month basis—that is, for a fiscal year which ends on December 31 or some other logical date, such as June 30 or September 30. Fiscal years can vary because companies generally pick a fiscal-year end date that coincides with the end of a peak selling period; thus a crabmeat processor might end its fiscal year in October, when the crab supply has dwindled. Most companies also produce financial statements on a quarterly or monthly basis. For Bob’s Re-Gripping, you’ll want to prepare them monthly to stay on top of how your new business is doing. Let’s prepare a balance sheet at the start and end of your first month in business.

The Accounting Equation

To prepare a balance sheet, one must first understand the fundamental accounting equation:

This simple but important equation highlights the fact that a company’s assets came from somewhere: either from investments made by the owners (owner’s equity) or from loans (liabilities). 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 the two balance sheets we mentioned: 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 below, 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 as follows:

Now let’s see how things have changed by the end of the month. Recall that Bob’s Re-Gripping earned $100 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). Below shows what your balance sheet will look like on April 30. 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).

Breakeven Analysis

Let’s take a short detour to see how this information might be put to use. As you look at your first financial statements, you might ask yourself: 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 analysis. To break even (have no profit or loss), your total sales revenue must exactly equal all your expenses (both variable and fixed). Variable costs depend on the quantity produced and sold. Fixed costs don’t change as the quantity sold changes; for example, you’ll pay for your advertising whether you sell Grips or not. The balance between revenue and expenses 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 (using data from the previous example): 

1. Determine your total fixed costs: Fixed costs = $240 salaries + $40 advertising + $20 renal equipment = $300

2. Identify your variable costs on a per-unit basis: Variable cost per unit = $6 

3. Determine your contribution margin per unit: Selling price per unit – variable cost per unit: Contribution margin = $10 selling price – $6 variable cost per unit = $4

4. Calculate your breakeven point in units: fixed costs: Contribution margin per unit: Breakeven in units = $300 fixed costs ÷ $4 contribution margin per unit = 75 units/grips

Your calculation means that if you sell 75 units/grips, 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 (your breakeven number). The resulting statement is shown in the table below.

Of course you want to do better than just break even, so you could modify this analysis to a targeted level of profit by adding that amount to your fixed costs and repeating the calculation. 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 certain profit. Such information will be vital to planning your business.

 The Cash Flow Statement

The Cash Flow Statement provides valuable information about a company’s expenses and receipts and allows insights into its future income needs in order to be able to meet its future obligations (expenses and receipts). The cash flow statement reports cash inflows and outflows, and it will identify the amount of cash the company currently holds, which is also reported in the balance sheet.

Typically the cash flow statement is reported on a month to month basis, however, a statement of cash flow will consolidate month to month cash flow to meet the requirements of the International Financial Reporting Standards.

A statement of cash flow will report cash in three distinct areas of business:

• Cash from Operations
• Cash from Investing
• Cash from Financing

Now let’s prepare the statement of cash flow for Bob’s Re-Gripping for the one month period ending April 30, 2022. Bob’s Re-Gripping would have incurred cash from Operations in the form of Net Income incurred after deducting the month’s expenses from the month’s revenues and would have also incurred cash from Financing from the initial $400 loan taken out to start the business and the additional $200 of personal income. As Bob’s Re-Gripping did not invest in new equipment, machinery or other assets for the business or use prior cash flows and/or retained earning to earn further investment income, Bob’s Re-Gripping would not report any cash from investing activities.

Financial Statement Analysis

Now that you know a bit about financial statements, it is important that owners, managers, investors, and creditors assess a business’ performance and financial strength. You can gain a wealth of information from financial statements, but the key is to understand a few basic principles for “unlocking” it. Ratio Analysis is used to help interpret the data to see how your business is performing. Some of the most common ratios measure profitability, liquidity, debt, effectiveness and efficiency. This will be explored in further detail in your Accounting class.