Read Chapter 15 Using Management and Accounting Information
Students,
Read Chapter 15, Using Management and Accounting Information.
HOW CAN INFORMATION REDUCE RISK WHEN MAKING A DECISION? Information is one of the four major resources (along with material, human, and financial) managers must have to operate a business. Information helps managers reduce risk when making a decision.
Information and Risk. To improve the decision-making process and reduce risk, the information used by individuals and business firms must be relevant or useful to meet a specific need.
Better intelligence and knowledge that lead to better decisions are especially important because they can provide a competitive edge and improve a firm’s profits.
Theoretically, with accurate and complete information, there is no risk whatsoever. On the other hand, a decision made without any information is a gamble. For the most part, business decision makers see themselves located someplace between the extremes.
As illustrated in Figure 15-1, when the amount of available information is high, there is less risk; when the amount of available information is low, there is more risk.
Information, when understood properly, produces knowledge and empowers managers and employees to make better decisions.
Information Rules. An information rule emerges when research confirms the same
results each time that it studies the same or a similar set of circumstances.
Businesspeople try to accumulate information rules to shorten the time they spend analyzing choices.
Information rules are the “great simplifiers” for all decision makers.
Business research is continuously looking for new rules that can be put to good use and looking to discredit old ones that are no longer valid.
The Difference Between Data and Information. Many people use the terms data and information interchangeably, but the two differ in important ways.
Data are numerical or verbal descriptions that usually result from some sort of measurement.
Information is data presented in a form that is useful for a specific purpose. For a manager, information presented in a practical, useful form such as a graph simplifies the decision-making process.
Knowledge Management. The average company maintains a great deal of data that can be transformed into information. A database is a single collection of data and information stored in one place that can be used by people throughout an organization to make decisions.
Although databases are important, the way the data and information are used is even more important and valuable to a firm. As a result, management information experts now use the term knowledge management (KM) to describe a firm’s procedures for generating, using, and sharing the data and information.
Making Smart Decisions. Three different software applications can actually help to improve and speed the decision-making process for people at different levels within an organization.
A decision-support system (DSS) is a type of software program that provides relevant data and information to help a firm’s employees make decisions. It can also be used to determine the effect of changing different variables and to answer “what if” type questions.
An expert system is a type of computer program that uses artificial intelligence to imitate a human’s ability to think.
An expert system uses a set of rules that analyze information supplied by a user about a particular activity or problem.
Based on the information supplied, the expert system then provides recommendations or suggests specific actions in order to help make decisions.
Business Application Software. Early software typically performed a single function. Today, however, integrated software combines many functions in a single package. Integrated packages allow for the easy linking of text, numerical data, graphs, photographs, and even audiovisual clips. Integration offers at least two other benefits. Once data have been entered into an application in an integrated package, the data can be used in another integrated package without having to reenter the data. In addition, once a user learns one application, it is much easier to learn another application in an integrated package.
WHAT IS A MANAGEMENT INFORMATION SYSTEM? A management information system (MIS) is a system that provides managers and employees with the information they need to perform their jobs as effectively as possible. The purpose of an MIS (sometimes
referred to as an information technology system or simply IT system) is to distribute timely and useful information from both internal and external sources to the managers and employees who need it.
A Firm’s Information Requirements. Today, many firms are organized into five
areas of management: finance, operations, marketing, human resources, and administration. Managers in each of these areas need specific information to make decisions. (See Figure 15-2.)
Financial managers must ensure that the firm’s managers and employees, lenders and suppliers, stockholders and potential investors, and government agencies have the information they need to measure the financial health of the firm.
Operations managers are concerned with present and future sales levels, current
inventory levels of work in process and finished goods, and the availability and cost of the resources used to produce products and services.
Marketing managers need to have detailed information about a firm’s products and services and those offered by competitors, including pricing strategies, new promotional campaigns, and products that competitors are test marketing. Information concerning the firm’s customers, current and projected market share, and new and pending product legislation is also important.
Human resources managers must be aware of anything that pertains to a firm’s
employees, such as current wage levels and benefit packages both within the firm and in firms that compete for valuable employees, current legislation and court
decisions that affect employment practices, and the firm’s plans for growth, expansion, or mergers.
Administrative managers are responsible for the overall management of the organization. They are concerned with the coordination of information. Administrators must ensure the information is used in a consistent manner throughout the firm.
Administrative managers must make sure that all managers and employees are able to use the information technology that is available, and that they receive the skills training required to access the information.
Administrative managers must commit to the costs of updating the firm’s MIS and providing additional training when necessary.
Costs and Limits of the System. An MIS must be tailored to the needs of the organization it serves.
In some firms, a tendency to save on initial costs may result in a system that is too small or overly simple.
Such a system generally ends up serving only one or two management levels or a single department.
Managers in the other departments “give up” on the system as soon as they find that it cannot accept or process their data.
Almost as bad is an MIS that is too large or too complex for the organization.
Unused capacity and complexity increase the cost of owning and operating the system.
A system that is difficult to use may not be used at all.
HOW DO EMPLOYEES USE A MANAGEMENT INFORMATION SYSTEM? To provide information, an MIS must perform five specific functions. It must collect data, store the data, update the data, process the data into information, and present information to users. (See Figure 15-3.)
Step 1: Collecting Data. A firm’s employees, with the help of an MIS system, must gather the data needed to establish the firm’s data bank. The data bank should include all past and current data that may be useful in managing the firm. The data entered into the system must be relevant to the needs of the firm’s managers. Perhaps most important, the data must be accurate. There are two data sources: internal and external.
Typically, most of the data gathered for an MIS come from internal sources. The most common internal sources of information are managers and employees, company records, and reports and minutes of meetings.
External sources of data include customers, suppliers, bankers, trade and financial publications, industry conferences, online computer services, and firms that specialize in gathering marketing research for organizations.
Whether the source of the data is internal or external, it is good to remember the following cautions:
The cost of obtaining data from some external sources can be quite high.
Although computers generally do not make mistakes, the people who use them can make or cause errors.
Step 2: Storing Data. An MIS must be capable of storing data until they are needed.
The method chosen to store data depends on the size and needs of the organization.
Small businesses may enter data and then store them directly on an employee’s computer.
Medium-sized to large businesses store data in a larger computer system and provide access to employees through a computer network.
Step 3: Updating Data
An MIS must be able to update stored data regularly to ensure that the information presented to managers and employees is accurate, complete, and up-to-date.
The frequency with which data are updated depends on how fast they change and how often they are used.
When it is vital to have current data, updating may occur as soon as the new data are available.
Data and information may also be entered into a firm’s data bank at certain
intervals—every 24 hours, weekly, or monthly.
Step 4: Processing Data. Some data are used in the form in which they are stored. Data processing is the transformation of data into a form useful for a specific purpose.
Most business data are in the form of numbers. Computers can be programmed to process such large volumes of numbers quickly.
Their contents can be summarized through the use of statistics. A statistic is a measure that summarizes a particular characteristic of an entire group of numbers.
Step 5: Presenting Information. An MIS must be capable of presenting the information in a usable form and be appropriate for the information itself and for the uses to which it will be put.
Business Reports. Verbal information may be presented in list or paragraph form. A typical business report includes four parts:
The introduction sets the stage for the remainder of the report, describes the problem to be studied in the report, identifies the research techniques that were used, and previews the material that will be presented in the report.
The body of the report describes the facts that were discovered in the process of completing the report.
The conclusions are statements of fact that describe the findings in the report.
The recommendations section presents suggestions on how the problem might be solved
Visual Displays and Tables. A visual display is a diagram that represents several items of information in a manner that makes a comparison easier.(See Figure 15-4.)
A tabular display is used to present verbal or numerical information in columns and rows. It is most useful in presenting information about two or more related variables.
Tabular displays generally have less impact than visual displays. However, displaying the information that could be contained in a multicolumn table such as the one shown in Table 15-2 would require several bar or pie charts.
WHY ACCOUNTING INFORMATION IS IMPORTANT. Accounting is the process
of systematically collecting, analyzing, and reporting financial information. Although accounting information can be used to answer questions about what has happened in the past,
it can also be used to help make decisions about the future. To improve the accuracy of their accounting information and financial statements, businesses rely on audits conducted by accountants employed by public accounting firms.
Why Audited Financial Statements Are Important? An audit is an examination of a company’s financial statements and the accounting practices that produced them. The purpose is to make sure that a firm’s financial statements have been prepared in accordance with generally accepted accounting principles (GAAPs).
GAAPs have been developed to provide an accepted set of guidelines and practices for U.S. companies reporting financial information and the accounting profession.
The Financial Accounting Standards Board (FASB), which establishes accounting standards for U.S. companies, is working toward establishing a new set of standards that combines GAAPs with the International Financial Reporting Standards (IFRS) to create one set of accounting standards that can be used by both U.S. and multinational firms.
Created by the International Accounting Standards Board, IFRS are now used in more than 100 different countries around the world.
For multinational firms, the benefits of global accounting standards are huge because preparing financial statements and accounting records that meet global standards saves both time and money.
Although an audit and the resulting report do not guarantee that a company has not “cooked” the books, it does imply that the company has followed GAAPs.
Without the audit function and GAAPs, there would be very little oversight or
supervision and the validity of a firm’s financial statements and its accounting
records would drop quickly.
Firms would find it difficult to obtain debt financing, acquire goods and services from suppliers, find investor financing, or prepare documents requested by government agencies.
Accounting Fraud, Ethical Behavior, and Reform
To help ensure that corporate financial information is accurate, Congress enacted the Sarbanes–Oxley Act in 2002. Key components include the following:
The Securities and Exchange Commission (SEC) is required to establish a full-time, five-member federal oversight board that will police the accounting industry.
Chief executive and financial officers are required to certify periodic financial reports and are subject to criminal penalties for violations of securities reporting requirements.
Accounting firms are prohibited from providing many types of consulting
services to the companies they audit.
Auditors must maintain financial documents and audit work papers for five years.
Auditors, accountants, and employees can be imprisoned for up to 20 years for destroying financial documents and willful violations of the securities laws.
A public corporation must change its lead auditing firm every five years.
There is added protection for whistle-blowers who report violations of the Sarbanes–Oxley Act.
While most people welcome the Sarbanes–Oxley Act, complex rules make compliance more expensive and time consuming for corporate management and more difficult for accounting firms.
Different Types of Accounting. Accounting usually is broken down into two broad categories: managerial and financial.
Managerial accounting provides managers and employees with the information needed to make decisions about a firm’s financing, investing, and operating
activities.
Financial accounting generates financial statements and reports for people outside of an organization (stockholders, financial analysts, bankers, lenders, suppliers, government agencies, and other interested groups).
Additional special areas of accounting include the following:
Cost accounting—determining the cost of producing specific products or
Tax accounting—planning tax strategy and preparing tax returns.
Government accounting—providing basic accounting services to ensure that tax revenues are collected and used to meet the goals of state, local, and federal agencies.
Not-for-profit accounting—helping not-for-profit organizations to account for all donations and expenditures.
Careers in Accounting
Accounting can be an exciting and rewarding career—one that offers higher-than-average starting salaries. To be successful in the accounting industry, employees must:
Be responsible, honest, and ethical.
Have a strong background in financial management.
Know how to use a computer and software to process data into accounting
Be able to communicate with people who need accounting information.
Accountants generally are classified as private or public accountants.
A private accountant is employed by a specific organization.
A public accountant works on a fee basis for clients and may be self-employed or be the employee of an accounting firm.
Typically, public accounting firms include on their staffs at least one
certified public accountant (CPA), an individual who has met state
requirements for accounting education and experience and has passed a rigorous accounting examination. State requirements usually include a college degree or a specified number of hours of college coursework and from one to three years of on-the-job experience. Details regarding specific state requirements for practice as a CPA can be obtained by contacting the state’s board of accountancy.
THE ACCOUNTING EQUATION AND THE BALANCE SHEET. Financial data are transformed into financial information and reported on three very important financial statements—balance sheet, income statement, and statement of cash flows.
The Accounting Equation. The accounting equation shows the relationship between the firm’s assets, liabilities, and owners’ equity.
Assets are the resources a business owns—cash, inventory, equipment, and real
Liabilities are the firm’s debts—what it owes to others.
Owners’ equity is the difference between total assets and total liabilities—what would be left for the owners if the firm’s assets were sold and the money used to pay off its liabilities.
The relationship between assets, liabilities, and owners’ equity is shown by the
accounting equation: Assets = Liabilities + Owners’ equity. This is the basis for the accounting process.
To use this equation, a firm’s accountants must record raw data—the firm’s day-to-day financial transactions—using the double-entry bookkeeping system, a system in which each financial transaction is recorded as two separate accounting entries to maintain the balance shown in the accounting equation.
At the end of a specific accounting period, the financial transactions are summarized in the firm’s financial statements, and information is presented in a standardized format to make the statements as accessible as possible to the various people who may be using it.
A firm’s financial statements are prepared at least once a year and included in the firm’s annual report—a report distributed to stockholders and other interested parties that describes a firm’s operating activities and its financial condition.
Most firms also have financial statements prepared semiannually, quarterly, or monthly.
The Balance Sheet. A balance sheet (sometimes referred to as a statement of financial position) is a summary of the dollar amounts of a firm’s assets, liabilities, and owners’ equity accounts at the end of a specific accounting period.
The balance sheet must demonstrate that assets are equal to liabilities plus owners’ equity and the accounting equation is still in balance.
Most people think of a balance sheet as a statement that reports the financial condition of a business firm, but balance sheets apply to individuals, too. Figure 15-5 shows Marty Campbell’s current personal balance sheet.
Figure 15-6 shows the balance sheet for Northeast Art Supply, Inc.
Assets. On a balance sheet, assets are listed in order from the most liquid to the least liquid. The liquidity of an asset is the ease with which it can be converted into cash.
Current Assets. Current assets are assets that can be converted quickly into cash or that will be used in one year or less.
Because cash is the most liquid asset, it is listed first.
Next are marketable securities—stocks, bonds, and other investments—that can be easily converted into cash in a matter of days.
Next are the firm’s receivables.
Its accounts receivable, which result from allowing customers to make credit purchases, are generally paid within 30 to 60 days.
However, the firm expects that some of these debts will not be collected. Thus, it has reduced its accounts receivable by a 5 percent allowance for doubtful accounts.
The firm’s notes receivable are receivables for which customers have signed promissory notes. They are generally repaid over a longer period of time than accounts receivable.
Merchandise inventory represents the value of goods on hand for sale to
Prepaid expenses are assets that have been paid for in advance but have not yet been used.
As shown in Figure 15-6, for Northeast Art, current assets total $182,000.
Fixed Assets. Fixed assets are assets that will be held or used for a period longer than one year.
Fixed assets generally include land, buildings, and equipment.
Note that the values of Northeast’s delivery equipment and furniture and store equipment are decreased by their accumulated depreciation.
Depreciation is the process of apportioning the cost of a fixed asset over its useful life.
The depreciation amount allotted to each year is an expense for that year, and the value of the asset must be reduced by the amount of depreciation expense
For Northeast Art, fixed assets total $137,000.
Intangible Assets. Intangible assets do not exist physically but have a value based on rights or privileges they confer on a firm.
Intangible assets include patents, copyrights, trademarks, franchises, and goodwill.
Intangible assets are long-term assets—they are of value to the firm for a number of years.
For Northeast Art, intangible assets total $21,000. As calculated in Figure
15-6, total assets are $340,000.
Liabilities and Owners’ Equity. The firm’s liabilities are separated into two categories—current and long-term liabilities.
Current Liabilities. A firm’s current liabilities are debts that will be repaid in one year or less.
Accounts payable are short-term obligations that arise as a result of making credit purchases.
Notes payable are obligations that have been secured with promissory notes. Only those that must be paid within the year are listed under current liabilities.
Northeast Art also lists salaries payable and taxes payable as current liabilities. These are both expenses that have been incurred during the current
accounting period but will be paid in the next accounting period.
For Northeast Art, current liabilities total $70,000.
Long-Term Liabilities. Long-term liabilities are debts that need not be repaid for at least one year.
Northeast lists only one long-term liability—a $40,000 mortgage payable for store equipment.
As you can see in Figure 15-6, Northeast’s current and long-term liabilities
total $110,000.
Owners’ or Stockholders’ Equity. For a sole proprietorship or partnership, the owners’ equity is the difference between assets and liabilities. For a corporation, the owners’ equity (usually referred to as stockholders’ equity) is the total value of stock plus retained earnings that have accumulated to date. Retained earnings are the portion of a business’s profits not distributed to stockholders.
The original investment by the owners of Northeast Art Supply was $150,000.
In addition, $80,000 of Northeast’s earnings has been reinvested in the business since it was founded.
Thus, owners’ equity totals $230,000.
As the two grand totals in Figure 15-6 show, Northeast’s assets and the sum of its
liabilities and owners’ equity are equal—at $340,000.
THE INCOME STATEMENT. An income statement is a summary of a firm’s revenues and expenses during a specified accounting period. The income statement is sometimes called the earnings statement or the statement of income and expenses.
Figure 15-7 shows a personal income statement for Marty Campbell. Although the difference between income and expenses is referred to as profit or loss for a business, it is normally referred to as a cash surplus or cash deficit for an individual. It is also possible to use information from a personal income statement to construct a personal budget, a specific plan for spending your income.
Figure 15-8 shows the income statement for Northeast Art Supply. For a business, revenues less cost of goods sold less operating expenses equals net income.
Revenues. Revenues are the dollar amounts earned by a firm from selling goods, providing services, or performing business activities.
Gross sales are the total dollar amount of all goods and services sold during the
accounting period.
Deductions made from this amount are:
Sales returns—merchandise returned to the firm by customers
Sales allowances—price reductions offered to customers who accept slightly damaged or soiled merchandise
Sales discounts—price reductions offered to customers who pay their bills promptly
The remainder is the firm’s net sales, the actual dollar amount received by the firm for the goods and services it has sold after adjustment for returns, allowances, and discounts.
For Northeast Art, net sales are $451,000.
Cost of Goods Sold. The standard method of determining the cost of goods sold by a
retailing or wholesaling firm during an accounting period is summarized as follows:
Cost of goods sold = Beginning inventory + Net purchases - Ending inventory
According to Figure 15-8, Northeast Art Supply began its accounting period with a merchandise inventory of $40,000.
It purchased merchandise valued at $346,000 but after deducting purchase discounts, it paid only $335,000 for this merchandise.
Thus, during the year, it had total goods available for sale valued at $40,000 + $335,000, for a total of $375,000.
Twelve months later, Northeast had sold all but $41,000 worth of the available goods. The cost of goods sold was therefore $375,000 less ending inventory of $41,000, or $334,000.
A firm’s gross profit is its net sales less the cost of goods sold.
For Northeast Art, gross profit was $117,000.
Operating Expenses. A firm’s operating expenses are all business costs other than the cost of goods sold. They are generally divided into two categories: selling expenses or general expenses.
Selling expenses are costs related to the firm’s marketing activities. For Northeast, selling expenses total $37,000.
General expenses are costs incurred in managing a business. For Northeast, general expenses total $42,500.
Net Income. When revenues exceed expenses, the difference is called net income. When expenses exceed revenues, the difference is called net loss.
In Figure 15-8, Northeast’s net income from operations is computed as gross profit on sales ($117,000) less total operating expenses ($79,500).
For Northeast Art, net income from operations totals $37,500.
Interest expense of $2,000 is deducted from net income to obtain a net income before taxes of $35,500. The interest expense is deducted in this section of the income statement because it is not an operating expense. Rather, it is an expense that
results from financing the business.
Northeast’s federal income taxes are $5,325. Although these taxes may or may not be payable immediately, they are an expense that must be deducted from income.
This leaves Northeast with a net income after taxes of $30,175.
This amount may be used to pay a dividend to stockholders, retained or reinvested by the firm, used to reduce the firm’s debts, or all three.
THE STATEMENT OF CASH FLOWS. The statement of cash flows illustrates how the operating, investing, and financing activities of a company affect cash during an accounting period. The statement of cash flows focuses on how much cash is on hand to pay the firm’s bills.
A statement of cash flows for Northeast Art Supply is illustrated in Figure 15-9. The cash flows statement is organized around three different activities: operating, investing, and
financing.
- Cash flows from operating activities—The first section addresses the firm’s primary revenue source: providing goods and services. Typical adjustments include adding the amount of depreciation to a firm’s net income. Other adjustments for increase or decrease in amounts for accounts receivable, inventory, accounts payable, and income taxes payable are also required to reflect a true picture of cash flows from operating activities.
- Cash flows from investing activities—The second section is concerned with cash flow from investments. This includes the purchase and sale of land, equipment, and other long-term assets and investments.
- Cash flows from financing activities—The third section deals with cash flow from all financing activities. It reports changes in debt obligation and owners’ equity accounts.
The totals of all three activities are added to the beginning cash balance to determine the ending cash balance. Together, the statement of cash flows, balance sheet, and income statement illustrate the results of past business decisions and reflect the firm’s ability to pay debts and dividends and finance new growth.
EVALUATING FINANCIAL STATEMENTS. To evaluate a firm’s financial health, often the first step is to compare a firm’s financial data with other firms in similar industries and with its own financial results over recent accounting periods.
Comparing Financial Data. Many firms compare their financial results with those of competing firms and with industry averages.
Comparisons are possible as long as accountants follow GAAPs.
Comparisons among firms give executives, managers, and employees a general idea of a firm’s relative effectiveness and its standing within the industry.
Competitors’ financial statements can be obtained from their annual report—if they are public corporations.
Industry averages are published by reporting services such as D&B (formerly Dun & Bradstreet), BizMiner, and Hoover’s, Inc., as well as by some industry trade associations.
Today, most corporations include in their annual reports comparisons of the
important elements of their financial statements for recent years.
Figure 15-10 shows such comparisons for Microsoft Corporation.
Financial Ratios. A financial ratio is a number that shows the relationship between two elements of a firm’s financial statements. Like the individual elements in financial statements, these ratios can be compared with those of competitors, with industry averages, and with the firm’s past ratios from previous accounting periods.
Measuring a Firm’s Ability to Earn Profits. A firm’s net income after taxes
indicates whether the firm is profitable. It does not, however, indicate how effectively the firm’s resources are being used. For this purpose, a return on sales ratio can be computed.
Return on sales (or profit margin) is a financial ratio calculated by dividing net income after taxes by net sales.
It indicates how effectively the firm is transforming sales into profits. A higher return on sales is better than a low one.
Today, the average return on sales for all business firms is between 4 and 5 percent.
A low return on sales can be increased by reducing expenses and increasing sales.
Measuring a Firm’s Ability to Pay Its Debts. A current ratio can be used to evaluate a firm’s ability to pay its current liabilities. It is computed by dividing
current assets by current liabilities.
The average current ratio for all industries is 2.0, but it varies greatly from
industry to industry.
A high current ratio indicates that a firm can pay its current liabilities.
A low current ratio can be improved by repaying current liabilities, by reducing dividend payments to stockholders to increase the firm’s cash balance, or by obtaining additional cash from investors.
Measuring How Well a Firm Manages Its Inventory. A firm’s inventory turn-over is the number of times the firm sells its merchandise inventory in one year.
It is approximated by dividing the cost of goods sold in one year by the average value of the inventory.
The average value of the inventory can be found by adding the beginning
inventory value and the ending inventory values and dividing the sum by two.
The average inventory turnover for all firms is about nine times a year, but turnover rates vary widely from industry to industry.
The quickest way to improve inventory turnover is to order merchandise in smaller quantities at more frequent intervals.