Chapter 1Q : Suppose XYZ Company must pick between two projects that each require an initial $10,000 outlay for facilities. The cash flows yielded by each investment for the first 5-years (years 1-5 consecutively) are:Project A: +800, +600, 0, +400, +900Project B: -1,000, +2,000, -2,000, +5,000, +6,000Discuss the following:1. Contrast the projects in terms of their risk/return relationship2. Contrast the projects in terms of their potential for problems in the area of viability (liquidity/solvency).”Review Chapter 1 Word file the end-of-chapter Key Terms, Questions and Solutions.Chapter 3Discuss the following.1. Suppose Joe Francis owns a Chevrolet Dealership called “Joe’s Chevrolet.” Joe charges all his personal gasoline purchases on the dealership and these amounts are reported among the dealership’s operating expenses. How does this violate the economic entity concept?2. Suppose Joe’s Chevrolet reports assets in the following way:Assets Owned:Building ………………………………………. 10,000 square feet total space, constructed in 1998.Inventory…………………………………….. 100 vehicles total, 75 new units, 25 used.How does this violate the monetary unit concept?3. Suppose Joe’s Chevrolet’s financial report reflects Assets of $500,000 and Liabilities of $400,000. There are 10,000 shares of common stock and therefore an accounting book value of $10 per share.Given the limitation of accounting to reliably measure intangible assets, would you expect the $10 per share to be a good estimate of the fair market value per share? you can Accounting Concepts. Two concepts underlying financial reporting are introduced: the economic entity concept, and the monetary unit concept. In addition, two types of assets are tangible and intangible assets. on the Word file
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Chapter 3
Accounting Concepts
BASICS
Accounting centers on the business entity. An entity is simply the unit for which we wish to
account. Entities frequently exist within a larger entity. An entity can be a department, or a project,
or a firm. For example, Joe’s Chili Dog Stand is a firm that is an entity. However, if it is not a
corporation and Joe owns it solely, the Internal Revenue Service considers it to be part of the larger
entity, Joe. That larger entity includes Joe’s salary, other investments, and various other sources
of income in addition to the chili dog stand.
From an accounting point of view there are two crucial aspects of the entity concept. First, once
we have defined the entity we are interested in, we shouldn’t commingle the resources and
obligations of that entity with those of other entities. If we are interested in Joe’s Chili Dog Stand
as an accounting entity, we mustn’t confuse the cash that belongs to Joe’s Chili Dog Stand with
the other cash that Joe has.
Second, we should view all financial events from the entity’s point of view. For example,
consider that the Chili Dog Stand buys chili dog rolls “on account.” A transaction on account gives
rise to an obligation or account payable on the part of the buyer and an account receivable on the
part of the seller. In order for both the buyer and seller to keep their financial records, or “books,”
straight, each must record the event from their own viewpoint. They must determine whether they
have a payable or a receivable.
We assume throughout this book that the firm you work for is the entity. Once we establish the
entity we want to account for, we can begin to keep track of its financial events as they happen.
There is a restriction, however, on the way in which we keep track of these events. We must use a
monetary denominator for recording all financial events that affect the firm. Even if no cash is
involved, we describe an event in terms of amounts of currency. In the United States, accounting
revolves around dollars; elsewhere the local currency is used.
This restriction is an important one for purposes of communication. The financial accountant
not only wants to keep track of what has happened to the firm but also wants to be able to
communicate the firm’s history to others after it has happened. Conveying information about the
financial position of the firm and the results of its operations would be cumbersome at best without
this monetary restriction. Imagine trying to list and describe each building, machine, parcel of land,
desk, chair, and so on owned by the firm. The financial statement would be hundreds if not
thousands of pages long.
Yet, don’t be too comfortable with the monetary restriction either, because currencies are not
stable vis-a-vis one another, nor are they internally consistent over time. During periods of
inflation or deflation, the assignment of a dollar value creates its own problems. For example, the
values of inventory, buildings, and equipment constantly change as a result of inflation or
deflation. This problem will be discussed in Chapter 21.
ASSETS
The general group of resources owned by the firm represents the firm’s assets. An asset is anything
with economic value that can somehow help the firm provide its goods and services to its
customers, either directly or indirectly. The machine that makes the firm’s product is clearly an
asset. The desk in the chief executive’s office is also an asset, however indirect it may be in
generating sales.
Assets may be either tangible or intangible. Tangible assets have physical form and substance
and are generally shown on the financial statements. Intangible assets don’t have any physical
form. They consist of such items as a good credit standing, skilled employees, and patents,
copyrights, or trademarks developed by the firm. It is difficult to precisely measure the value of
intangible assets. As a result, accountants usually do not allow these assets to be recorded on the
financial statements.
An exception to this rule occurs if the intangible asset has a clearly measurable value. For
example, if we purchase that intangible from someone outside of the firm, then the price we pay
puts a reasonable minimum value on the asset. It may be worth more, but it can’t be worth less or
we, as rational individuals, wouldn’t have paid as much as we did. Therefore the accountant is
willing to allow the intangible to be shown on the financial statement for the amount we paid for
it.
If you see a financial statement that includes an asset called goodwill, it is an indication that a
merger has occurred at some time in the past. The firm paid more for the company it acquired than
could be justified based on the market value of the specific tangible assets of the acquired firm.
The only reason a firm would pay more than the tangible assets themselves are worth is because
the firm being acquired has valuable intangible assets. Otherwise the firm would have simply gone
out and duplicated all of the specific tangible assets instead of buying the firm.
After the merger, the amount paid in excess of the market value of the specific tangible assets
is called goodwill. It includes the good credit standing the firm has with suppliers, the reputation
for quality and reliability with its customers, the skilled set of employees already working for the
firm, and any other intangible benefits gained by buying an ongoing firm rather than by buying
the physical assets and attempting to enter the industry from scratch.
The implication of goodwill is that a firm may be worth substantially more than it is allowed to
indicate on its own financial statements. Only if the firm is sold will the value of all of its
intangibles be shown on a financial statement. Thus we should exercise care in evaluating how
good financial statements are as an indication of the true value of the firm.
LIABILITIES
Liabilities, from the word liable, represent the obligations that a firm has to outside creditors.
Although there generally is no one-on-one matching of specific assets with specific liabilities, the
assets taken as a whole represent a pool of resources available to pay the firm’s liabilities. The
most common liabilities are money owed to suppliers, employees, financial institutions,
bondholders, and the government (taxes).
OWNERS’ EQUITY
Equity represents the value of the firm to its owners. For a firm owned by an individual proprietor
we refer to this value as owner’s equity. For a partnership we speak of this value as partners’
equity. For a corporation we talk of this value as shareholders’ or stockholders’ equity. A not-forprofit organization refers to this as net assets. Governments call it the fund balance. This book
commonly uses the term stockholders’ equity whenever the equity of the owners is meant.
The stockholders’ equity of a firm is often referred to as the “net worth” of the firm or its “total
book value.” Book value per share is simply the total book value divided by the number of shares
of stock outstanding.
The equity of the owners of the firm is quite similar to the equity commonly referred to with
respect to home ownership. If you were to buy a house for $400,000 by putting down $80,000 of
your own money and borrowing $320,000 from a bank, you would say that your equity in the
$400,000 house was $80,000.
If the house were a factory building owned by a firm, the $400,000 purchase price could be
viewed as the value of the factory building asset, the $320,000 loan as the firm’s liability to an
outside creditor, and the $80,000 difference as the stockholders’ equity, or the portion of the value
of the building belonging to the owners.
THE ACCOUNTING EQUATION
The relationship among the assets, liabilities, and stockholders’ equity is shown in the following
equation and provides a framework for all of financial accounting.
ASSETS = LIABILITIES + OWNERS’ EQUITY
The left side of this equation represents the firm’s resources. The right side of the equation gives
the sources of the resources. Another way to think about this equation is that the right side represent
the claims on the resources. The liabilities represent the legal claims of the firm’s creditors. The
owners’ equity is the owners’ claim on any resources not needed to meet the firm’s liabilities.
The right side of the equation is frequently referred to as the equity side of the equation because
the liabilities and owners’ equity both represent legal claims on the firm’s assets. Therefore, both
can be thought of in an equity sense. Frequently the entire equation is referred to as the firm’s
assets and equities.
By definition, this equation is true for any entity. Once the firm’s assets and liabilities have been
defined, the value of ownership or stockholders’ equity is merely a residual value. The owners
own all of the value of the assets not needed to pay off obligations to creditors. Therefore, the
equation need not ever be imbalanced because there is effectively one term in the
equation, owners’ equity, that changes automatically to keep the equation in balance. We refer
back to this basic equation of accounting throughout this book.
KEY TERMS
Entity—the unit for which we wish to account. This unit can be a person, department, project,
division, or firm. Avoid commingling the resources of different entities.
Monetary denominator—All resources are assigned values in a currency such as dollars in order
to simplify communication of information regarding the firm’s resources and obligations.
Assets—the resources owned by the firm.
a. Tangible assets—assets having physical substance or form.
b. Intangible assets—assets having no physical substance or form; result in substantial valuation
difficulties.
Liabilities—obligations of the firm to outside creditors.
Owners’ equity—the value of the firm to its owners, as determined by the accounting system. This is
the residual amount left over when liabilities are subtracted from assets.
Fundamental equation of accounting—Assets = Liabilities + Owners’ Equity
QUESTIONS FOR REVIEW
1.
What is an accounting entity?
2.
Define the following:
a.
Asset
b.
Liability
c.
Owners’ Equity
3.
What is the equation that provides a framework for financial accounting?
1
Textbook Solutions
Chapter one
Chapter 1
An Introduction to Financial Management
WHAT IS FINANCIAL MANAGEMENT?
Financial management is the part of management that focuses on the organization’s finances.
Within financial management there are two primary disciplines: accounting and
finance. See Figure 1-1. Accounting is a system for providing financial information. It is
generally broken down into two principal elements: financial accounting and managerial
accounting. Finance is the area of financial management that supervises the acquisition and
disposition of the firm’s resources, especially cash.
The financial accounting aspect of accounting is a formalized system designed to record the
financial history of the firm. The financial accountant is simply a historian who uses dollar signs.
An integral part of the financial accountant’s job is to report the firm’s history to interested
individuals, usually through the firm’s annual and quarterly financial reports.
The managerial accountant looks forward whereas the financial accountant looks backward.
Instead of reporting on what has happened, the managerial accountant provides financial
information that may be used to improve decisions about an organization’s future. In many small
firms the same individual is responsible for providing both financial and managerial accounting
information.
FIGURE 1-1
Financial Management
Finance is responsible for an organization’s money. It focuses on borrowing funds and
investing the cash resources of the firm. However, the finance function also involves providing
financial analyses to improve decisions that will impact the wealth of the organization and its
owners. The managerial accountant provides the information for use in the analyses performed
by the finance officer.
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Chapter 1
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Finance & Accounting for Nonfinancial Managers
THE GOALS OF FINANCIAL MANAGEMENT
At first thought, one might simply say that the goal of financial management is to aid in the
maximization of wealth, or more simply, maximization of the firm’s profits. Profits are, after all,
literally, the bottom line for for-profit organizations. That’s true, but as all managers know, the
corporate environment has many other goals—maximization of sales, maximization of market
share, maximization of the growth rate of sales, and maximization of the market price of the
firm’s stock, for example. For not-for-profit organizations maximization of profits may not be a
goal, although at least some profit is usually necessary to ensure the not-for-profit’s financial
well-being.
On a more personal level, managers are concerned with maximization of salary and perks.
Such maximization is often tied in with the maximization of return on investments (ROI), return
on equity (ROE) or return on assets (ROA). (See Chapter 24 for a discussion of these terms.) The
list of goals within the organization is relatively endless, and our intention is to narrow the range
rather than broaden it.
From the perspective of financial management there are two over-riding goals: profitability
and viability. See Figure 1-2. The firm wants to be profitable, and it wants to continue in
business. It is possible to be profitable and yet fail to continue in business. Both goals require
some clarification and additional discussion.
FIGURE 1-2
Organizational Goals
Profitability
In maximizing profits there is always a trade-off with risk. See Figure 1-3. The greater the risk
we must incur, the greater the anticipated profit or return on our money we demand. Certainly,
given two equally risky projects, we would generally choose to undertake the one with a greater
anticipated return. More often than not, however, our situation revolves around whether the
higher return on a specific investment is great enough to justify the extra risk involved.
Consider keeping funds in a passbook account insured by the Federal Deposit Insurance
Corporation (FDIC). The return on a bank savings account is low, but so is the risk.
Alternatively, you could put your money in a nonbank money market fund where the return
might be higher. However, the FDIC would not insure the investment. The risk is clearly greater.
Or you could put your money into the stock market. In general, do we expect our stocks to do
better or worse than a money market fund? Well, the risks inherent in the stock market are
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Chapter 1
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Textbook Solutions
significantly higher than in a money market fund. If the expected return weren’t higher, would
anyone invest in the stock market?
FIGURE 1-3
Profitability Trade-Off
That doesn’t mean that everyone will choose to accept the same level of risk. Some people
keep all their money in FDIC insured bank accounts, and others choose the most speculative of
stocks. Some firms will be more willing to accept a high risk in order to achieve a high potential
profit than other firms. The key here is that in numerous business decisions the firm is faced with
a trade-off—risk vs. return. Throughout this book, when decisions are considered, the question
that will arise is, “Are the extra expected profits worth taking the risk?” It is, I hope, a question
that you will be somewhat more comfortable answering before you’ve reached the end of this
book.
Viability
Viability refers to the ability to continue to provide goods and services, and to not go out of
business. Firms have no desire to go bankrupt, so it is no surprise that one of the crucial goals of
financial management is ensuring financial viability. This goal is often measured in terms
of liquidity and solvency. See Figure 1-4.
FIGURE 1-4
Viability
Liquidity is simply a measure of the amount of resources a firm has that
are cash or are convertible to cash in the near term, to meet the obligations
the firm has that are coming due in the near term. Accountants use the
phrases “near-term,” “short-term,” and “current” interchangeably.
Generally, the near-term means one year or less. Thus a firm is liquid if it
has enough near-term resources to meet its near-term obligations as they
become due for payment.
Solvency is simply the same concept from a long-term
perspective. Long-term simply means more than one year. Does the firm
have enough cash generation potential over the next three, five, and ten
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Chapter 1
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Finance & Accounting for Nonfinancial Managers
years to meet the major cash needs that will occur over those periods? A
firm must plan for adequate solvency well in advance because the
potentially large amounts of cash involved may take a long period of
planning to generate. The roots of liquidity crises that put firms out of
business often are buried in inadequate long-term solvency planning in
earlier years.
So a good strategy is maximization of your firm’s liquidity and solvency,
right? No, wrong. Managers have a complex problem with respect to
liquidity. Every dollar kept in a liquid form (such as cash, Treasury bills
(T-bills), or money market funds) is a dollar that could have been invested
by the firm in some longer-term, higher yielding project or investment.
There is a trade-off in the area of viability and profitability. The more
profitable the manager attempts to make the firm by keeping it fully
invested, the lower the liquidity and the greater the possibility of a liquidity
crisis and even bankruptcy. The more liquid the firm is kept, the lower the
profits. Essentially this is just a special case of the trade-off between risk
and return discussed earlier.
We mentioned that profitability and viability are not synonymous. A firm
can be profitable every year of its existence, yet go bankrupt anyway. How
can this happen? Frequently it is the result of rapid growth and poor
financial planning. Consider a firm whose sales are so good that inventory
is constantly being substantially expanded. Such expansion requires cash
payments to suppliers well in advance of ultimate cash collection from
customers.
Consider the hypothetical firm, Expanding Growth Company, that starts
the year with $40,000 in cash, $80,000 of receivables, and 10,000 units of
inventory. Receivables are amounts that Expanding Growth’s customers
owe it for goods and services that they bought, but have not paid for yet.
Its inventory units are sold for $10 each and they have a cost of $8,
yielding a profit of $2 on each unit sold. During January it collects all of its
receivables from the beginning of the year (no bad debts!), thus increasing
available cash to $120,000. January sales are 10,000 units, up 2,000 from
the 8,000 units sold last December.
Due to increased sales, Expanding Growth decides to expand inventory
to 12,000 units. Of the $120,000 available, it spends $96,000 on
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Chapter 1
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Textbook Solutions
replacement and expansion of inventory (12,000 units acquired @ $8). No
cash is collected yet for sales made in January. This leaves a January
month-end cash balance of $24,000.
$ 40,000Cash, January 1
+ 80,000Collections during January
$120,000Cash Available
− 96,000Purchase of Inventory (12,000 units @ $8)
$ 24,000Cash Balance, January 31
During February all $100,000 of receivables from January’s sales (10,000 units @ $10) are
collected, increasing the available cash to $124,000. In February the entire 12,000 units on hand
are sold and are replaced in sto …
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