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12

UNDERSTANDING FINANCIAL INFORMATION AND ACCOUNTING

Other Teaching Tools 12.3

Video Notes 12.4

Brief Chapter Outline and Learning Goals 12.5

Lecture Outline and Lecture Notes 12.7

Career and Study Skills Notes 12.14

CAREER DEVELOPMENT: Create a Career Plan 12.14

STUDY SKILLS: Make Good Career Planning Habits a Life Skill 12.16

Lecture Links 12.17

LECTURE LINK 12-1 Managerial Accounting and the Budgeting Process 12.17

LECTURE LINK 12-2 Auditing the Audit Process 12.18

LECTURE LINK 12-3 The Power of the Internal Auditor 12.20

LECTURE LINK 12-4 It’s the Earnings that Count 12.20

LECTURE LINK 12-5 Using the Statement of Cash Flows 12.21

LECTURE LINK 12-6 Knowing the Numbers 12.22

Bonus Internet Exercises 12.24

BONUS INTERNET EXERCISE 12-1 Annual Reports Online 12.24

BONUS INTERNET EXERCISE 12-2 CPA Certification 12.25

Critical Thinking Exercises 12.26

CRITICAL THINKING EXERCISE 12-1 Budgetary Control 12.26

CRITICAL THINKING EXERCISE 12-2 Preparing a Balance Sheet 12.29

CRITICAL THINKING EXERCISE 12-3 The Pizza Stand 12.31

CRITICAL THINKING EXERCISE 12-4 Comparing Industry Ratios 12.35

12.1

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Bonus Cases 12.39

BONUS CASE 12-1 Getting Through the Hard Times at Hard Rock 12.39

BONUS CASE 12-2 Survival of the Financially Fittest 12.41

BONUS CASE 12-3 Chicago Rush: When the Goal Line Meets the 12.43Bottom Line (Video Case)

BONUS CASE 12-4 The Best Laid Plans Often Go Awry 12.45

BONUS CASE 12-5 Managing by the Numbers 12.47

12.2 INTRODUCTION TO BUSINESS: Instructor’s Resource Manual

OTHER TEACHING TOOLS

For a description of each of these valuable teaching tools, please see the Preface in this manual.

Student Learning ToolsStudent Online Learning Center (OLC) www.mhhe.com/diasbusinessStudent Study GuideSpanish Translation Glossary (OLC)Spanish Translation Quizzes (OLC)

Instructor Teaching ToolsAnnotated Instructor’s Resource ManualIRCD (Instructor’s Resource Manual, Test Bank, PowerPoints, EZtest)Asset Map Online Learning Center (OLC) www.mhhe.com/diasbusinessPageOutPowerPoint Presentations (on IRCD and OLC)Test Bank Business Videos on DVD Enhanced Cartridge optionSpanish Translation Glossary (OLC)

CHAPTER 12: Understanding Financial Information and Accounting 12.3

http://www.mhhe.com/diasbusiness

http://www.mhhe.com/diasbusiness

VIDEO NOTES

Twenty videos are available, geared to individual chapter topics. The teaching notes for these videos are also included in the Video Notes section of this Instructor’s Resource Manual, beginning on page V.1.

VIDEO 12: “Chicago Rush: When the Goal Line Meets the Bottom Line”

This video features the Chicago Rush, an arena football team. On the field and off the field, numbers are critical. The video shows how Chicago Rush’s management uses accounting to provide key financial information to stakeholders.

(BONUS CASE 12-3, “Chicago Rush: When the Goal Line Meets the Bottom Line” on page 12.43 of this manual relates to this video.)


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BRIEF CHAPTER OUTLINE AND LEARNING GOALS

CHAPTER 12

Understanding Financial Information and Accounting

I. INTRODUCTION TO ACCOUNTING

II. THE IMPORTANCE OF FINANCIAL INFORMATIONLEARNING OBJECTIVE 1Describe the importance of financial information and accounting.

A. What Is Accounting?

III. AREAS OF ACCOUNTINGLEARNING OBJECTIVE 2Define and explain different areas of accounting.

A. Managerial and Financial AccountingB. AuditingC. Tax AccountingD. Government and Not-for-Profit AccountingE. Accounting ToolsF. Sarbanes-Oxley Act

IV. THE SIX-STEP ACCOUNTING CYCLELEARNING OBJECTIVE 3List the steps in the accounting cycle.

V. FINANCIAL STATEMENTSLEARNING OBJECTIVE 4Explain how the major financial statements dif-fer.

A. The Accounting EquationB. The Balance Sheet

1. Assets2. Liabilities

C. The Income Statement1. Revenue


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2. Cost of Goods Sold (Cost of Goods Manufactured)3. Operating Expenses and Net Profit or Loss

D. The Statement of Cash FlowsE. A Word about Depreciation

VI. ANALYZING FINANCIAL STATEMENTS: RATIO ANALYSISLEARNING OBJECTIVE 5Explain the importance of ratio analysis in re-porting financial information.

A. Liquidity RatiosB. Leverage (Debt) RatiosC. Profitability (Performance) Ratios

1. Earnings per Share2. Return on Sales (Net Profit Margin)3. Return on Equity

D. Activity Ratios

VII. SUMMARY


LECTURE OUTLINE AND LECTURE NOTES

CHAPTER OPENING PROFILER. J. Julia Booksellers (Text pages 384-385)

Roxanne Coady, a former corporate accountant, started a new business—R.J. Julia Booksellers. Coady’s business was successful for its first five years, with growth of 30-75%. However, after that the company began experiencing problems. Coady belatedly put her accounting knowledge to use and dis-covered that her love of books had affected her business decision making. She began studying the firm’s financial statements on a regular basis, refocusing on the bottom line.

LECTURE OUTLINE LECTURE NOTES

I. INTRODUCTION TO ACCOUNTINGA. Businesspeople need to understand the

business’s financial numbers.B. Basic accounting information can help

businesses better understand and control their operations.

C. This chapter presents basic accounting in-formation and explains the basic account-ing statements and what they mean to business.

POWERPOINT 12-1Chapter Title (Refers to text page 384)

POWERPOINT 12-2Learning Objectives(Refers to text page 385)


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II. THE IMPORTANCE OF FINANCIAL INFORMATION

LEARNING OBJECTIVE 1Describe the importance of financial information and accounting. (Text pages 386-387)

A. All individuals need a basic working knowl-edge of accounting.

1. Accounting has a unique language. 2. Many people use accounting informa-

tion, not just managers.B. What Is Accounting? 1. ACCOUNTING is the recording, clas-

sifying, summarizing, and interpreting of financial events and transactions to provide management and other inter-ested parties with the information they need to make good decisions.

a. Financial transactions include:i. buying and selling goods and

services;ii. acquiring insurance;iii. paying employees;iv. using supplies.

b. Transactions are usually classified into groups with common charac-teristics.

c. An accounting system is the method used to record and sum-marize accounting data into re-ports.

2. Purposes of accounting: a. To give managers basic financial

information so they may make bet-ter decisions;

b. To report financial information to

POWERPOINT 12-3The Importance of Finan-cial Information(Refers to text pages 386-387)

TEXT REFERENCE Real World Business Apps(Box in text on page 387) John Miller opened a candle store and has expanded his product line. He soon de-cided that handling his own recordkeeping was more complicated than he antici-pated. He has decided to call in an accountant to help man-age his finances.

BONUS CASE 12-1Getting Through the Hard Times at Hard RockTheme-dining businesses en-countered difficulties in the early 2000s. To survive, Hard Rock Café recruited a new financial manager and changed its financial report-ing and information struc-ture. (See complete case, dis-cussion questions, and sug-gested answers on page 12.39 of this manual.)

BONUS CASE 12-2Survival of the Financially Fittest“Non-profit” may mean no


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III. AREAS OF ACCOUNTINGLEARNING OBJECTIVE 2Define and explain different areas of accounting. (Text pages 388-393)

A. The accounting profession is divided into five areas.

B. Managerial and Financial Accounting 1. Definitions a. MANAGERIAL ACCOUNTING

provides information and analysis to managers within the organiza-tion to assist them in decision making.

b. FINANCIAL ACCOUNTING gen-erates information for use outside the organization.

c. Managerial accounting is con-cerned with: i. measuring and reporting

costs of production, market-ing, and other functions (cost accounting);

ii. preparing budgets (planning);iii. checking whether or not units

are staying within their bud-gets (controlling);

iv. designing strategies to mini-mize taxes (tax accounting).

d. The information prepared by finan-cial accounting is used by:i. company owners, managers,

and employees;ii. creditors and lenders;iii. employee unions, customers,

POWERPOINT 12-4Areas of Accounting(Refers to text pages 388-389)

LECTURE LINK 12-1Managerial Accounting and the Budgeting ProcessIn addition to the balance sheet, income statement, and cash flow statement, man-agers need other forms of fi-nancial information, espe-cially information for bud-geting and cost accounting. (See complete lecture link on page 12.17 of this manual.)

CRITICAL THINKING EXERCISE 12-1Budgetary ControlThis exercise is a continua-tion of LL 12-1 above. It asks the student to analyze a company’s monthly bud-getary report to determine which expenses are over or under budget. (PPT 12-5 be-low can be used with this ex-ercise. Also see complete ex-ercise on page 12.26 of this manual.)

POWERPOINT 12-5Budgetary Control Wein-stein Manufacturing Inc. (Use with CTE 1-1 above. Refers to text pages 388-389)

BONUS INTERNETEXERCISE 12-1Annual Reports OnlineThis Internet exercise asks the student to explore the an-nual report of a specific com-


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IV. THE SIX-STEP ACCOUNTING CYCLELEARNING OBJECTIVE 3List the steps in the accounting cycle. (Text pages 393-394)

A. The accounting cycle is a six-step proce-dure for preparing and analyzing the major financial statements.

B. The six-step accounting cycle includes: 1. Step 1. Analyzing and categorizing

documents; 2. Step 2. Putting the information into

journals;

3. Step 3. Posting that information into ledgers;

4. Step 4. Preparing a TRIAL BALANCE (a summary of all the data in the ac-count ledgers to check whether the fig-ures are correct and balanced);

5. Step 5. Preparing an income state-ment, balance sheet, and statement of cash flows;

6. Step 6. Analyze the financial state-ments and determine the financial health of company.

TEXT FIGURE 12.1 The Steps in the Account-ing Cycle (Box in text on page 394)

POWERPOINT 12-8The Six-Step Accounting Cycle (Refers to text pages 393-394)


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V. FINANCIAL STATEMENTSLEARNING OBJECTIVE 4Explain how the major financial statements dif-fer. (Text pages 394-406)

A. A FINANCIAL STATEMENT is the sum-mary of all transactions that have occurred over a particular period.

1. These indicate a firm’s financial health and stability.

2. The key financial statements are:a. The balance sheet, which reports

the firm’s financial condition on a specific date;

b. The income statement (or profit and loss statement, or “P&L” for short, reports revenues, ex-penses, and profits (or losses) for a specific period of time;

c. The statement of cash flows, which provides a summary of money coming into and going out of the firm.

3. The differences among the financial statements:a. The balance sheet details what

the company owns and owes on a certain day.

b. The income statement shows what a firm sells its products for and what its selling costs are over a specific period.

c. The statement of cash flows shows the difference between cash coming in and cash going out of a business.

B. The Accounting Equation

POWERPOINT 12-9Financial Statements(Refers to text pages 394-396)

TEXT REFERENCE Study Skills: Make Good Study Habits a Life Skill (Box in text on page 395) An additional exercise and discussion is available page 12.16 of this manual.


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VI. ANALYZING FINANCIAL STATEMENTS: RATIO ANALYSIS

LEARNING OBJECTIVE 5Explain the importance of ratio analysis in report-ing financial information. (Text pages 406-413)

A. Accountants use financial information to perform financial calculations, called ratios.

1. Financial ratios help in analyzing the actual performance of the company compared to its financial objectives.

2. RATIO ANALYSIS is the assessment of a firm’s financial condition and per-formance through calculations and in-terpretations of financial ratios devel-oped from the firm’s financial state-ments.

3. They also give insight into the firm’s performance compared to other firms in the industry.

4. There are four types of ratios busi-nesses use to measure financial per-formance.

a. liquidity (speed of changing assets into cash);

b. debt (leverage); c. profitability; d. business activity.B. Liquidity Ratios

1. Liquidity ratios measure the com-pany’s ability to turn assets into cash to pay its short-term debts.

2. These short-term debts are expected to be repaid within one year.

3. The current ratio is the ratio of a firm’s current assets to its current liabilities.

POWERPOINT 12-13Analyzing Financial State-ments: Ratio Analysis(Refers to text pages 406-408)



VII. SUMMARY


CAREER AND STUDY SKILLS NOTES

CAREER DEVELOPMENT BOX:

Create a Career Plan (Text page 412)

Instructor’s Notes for Text Box Twelve:(Objectives to consider and implement to increase stu-dents’ knowledge, usage, and understanding of the concepts).

At some point, all successful students will think through the career process and learn to establish some sort of plan. Without much help, this plan might have very low expectations, and not be very help-ful to the student’s career. To help in this process, showing students how to do career planning and help-ing them write career goals is an important function!

STUDENT EXERCISE:

Review the following outline regarding career planning. Have students spend time developing their answers and discuss their career plans in class. Make note of the various answers and thoughts that each students formulates about their own career ideas.

Career Planning & Forecasting Short-Medium-Long Range Goals

One of the most important elements to writing your career plan is the ability to have a sense of the goals you have set for yourself and for your career. How you arrive at these goals is discussed throughout this text. How you move successfully toward these goals are the methods of short-term, medium range, and long-term goals.

The question that is most asked is how do I begin to set career and personal goals? From this question the real work begins. If you are not familiar with this process, start with basic goals. Questions like the following must first be asked:

(1) What type of job would you like to have in the next year, five years, and ten years? (job de-scription, pay, title, etc.)

(2) What industry would this job/career be in?

(3) What is the state of affairs of this industry (new, high growth, slow growth but stable, stag-nant, losing sales, and companies that compete)?

(4) What are the types of job(s) available which use your skills as they are today?

(5) What new or better skills would you need to enhance your chance of getting the type of job you would like?

(6) Name five companies you would like to work for in the industry you are interested in.

(7) Name two other jobs/industries that would be your second and third choices if you do not get work in the job/industry of your preference.

(8) Find someone working in the position you would like to have over the next year and find out what they do (job duties) and how their position functions in the company. Find a person


doing the job/work you would like to be doing in the next five years and ten years and in-terview them with the same set of questions.

(9) Note your success in jobs you currently hold or have held in the past.

(10) How can you use these success/skills in your current or future job?

(11) What areas could you improve upon to accentuate your career?

(12) What personal goals do you have for the next year, five years, and ten years?

(13) How do these personal goals accentuate your job/career?

(14) How do these personal goals change the job opportunities you might consider?

(15) How do you feel about your career to date?

(16) If you change what you are currently doing, what would that be? Explain.

(17) What help/assistance would benefit you in your career?

(18) How willing are you to change current skills/attitudes to better your career?

(19) What feedback have you gotten so far from immediate bosses on your job performances?

(20) What are the positives? What are the negatives? Where can you improve?

Long-term goals are met with high success when a person can (1) identify what they are in some detail, (2) use a format to express long-term, mid-term and short-term goal setting, (3) understand that mid-term goals are a measure of how successful you have been in pursuit of your long-term goals; and short-term goals are the yearly objectives to reaching mid-term and long-term goals. Based on this, use the following to express your long-term, mid-term and short-term goals:


STUDY SKILLS BOX:Make Good Career Planning Habits a Life Skill (Text page 395)

Instructor’s Notes for Text Box Twelve:(Objectives to consider and implement to increase stu-dents’ knowledge, usage, and understanding of the concepts).

A successful interview, well written résumé, and good etiquette habits are a real positive for any and all students. To refresh your career assessment and implementation, here is a reminder of the basics of what you will need to do to stay on course regarding establishing good career skills. Use the BORD method. Balance, Organization, Routine and Discipline (BORD) will maintain the process no matter how your job, school, personal life or professional life might be going (sometimes some areas are going well, sometimes not). You will know that the process is the same, and you can expect an outcome that meets your needs at the time.

When you BALANCE all your responsibilities in a series of priorities, you have a healthy ap-proach to accomplishing your goals and objectives while achieving a high level of success. However, be-ing able to correctly balance all your responsibilities requires that you become extremely ORGANIZED to assure that you stay on course. When you do this on a regular basis, this becomes a ROUTINE.

STUDENT EXERCISES:

Help students with the basic prioritizing skills. Have them discuss their own prioritizing practices and discuss both the good habits and what needs improvement.


LECTURE LINKS

LECTURE LINK 12-1

Managerial Accounting and the Budgeting Process

In addition to the balance sheet, income statement, and cash flow statement, managers need other forms of financial information—especially for the budgeting process. They also need this information to help make decisions such as when to replace a machine, whether to hire extra people, how much wages can be raised, and if advertising should be increased or decreased. Detailed reports are needed on such things as departmental costs, special projects, cash flow, financial analyses, taxes, and labor costs. These reports, which are a part of managerial accounting, do not have to be standardized but can be tailored to the firm’s individual needs.

BUDGETING AND BUDGETARY CONTROL

Two of the primary functions of management are planning and control. When these two functions are combined with the accounting techniques we have studied, they provide one of management’s most useful tools: the budgeting process. This process, in turn, involves both budgeting and budgetary control.

Budgeting is simply stating in dollars-and-cents terms what the firm wants to accomplish in a given period of time. Most individuals have some informal plan at the beginning of the month as to how they are going to spend their money. They know, in general, what their expected income is and what ex-penses they must use that money for.

Businesses must use more formal plans, but they follow the same procedure an individual does—determine how much revenue will come into the firm, divide that revenue among the expenses, and deter-mine the expected profit or loss from operations. In essence, the firm is preparing a “planned” income statement when it sets up a budget.

The starting point in budgeting is estimating expected revenue, which is the total amount of goods or services that company expects to sell. For management to get an accurate figure, the firm’s sales department must give a realistic estimate of probable sales. This figure will be a blend of past sales fig-ures, expected business conditions, and company objectives. For example, if 1,200,000 units are to be sold, and the expected price per unit is $7.00, the total revenue should be $8,400,000.

Next, expected expenses are calculated by the departments in the firm that will be involved. The production department should submit a plan showing how much it will cost to produce those items, in-cluding such costs as raw materials, wages, electricity, and maintenance. The marketing department should develop a plan for sales activities such as advertising, personal selling, and sales promotion. Then administrative, depreciation, and other costs must be computed.

After all the firm’s departments have submitted their estimates, management can calculate the projected net income by subtracting total expected expenses from expected revenues.

At this point, management adds its plans and projections to the raw figures and begins “fine-tun-ing” the budget. The departmental budgets may be sent back for further work and the first few steps re-peated until a comprehensive budget acceptable to all is created. Each department then develops a depart-mental budget based on the figures in the comprehensive budget.

The budgeting process does not end here. The only thing you have at this point is a plan, stated in monetary terms, of what you expect to do during the next year. Unless budgetary control is added, the


budget becomes useless. Budgetary control involves comparing actual performance against planned per-formance and taking corrective action if differences are found.

For instance, the production department budget may call for spending $490,000 each month to produce one month’s output of 100,000 units. If, at the end of the month, the chief accountant finds that $505,000 has been spent, he or she knows that actual expenses are exceeding planned expenses by $15,000 and can notify the production manager to take corrective action. (CRITICAL THINKING EXER-CISE 12-1, “Budgetary Control,” gives the student the ability to practice budgetary control.)

With this information, the manager can investigate the problem. Are raw materials being wasted? Was there an increase in the cost of these materials? On the basis of the results of this investigation, a change may be made in production methods or a new supplier may be found. If it is found that the origi-nal budget was not realistic, the budget itself may be changed to show realistic goals. In this way, man-agement makes adjustments in order to meet the goals it has set. Budgets and budgetary control are excel-lent planning and control tools.

DETERMINING COSTS AND SETTING PRICES

The income statement shows an item called “cost of sales” or “cost of goods sold,” which in-cludes various costs—material, labor, and overhead. Analyses that are more detailed can be made to re-late these costs to each product, and costs can be compared with the income from the sales of that prod-uct. This shows what the present cost/profit situation is at a given level of sales. Another study is usually made to find out what the situation would be if sales increased or decreased.

Each company has its own approach to cost accounting. Some emphasize quality, others price. Cost analysis provides a basis for determining which approach to follow. All involve a trade-off of value against cost.

DECIDING ON CAPITAL INVESTMENTS

Managers must make daily and long-term capital investment decisions. Daily decisions may be made on whether to use machine A or machine B for a given operation. Should a salesperson visit cus-tomer X on this trip or the next? Should Jones’s order be produced today to assure on-time delivery, or can it wait?

Capital investment decisions are concerned with changes in fixed assets that affect longer periods of time. Should a manual operation be replaced with a machine? Should a piece of equipment be replaced, rebuilt, or discarded? Many of these decisions involve large sums of money and have long-term effects on the company. Special consideration must therefore be given to such decisions, including such factors as interest charges and the unavailability of money for other purposes, called opportunity cost.

These and other capital investment studies consume much time and involve many people. They also involve the use of detailed accounting records to obtain costs for their analysis.

LECTURE LINK 12-2

Auditing the Audit Process

The independent audit once occupied a lofty spot in corporate reporting. It was perceived as the ultimate business reality check that ensured a company’s financial statements were accurate and prepared according to Generally Accepted Accounting Principles (GAAP). Unfortunately, accounting scandals at companies such as Enron, WorldCom, Tyco, and Global Crossing questioned the legitimacy and accuracy of the once respected process. The fallout, however, had much more severe repercussions in the industry. The scandals led to the demise of one of the largest and most respected accounting firms in the United


States, Arthur Andersen. The company was convicted of obstruction of justice for its actions in the Enron case. The accounting misdeeds also inspired the U.S. Congress and the U.S. Securities and Exchange Commission (SEC) to impose vast new reporting and auditing requirements on businesses.

The Sarbanes-Oxley Act of 2002 attempts to regulate financial markets and prevent financial fias-cos such as Enron and WorldCom from cheating unsuspecting investors. The legislation enacted several key reforms:

(1) The law prevents public company auditors from serving as business consultants to firms they audit. However, auditors can provide a tax preparation role at such companies.

(2) The Public Company Accounting Oversight Board was created to oversee public company accounting.

(3) Roles and duties for audit committees of public companies were to be expanded.

(4) Executives of publicly-held companies are required to sign off on their firm’s financial statements and vouch for the effectiveness of financial controls.

The roles and duties for audit committees within companies were crafted by the Securities and Exchange Commission. The new rules require accounting firms to follow specific do’s and don’ts in what kinds of non-audit services they can provide firms that they audit. For example:

(1) Audit firms must disclose how much money they were paid from audit and non-audit ser-vices provided to a client.

(2) The top two accounting partners working for a particular client must rotate off the account after a five-year period and wait at least five years before returning to that audit assign-ment.

(3) Outside auditors may not join the client firm and oversee the auditing firm’s work until af-ter a one-year “cooling off” period.

(4) Auditors are also barred from offering other services such as the design and installation of financial information systems, appraisal services, actuarial services, investment banking services, legal advice, and management and human resource functions.

A result of the new rules set forth by Congress and the SEC is that the role of internal auditors within a company had to be beefed up. In fact, most would argue that when it comes right down to it, the financial and operations policing of company operations should be an “inside job,” done by an internal auditor. Internal auditors need to keep an eye on a company’s “controls” not just its financial operations. In the case of the WorldCom disclosures, it was Cynthia Cooper, an internal auditor at the company, who blew the whistle on the firm for inflating its profits to the tune of $3.8 billion.

The Sarbanes-Oxley Act and administrative regulations from the SEC (discussed above) has led to a surge in demand for people trained in the internal-audit field. William Bishop III, president of the In-stitute of Internal Auditors (IIA), said job postings on the organization’s website have more than doubled in the year since the law was passed. Bishop also notes that a company with $3 billion to $4 billion in rev-enues typically now employs about 16 internal auditors.

If you are interested in pursuing a career in the internal-audit field, it’s important to keep a few points in mind. The main goal of the internal audit is to make sure the systems already in place within the company are working correctly. The internal auditor also must know the company inside-and-out but still have enough independence to give honest feedback and advice when it’s needed. Finally, guts also help. Anyone considering a career in internal auditing should have the guts to speak out and most importantly the ability to “tell the truth.”i


LECTURE LINK 12-3

The Power of the Internal Auditor

The largest bankruptcy in U.S. history was the 2002 collapse of telecom giant WorldCom. The company’s downfall was caused by a fraudulent $11 billion accounting scheme. The unlikely heroine at the center of this story is an internal auditor who wouldn’t stop asking questions.

Cynthia Cooper admits that she was “literally scared to death” during the process of uncovering WorldCom’s fraudulent activities. In the course of a routine internal audit into the obscure area of line cost expenses, Cooper uncovered something that didn’t look right. Other executives told her she was wasting her time and the department’s resources by pursuing the audit. But she never allowed herself to be intimidated. It was the urging to move onto something else that encouraged her to keep looking. Her department eventually discovered $3.8 billion in fraudulent accounting involving line fees—fees World-Com paid to other telephone companies for the right to use their lines.

Cooper said there was a spider web of entries used to disguise the fraud, and after her auditing staff traced them backward and forward, they still couldn’t understand what was happening. When she confronted former controller David Myers about the entries, he was honest and said there was no support to back up the accounting.

According to Cooper, the internal audit department never considered backing down once they be-gan the investigation. “We were at a crossroads,” Cooper said of the internal auditing team. “The decision to come forward was easy, but doing the right thing doesn’t come without a cost.” The role of whistle-blower isn’t one she relishes.

The WorldCom debacle eventually sent several executives to prison. Bernie Ebbers, former chief executive officer and co-founder, was sentenced to 25 years after being found guilty of fraud and conspir-acy for his role in the accounting scheme. This is the harshest sentence ever given in a white-collar crimi-nal case. Scott Sullivan, the former chief financial officer who testified against Ebbers, received five years. Cooper has trouble reconciling those sentences.

Cooper now runs Cynthia Cooper Consulting Company and spends a great deal of time speaking on the events surrounding the WorldCom scandal. “Small decisions matter. Make sure your moral com-pass is pointed at true North. Never allow yourself to be intimidated.”ii

LECTURE LINK 12-4

It’s the Earnings That Count

Marvin Morris’s firm, In-Person Payments, runs payment centers in inner city stores that allow people without checking accounts to pay their bills. His long-standing approach to profit management: when he made enough money, he’d hire somebody. Marketing and expansion efforts were also financed using this bootstrapping approach.

Morris’s company has been a financial success, with revenues of nearly $18 million and 3,000 stores in 20 states. But when he approached venture capitalists to fund his expanding enterprise, he was surprised at the bargain basement valuation calculated by the venture capitalists. The VC were impressed with In-Persons’ ability to grow so quickly with so little capital, and they liked the company’s mainly Hispanic customer base, a fast-growing segment of the population.

What they didn’t like was the company’s low EBITDA, or earnings before interest, taxes, depre-ciation, and amortization. EBITDA is basically the firm’s net earnings from normal operations. Morris had always used revenue as his measuring system, and revenue was growing quickly. But most venture


capitalists look at the bottom line, the company’s earnings after operating expenses are deducted. That figure lets investors determine a company’s profitability, regardless of industry or accounting method.

To get a better EBITDA, Morris needed to cut expenses. He cut $100,000 from his marketing budget and dismissed nearly half of his staff. The company even negotiated a lower rate on its phone ser-vice.

The increase in earnings was almost immediate. The company went from running at breakeven to posting $1.4 million in EBITDA in one year. Investors were also impressed. He has attracted venture cap-italists willing to invest up to $3.5 million to expand In-Person Payments nationally.iii

LECTURE LINK 12-5

Using the Statement of Cash Flows

Rather than studying the income statement, many investors are choosing to look beyond that list of a company’s revenues and expenses to the cash flow statement. And because cash flow is key to fi-nancing many takeovers and leveraged buyouts, understanding and profiting from acquisitions often means understanding figures such as “operating cash flow” and “free cash flow.”

Companies do not go out of business because they report net losses. They fade away because they run out of cash. Monitoring your ability to generate cash flow is critical to success. To maximize long-term value, a company must continually evaluate its consistent capacity for generating cash. Commercial lenders realize that it is cash flow, not net income, which will repay their loans.

The true definition of cash flow is unclear. It is one of the most over used and least agreed upon terms in corporate finance. Cash flows can be divided into three primary categories:

Cash flows from operating activities. Cash flows from investing activities. Cash flows from financing activities. Cash flow is often a better measure of company health than earnings, analysts say, because earn-

ings can be puffed up or hidden through accounting changes or other manipulations that don’t reflect the true state of a company’s business. When times are tough, companies can fool around with tax rates and make timing adjustments. Due to such manipulations, many analysts rate the usefulness of cash flow statements far above earnings statements.

In today’s competitive environment, it is vital for the owner/operator to monitor current and fu-ture cash flow requirements. Careful tracking of cash flow is especially important for industries facing seasonal fluctuations, such as the retail industry. These companies must prepare projections of cash in-flows and outflows, preferably on a monthly basis, but certainly no less than on a quarterly basis. A fore-cast of the company’s monthly balance sheet is also important to show its financial position and available assets, such as accounts receivable and inventory, which can be used as collateral for working capital loans.

Based on these projections, periods of negative cash flow will be highlighted and anticipated. To lessen the effect of periods of negative cash flow, many factors should be considered, including the com-pany’s business cycle and its ability to fund the negative cash flow period.

In anticipation of these down times, it’s necessary to pay particular attention to cash-producing assets, such as accounts receivable, and cash-flow-draining liabilities, such as accounts payable. Steps to speed up time for collections of receivables might include reducing the time between the sale and mailing the invoice to the customer or changing sales terms to cash on delivery. It may also be worthwhile to meet with the company’s banker to review the cash flow requirements of the company and obtain a seasonal line of credit to cover the negative cash flow periods.


Cash flow can be used in different ways for different types of companies: For developing companies, cash flow and free cash flow are usually negative, because the

company is burdened with low sales and one-time expenses necessary to build the business. Matching the cash being lost in a cash flow statement to the assets on hand to pay bills can predict how long the company can survive.

Minding cash flow is especially crucial in energy and real estate companies, whose bottom line often is obscured by heavy depreciation and depletion allowances.

Companies that recently have made takeovers often have depressed earnings because they must write off massive amounts of goodwill carried on their balance sheet. The goodwill comes from paying a premium over a company’s book value to buy the company.

Monitoring cash flows is crucial to a company’s success. As owners and financial statement users become more familiar with the concept and use of cash flow ratios, their decision-making process will improve greatly and become more focused on the cash flow impact of their decisions.

LECTURE LINK 12-6

Knowing the Numbers

Employees at Setpoint know more about their company’s finances than most investors do. Set-point is a custom-manufacturing company with 30 employees and a little more than $6 million in sales. Most of its revenues come from designing and building factory-automation equipment, a highly competi-tive business.

In the shop, a spacious, well-lit room, ten employees work on half a dozen machines. Off to one side is a large whiteboard on a wall next to a canteen area. Scribbled across the board are about 20 rows and 10 columns of numbers forming a table, with a few dollar signs sprinkled here and there. Setpoint’s CEO, Joe Knight, says, “That’s our board. It’s how we trace our projects and figure out whether or not we’re making money.” Knight can explain what all the numbers mean, but more surprisingly, so can indi-vidual workers.

One worker explained how the GP—gross profit—is calculated and how much he and other workers had earned the previous week on each project. He pointed out the column showing each project’s GP per hour and explained the importance of keeping that number in mind. He said he also watched the ratio of overall GP to OE—operating expenses—since that’s how you know if the company was making money. He added that he like to see it running at about 2.0.

CEO Knight explained that the people on the shop floor all had it down like that. It was their scoreboard. It was the way they could tell if they were winning or losing.

The whiteboard began in November 1998 when Knight was still the Chief Financial Officer. Set-point had been on a growth binge and was pushing the limits of its credit line. The bank’s loan officer was breathing down his neck. “We’d had three months of losses, and we were running the company on our credit line, but I’d told the bank we’d break even in November and get back to profitability by December. Then I got the numbers for the first week of November, and they were awful. We just had too many projects that were losing money.”

Knight didn’t have the board back then, but he was using the same system on a spreadsheet. Knight handed it out to everybody and then talked to Steve Nuetzman, the lead engineer. Knight remem-bers saying “Look at this, Steve. We’re losing money again. If we don’t do something, we’re going to max out our credit line, and then we’re really going to be in trouble with the bank.”

Nuetzman got the message. On the following Monday, when Knight looked at the spreadsheet for the previous week, he was stunned to see that the situation had been turned completely around. Virtually


no work had been done on the money-losing projects. Instead people had focused almost all their atten-tion on the projects with higher gross-profit margins, so the company had made money for the week.

“I went right over to Nuetzman and congratulated him. I was pretty excited because it meant I’d be able to go to the bank and say, ‘See, I said we could turn it around, and we did.’ How many companies can find out they’re losing money in the first week of November and turn it around like that? Not many.”

According to Nuetzman, it wasn’t a big idea, really. “We just looked at the projects we had and realized we could shuffle resources around.” They got the delivery dates on the less profitable projects ex-tended and turned them over to contract labor. Then they put their high-powered internal resources on the most profitable projects.

The accounting system was developed by Joe Cornwell and Joe VanDenBerghe, who cofounded Setpoint in 1992 and, with Knight, developed its management system. In order to create a project-man-agement system that worked, they realized they’d have to delve into the accounting processes, which plays a major role in the way projects are tracked.

Cornwell eventually introduced unconventional accounting ideas. “I didn’t agree with the text-book about the way you should do things. For example, they said you should treat labor as a variable cost. Well, you can’t treat labor as variable ... It’s stupid to treat your regular employees as a variable cost, be-cause the cost doesn’t vary in reality. You can’t hire and fire people as the work comes in and goes out. Even if you were a hard, cruel bastard, you couldn’t do it. Nobody would come to work for you if you did.”

Cornwell, VanDenBerghe, and Knight decided early that Setpoint would be an open-book com-pany. To get employee involvement, they put great emphasis on financial training and sharing informa-tion. Then in 1998 a project engineer hit upon an idea to communicate the numbers. Instead of the weekly spreadsheet, why not put the same information up where everybody could see it? Thus the board was born. iv


BONUS INTERNET EXERCISES

BONUS INTERNET EXERCISE 12-1

Annual Reports Online

PURPOSE:The purpose of this exercise is to explore the annual report of a specific company by visiting

the company’s website using the principles presented in this chapter.

EXERCISE:Locating corporate annual reports is easier than it has ever been. AnnualReports.com hosts a web-

site (www.reportgallery.com) containing annual reports for hundreds of corporations. The site is compre-hensive and easy to use.

Go to the website (www.reportgallery.com) and choose one company to research. Use the infor-mation given in this report to answer the following questions. (Sometimes the web address for a location changes. You might need to search to find the exact location mentioned.)

Company name ________________________________ Financial Year ______________________

1. Locate the report of the independent auditors. a. Who are the auditors?

b. Are there any auditor reservations—anything that the auditors flag with the term “except”?

2. Locate the report of management. Since the passage of the Sarbanes-Oxley Act in 2002, corporate management has to certify these financial results. Who signed the management report?

3. Which intangible assets are listed on the balance sheet?

4. How much income tax did the company pay?

5. Using the financial ratios discussed in this chapter, answer the following:

a. What is the current ratio?

b. What is the debt to owners’ equity ratio?

6. What is the basic earnings per share? Diluted earnings per share?


BONUS INTERNET EXERCISE 12-2

CPA Certification

PURPOSE:To let students investigate the certification examination required to become a Certified Public Ac-

countant.

EXERCISE:The American Institute of Certified Public Accountants sponsors a website giving information on

the Uniform CPA Examination. Go to the AICPA website (www.cpa-exam.org) and use the information there to answer the following questions. (Sometimes the web address for a location changes. You might need to search to find the exact location mentioned.)

1. What are the requirements to take the CPA exam?

2. The website gives the official statement of purpose for the exam, created by the American Insti-tute of Certified Public Accountants. Locate and record this statement of purpose.

3. What are the major areas covered in each section of the exam?

4. Each section is timed. How much time is allocated for each section?

5. Each section is given a percent value adding up to 100%. What percent value is assigned to each section?


http://www.cpa-exam.org/

CRITICAL THINKING EXERCISES

CRITICAL THINKING EXERCISE 12-1

Budgetary Control

The Weinstein Manufacturing Company prepared a budget for its production department as fol-lows. At the end of the first month, the production manager compared actual results with budgeted amounts and found that some were over and some were under budget. An expenditure is considered ex-ceptional if it varies by more than 10% from the budgeted amount.

WEINSTEIN MANUFACTURING COMPANYMONTHLY BUDGETARY CONTROL WORKSHEET

____________________________________________________________________________EXPENSE BUDGETED ACTUAL DIFFERENCECATEGORY AMOUNT EXPENDITURE FROM BUDGET____________________________________________________________________________

Labor $162,500 $195,000 _______________

Raw materials 172,500 151,500 _______________

Utilities 6,500 6,300 _______________

Maintenance 9,750 8,950 _______________

Other variable expenses 16,750 18,000 _______________

Fixed overhead expenses 25,000 25,000 _______________

TOTAL EXPENSES $393,000 $404,750 __________________________________________________________________________________________________


CRITICAL THINKING EXERCISE 12-1 (continued)

1. Which of the budget items should be investigated?

2. What could be causing the difference?

3. What are some suggestions for improvement?


NOTES FOR CRITICAL THINKING EXERCISE 12-1

WEINSTEIN MANUFACTURING COMPANYMONTHLY BUDGETARY CONTROL WORKSHEET

____________________________________________________________________________EXPENSE BUDGETED ACTUAL DIFFERENCECATEGORY AMOUNT EXPENDITURE FROM BUDGET____________________________________________________________________________

Labor $162,500 $195,000 +32,500 +20.0%

Raw materials 172,500 151,500 -21,000 -12.2%

Utilities 6,500 6,300 -200 -3.1%

Maintenance 9,750 8,950 -800 -8.2%

Other variable expenses 16,750 18,000 +1,250 +7.5%

Fixed overhead expenses 25,000 25,000 0 0 .0%

TOTAL EXPENSES $393,000 $404,750 +11,750 +3.0%___________________________________________________________________________________

1. Which of the budget items should be investigated?

If management looked only at the bottom line, this budget report would appear very positive. The total expenditures are over budget by only 3%. However, closer inspection of the individual budget items shows that the actual labor cost is exceeding the budgeted amount by 20%, a significant overage. This item needs to be investigated—what is causing labor costs to increase so much?

The second item that needs to be investigated is the expenditure for raw materials. Spending here is 12% below budget. Students may argue that this is good news—why question it? However, the reasons for the decrease need to be identified. Has the cost of raw materials declined? If so, the budget needs to be modified. Are workers using a more efficient production method that uses fewer raw materials? If so, the company needs to make certain that everyone in the organization is using the improved method.

2. What could be causing the difference? The increased labor costs may be due to an increase in the number of workers or an increase in

the amount paid each worker. In other words, has the workforce increased or have individual worker earnings increased? The production department may be relying more on expensive overtime, thus increas-ing costs. Or the company may have added additional workers to meet seasonal increases in demand.

A critical financial element is missing here—what is the total revenue earned for this period? This budget overage would be less significant if sales revenue were also increasing.

3. What are some suggestions for improvement?How can workers be used more efficiently? Are there ways to increase productivity? Is automa-

tion an option? If the increase is seasonal, how can the company even out the fluctuations? Perhaps the budget report should be prepared more frequently—weekly instead of monthly.



Preparing a Balance Sheet

As the accountant for Wheatley International, it is your job to prepare the company’s balance sheet. Use the accounts listed below to construct the statement.

List of Accounts forWheatley International

Accounts Receivable $120,600 Land 1,500,000 Notes Receivable 61,200

Accounts Payable 45,000Common Stock 1,896,000Net Sales 1,053,000Notes Payable (Long-term) 270,000Retained Earnings 1,459,800Cash 72,000Short-Term Notes Payable 15,600Buildings (after depreciation) 1,050,000Equipment & Vehicles (after depreciation) 1,066,000Inventory 126,600Goodwill 90,000


NOTES ON CRITICAL THINKING EXERCISE 12-2

The formula for the balance sheet is assets equal liabilities plus stockholders equity. To prepare a balance sheet, record the assets and liabilities. The difference between the two is stockholders equity.

(Note: The format of this statement may be slightly different from the format taught in students’ accounting courses. The exact format is less important than understanding the overall concepts.)

Wheatley International Balance Sheet

ASSETS Current Assets

Cash $72,000Accounts Receivable 120,600Notes Receivable 61,200Inventory 126,600Total Current Assets $380,400

Fixed AssetsLand $1,500,000Buildings 1,050,000Equipment & Vehicles 1,066,000Total Fixed Assets $3,216,000

Other AssetsGoodwill $90,000 Total Other Assets $90,000

TOTAL ASSETS $3,686,400

LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities

Accounts Payable $45,000Short-Term Notes Payable 15,600 Total Current Liabilities $60,600

Long-Term LiabilitiesNotes Payable (Long-Term) $270,000Total Long-Term Liabilities $270,000

Total Liabilities 330,600

Owner’s EquityCommon Stock $1,896,000Retained Earnings 1,459,800 Total Owner’s Equity $3,355,800

TOTAL LIABILITIES & STOCKHOLDERS’ EQUITY $3,686,400



The Pizza Stand

A student organization has been given permission to operate a pizza stand during the upcoming homecoming weekend. The stand will be located just outside the football stadium, making it accessible during the ball game. The location is also convenient for visitors as they tour the campus at other times during the weekend. An estimated 2,500 visitors will be on campus, in addition to the campus population of 1,500.

Each pizza requires:

1/2 pound of pizza flour

2 ounces of pizza sauce

1/8 pound of pepperoni

1/2 pound of cheese.

Pizza flour costs $8.00 per 10-pound bag; pizza sauce, $4.80 per 64-ounce jar; pepperoni, $18.00 per 5-pound package; and cheese, $15.00 per 5-pound package. Club members will cook the pizzas and staff the stand on a volunteer basis. The university requires each vendor to pay a $25 permit fee and a $50 refundable deposit on the building. Your club plans to donate the profits from the pizza sales to a local children’s hospital.

1. How many pizzas can you anticipate selling?

2. What price should you charge per pizza?

3. How much of each raw material do you need to buy?

4. What will be your probable profit?

5. Develop a financial plan for your weekend enterprise.



I have used this exercise several times in my classes. Below are two of the potential solutions, one conservative and one very optimistic.

ALTERNATIVE 1


On the homecoming weekend, there will be about 4,000 people on campus. The first step in de-veloping a budget is to estimate what percentage of attendees will purchase your pizzas. This can be com-plicated. Factors such as the weather, time of day, and presence of other food vendors would have to be considered. Obviously, you would have to consider the demand for pizzas at several price points. Perhaps the simplest method is to use a percentage, say 10%. Potential sales: 400 pizzas.


You could consider several pricing strategies. Chapter 9 covered several possibilities: demand-based pricing, competition-based pricing, cost-based pricing, and break even analysis. What is the price are people willing to pay? What price is our competition charging? What is the break even point? To sim-plify transactions on the day of the sale, you may want to set the price at a whole dollar amount and not have to bother with coin change.

The analysis below uses cost-based pricing. The fixed costs are quite low—the only one given is the $25 permit. Next, calculate the cost of raw materials per pizza, the variable cost.

IngredientAmount per

pizza OuncesCost of

ingredientCost per

ounceCost per

pizzaPizza flour ½ pound 8 oz. $8 per 10 lb $0.05 $0.40

Pizza sauce 2 ounces 2 oz. $4.80 per 64 oz $0.075 $0.15

Pepperoni 1/8 pound 2 oz. $18 per 5 lb. $0.225 $0.45

Cheese ½ pound 8 oz. $15 per 5 lb $0.1875 $1.50

$2.50

After determining the cost of raw materials, a price can be set that covers these costs and provides the desired profit. Possible prices: $5.00, $7.00, or $9.00. Setting the price



pizza OuncesPotential sales

units

Total ounces needed

Total pounds

Pizza flour ½ pound 8 oz. 400 3200 200

Pizza sauce 2 ounces 2 oz. 400 800

Pepperoni 1/8 pound 2 oz. 400 800 50

Cheese ½ pound 8 oz. 400 3200 200


You will need:Pizza flour 20 10-pound bags 20 x $8.00 $160.00Pizza sauce 12½ 64-ounce jars 13 x $4.80 $62.40Pepperoni 10 5-pound packages 10 x $18.00 $180.00Cheese 40 5-pound packages 40 x $15.00 $600 .00

Total cost $1,002.40


Your profit will depend on the price you charge. Using $7.00:Price $7.00Revenue $2,800.00 (400 x $7.00)Variable costs $1,002.40Fixed costs $25.00Total costs $1,027 .40 Profit $1,772.60


Project Costs:Buy permit: $25.00Purchase raw materials:

Pizza flour 20 10-pound bags 20 x $8.00 $160.00Pizza sauce 12½ 64-ounce jars 13 x $4.80 $62.40Pepperoni 10 5-pound packages 10 x $18.00 $180.00Cheese 40 5-pound packages 40 x $15.00 $600 .00

Total cost $1,002.40(The $50 deposit is a wash, $50 cost, $50 refund. Therefore, it was not used in these calcula-tions.)

Project RevenueAssuming sales of 400 pizzas (10% of attendees) and using $7.00 sale price:

400 x $7.00 = $2,800.00

Project Net Profit:Revenue: $2,800.00Cost of Goods: $1,002.40Fixed Costs: $25 .00 Net Profit $1,772 .60


ALTERNATIVE 2


Assume that you will sell pizzas to 75% of the people at homecoming (3,000 pizzas.) People will be hungry, and they will want to support the club.


Charge $10.00 per pizza.



pizza OuncesPotential sales

units

Total ounces needed

Total pounds

Pizza flour ½ pound 8 oz. 3000 24,000 1500

Pizza sauce 2 ounces 2 oz. 3000 6,000

Pepperoni 1/8 pound 2 oz. 3000 6,000 375

Cheese ½ pound 8 oz. 3000 24,000 1500

Supplies needed:Pizza flour 150 10-pound bags 150 x $8.00 $1,200.00Pizza sauce 93.75 64-ounce jars 94 x $4.80 $ 451.20Pepperoni 75 5-pound packages 75 x $18.00 $1,350.00Cheese 300 5-pound packages 300 x $15.00 $4,500 .00

Total cost $7,501.20


Price is $10.00Revenue $30,000.00 (3,000 x $10.00)Variable costs $7,501.20Fixed costs $25.00Total costs $7526 .20 Profit $22,473 .80


Purchase enough raw materials to make 3,000 pizzas and market aggressively. If sales don’t meet expectations by the end of the third quarter, lower the price by half. Even at a $5.00 sales price, you will cover the $2.50 variable cost and make $2.50 profit per pizza.



Comparing Industry Ratios

You are interested in investing in a regional hotel company and have investigated the financial statements of four potential investments. Use the information in the table below to answer the questions at the bottom of the page.

KEY FINANCIAL STATISTICS

Hotel N Hotel J Hotel C Hotel W

Information from the income statement

Total revenue $10,099,000 $3,816,000 $428,806 $1,277,550

Total expenses $9,503,000 $3,618,000 $354,461 $1,822,748

Information from the balance sheet

Current assets $1,946,000 $1,020,000 $68,629 $526,549

Total assets $8,668,000 $8,183,000 $262,388 $3,783,127

Current liabilities $2,356,000 $895,000 $101,091 $693,809

Total liabilities $4,587,000 $5,944,000 $456,441 $3,089,318

Total shares of common stock outstanding 225,800 389,000 32,312 168,238

(Use the table on the following page for your answers.)

1. What is the net profit (or net loss) for each company?

2. Calculate the return on sales for each company.

3. Calculate the total stockholders’ equity for each company.

4. What is the current ratio for each company?

5. Calculate the return on equity ratio for each company.

6. What is the debt to equity ratio for each company?

7. Calculate the basic earnings per share for each company.


KEY FINANCIAL RATIOS


1. Net income (net profit or net loss)

2. Return on sales

3. Current ratio

4. Stockholders’ equity

5. Return on equity

6. Debt-to-equity ratio

7. Earnings per share (basic)

8. Which company would you rather invest in? Why?



The requested financial information and ratios are given below.

KEY FINANCIAL RATIOS


1. Net income (net profit or net loss) $596,000 $198,000 $74,345 ($545,198)

2. Return on sales 5.9% 5.2% 17.3% (42.7%)

3. Current ratio 0.83 1.13 0.68 0.76

4. Stockholders’ equity $4,081,000 $2,239,000 ($194,053) $693,809

5. Return on equity 14.6% 8.8% not meaningful (78.5%)

6. Debt-to-equity ratio 112% 265% not meaningful 445%

7. Earnings per share (ba-sic) $2.64 $0.51 $2.30 ($3.24)

Hotel N. Return on sales is in the mid-range for the industry. The current ratio, while less than the ideal 2.0, is in line with two of the other three companies. Return on equity is healthy and at the top of the industry, showing that the company has made good use of the funds invested by the investors. The debt-to-equity is much higher than the ideal ratio of 100%. However, when compared to the other companies in the industry, a 112% debt-to-equity ratio looks good. Earnings per share are also at the top range in the industry.

Hotel J. Return on sales is in the mid-range. Current ratio is at the top of the industry, showing a better than average liquidity. Return on equity is not exceptional, but in the mid-range for the industry. The debt-to-equity ratio, however, is alarming. With a debt-to-equity ratio of 265%, the company is heavily leveraged. Creditors provide almost three times as much capital as stockholders do. This would be a relatively risky investment.

Hotel C. If you just look at earnings, return on sales, and earnings per share, Hotel C looks like a winner. The 17.3% return on sales is the highest in the industry. Earnings per share is also at the high end. But investors in this company have a significant problem. The company has not only burned through all of the invested capital, but the stockholders’ equity is actually in the red. Not a good sign at all. Calculating the return-on-equity and debt-to-equity ratios is therefore meaningless. Return on a negative is irrelevant. This company is on the edge of bankruptcy, if it has not al-ready filed.

Hotel W. Hotel W has the opposite problem from Hotel C. Stockholders’ equity is still in the positive, but the company is hemorrhaging money. The company’s return-on-sales shows that the company is spending almost 43% more than it takes in as revenue—$1.00 in sales costs the company $1.43.


Hotels C and W are horrible investment candidates. That leaves Hotel N and J. Hotel J is heavily leveraged and would be more risky. Hotel N is a steady, safe performer. Knowing that there is a direct re-lationship between risk and return, the investment decision would depend on the investors’ tolerance for risk.


BONUS CASES

BONUS CASE 12-1

Getting Through the Hard Times at Hard Rock

In the mid-1990s, the theme-dining business seemed like a path lined with gold. With regularity, celebrity stargazers, enthusiastic press from around the globe, and hungry customers gathered at the open-ings of theme restaurants like Planet Hollywood and Motown Café. Unfortunately, the situation changed. In the late 1990s and early 2000s, Planet Hollywood filed for bankruptcy protection and Motown Café closed units across the country. Consumer boredom, a slowing economy, and a saturated market were blamed.

The changing “eatertainment” market raised eyebrows at the granddaddy of theme restaurants, the Hard Rock Café (HRC). HRC knew its market position was shaky due to increased competition and shifting consumer attitudes. The company also felt growing financial pressures, and speculated that a change in financial management might be needed. HRC had operated with a traditional, competent ac-counting department that made sure the company paid its bills, had money left at the end of the day, and could state how much it was earning. The problem was that HRC lacked the ability to analyze its financial information fully and use it to improve operations. To address these concerns, the company recruited a new chief financial officer (CFO) and dedicated itself to changing the financial reporting and information structure at the company.

Hard Rock Café believed that it had a tremendous undervalued asset—a premium global brand. The company dedicated itself to protecting and expanding that asset. However, it was evident that the company could have brand loyalty but that, without revenue, doesn’t matter. Hard Rock’s CFO was astonished to find that HRC sold $180 million a year in merchandise (primarily its well-known T-shirts) in addition to food, yet could not explain exactly how these individual items contributed to the firm’s profit. It was then the company realized that Hard Rock Café’s accounting and financial management had to change.

To start things off, the company piloted a food and beverage management system to track usage and item profitability. This system included information such as daily and seasonal buying patterns, prof-itability of one menu versus another, average weekly guest counts per café, and specific cost of sales and profit margins per item. The company then shifted the responsibility of the firm’s accountants. Instead of company accountants being responsible for profit-and-loss statements for a certain number of cafés, they now were responsible for one major financial category only, such as cost of goods sold, for all the com-pany’s operations. The objective was to compile companywide information for sound financial decision making.

Hard Rock Café also broke down the barriers that existed between the finance and accounting de-partments and operations, merchandising, and marketing. Today, financial information is shared directly with managers who can execute the recommendations at the restaurant level. Still, the company realized this was not going to be a quick fix for the company but instead an ongoing challenge. Each year about 25 million people visit a Hard Rock Café at the company’s 103 locations. Even so, competitors such as Rain-forest Café, Cheesecake Factory, Dick Clark’s Bandstand Café, and House of Blues promise to make the fight for eatertainment customers an interesting one.


DISCUSSION QUESTIONS FOR BONUS CASE 12-1

1. Why is it important for Hard Rock Café to know how different products contribute financially to overall company profits?

2. Do you think Hard Rock Café’s focus on improved financial reporting helped its company plan-ning capabilities? How?

3. Have you ever visited one of Hard Rock Café’s restaurants? Describe your experience.

ANSWERS TO DISCUSSION QUESTIONS FOR BONUS CASE 12-1

1. Why is it important for Hard Rock Café to know how different products contribute financially to overall company profits?

If a company knows which products are unprofitable, it can drop them from its offerings. On the other hand, if a company knows which items are most profitable, it can focus promotional efforts on those items to raise profits. The problem is that cost accounting is difficult to manage on an item-by-item basis. One must charge each item with costs such as rent, utilities, etc. That is very difficult to do. But the pay-off is worth the effort, as the Hard Rock Café is learning.

2. Do you think Hard Rock Café’s focus on improved financial reporting helped its company plan-ning capabilities? How?

Absolutely. The company now knows how much effort should go into nonfood promotions for things like T-shirts. It also knows which food items to drop and which to promote. Furthermore, restau-rant locations that are not proving profitable can be closed, and others revamped.

3. Have you ever visited one of Hard Rock Café’s restaurants? Describe your experience. Students will have different experiences.


BONUS CASE 12-2

Survival of the Financially Fittest

Are you the kind of person that likes to live life to the fullest? Are you looking for a career that’s challenging, with opportunities for advancement, and a large number of openings? Then welcome to the world of financial management in non-profit organizations. Non-profits are crying out for the talents of skilled financial managers who often overlook non-profits in favor of profit-seeking firms. As the avail-ability of public funding becomes scarcer, the demand for financing expertise has soared among non-prof-its. The call for innovative and experienced financial managers has grown louder.

Don’t be fooled, however, into thinking that “non-profit” means “no money.” The size and scope of the non-profit sector often surprises even seasoned business professionals. Also, misconceptions abound about work in non-profits. For starters, many people assume that the non-profit sector of the econ-omy is quite small. In reality, it is valued at approximately $665 billion per year. This makes the U.S. non-profit sector twice as large as the U.S. construction industry. Also, the term “non-profit” is some-times deceiving, bringing to mind church-sponsored bingo games or bake sales. Unfortunately, people forget that the - sector contains such notables as the American Red Cross, Harvard University, the Smith-sonian Institution, and the National Audubon Society, none of which sponsors bingo or bake sales. In the United States today, the non-profit sector includes over 1.24 million institutions, including schools, hospi-tals, human service organizations, religious groups, museums, and more. Over 15 million people are em-ployed in the non-profit sector of the economy.

Work in non-profits often includes important interactions with the profit-seeking sector. For ex-ample, Sandy Boutin works as the director of Great Dane Rescue in Plymouth, Michigan. Her organiza-tion is always in need of dog food but has a very small budget. Boutin decided to invite dog food manu-facturers to participate in her group’s fund-raising efforts. The companies got their name exposed to a large group of prospective customers in return for donating dog food to the rescue program. Through Boutin’s efforts, both groups got what they wanted. Often large non-profits, like the Smithsonian Insti-tute, actively seek corporate sponsorship programs to help fund such activities as its traveling exhibitions.

Many non-profit organizations experience problems at the top of their organizations. David La-Greca, a manager with the Volunteer Consulting Group, says that top management positions at non-prof-its are often filled with social workers, former dancers, and musicians. These individuals have creative and artistic skills but often lack the training and business expertise of executives at profit-seeking firms. Chris Perks, president of Perks Reutter Associates, an engineering consulting firm, agrees. According to Perks, “In non-profits you are often dealing with people whose expertise is in the mission of the organiza-tion, not necessarily in administration or management. Furthermore, many employees do not come from business backgrounds. They are often hired as staffers because they are committed to what they are do-ing.” It’s also difficult to recruit qualified individuals to serve on non-profit boards. The corporate scan-dals of the early 2000s caused waves in the non-profit sector. Many prospective board members fear that the potential of scandal or poor business practices at a non-profit could damage their reputation or busi-ness standing in a community.

Non-profits have also been severely lacking in another critical aspect of 21st-century business: Most are not taking advantage of the powerful technology of the Web. Financial experts fault non-profits for not taking advantage of such technology tools as tracking software and databases. With the proper fi-nancial management and technological expertise, non-profits could use the Internet to enhance their fund-raising capabilities. Non-profits seem to be listening to this advice. The possibilities for non-profits are clearly there if they can attract qualified business and financial expertise.v



1. How is the job of a financial manager in a non-profit organization different from that of a finan-cial manager with a profit-seeking firm?

2. Should financial managers in non-profit organizations be compensated equally to their counter-parts in profit-seeking firms? Why or why not?

3. Do you see the job of the non-profit financial manager as getting easier or more difficult in the future? Where might you get facts to support your conclusions?

4. How can a financial manager at a non-profit make better use of Web capabilities to enhance the financial position of the organization?


1. How is the job of a financial manager in a non-profit organization different from that of a finan-cial manager with a profit-seeking firm?The financial management of a non-profit organization differs in many ways from that of a profit-

seeking firm. The financial manager of a for-profit organization usually has a very accurate estimate of sales revenue and its timing. The non-profit financial manager does not have the same planning accuracy—inflows may be donations that cannot be anticipated accurately. The goals of the organization are also quite different. The for-profit organization is in business to make a profit. The non-profit organization’s mission is often to provide a service that cannot be stated in dollars and cents.

2. Should financial managers in non-profit organizations be compensated equally to their counter-parts in profit-seeking firms? Why or why not?

Non-profit managers tend to have very different motivations those managers of profit-seeking firms. The “non-profit mindset” is well known. Often the need for achievement is high. Monetary com-pensation is less important than the satisfaction of doing a worthwhile job. While all good managers de-serve compensation for their efforts, non-profit financial managers usually expect to receive less in mone-tary terms.

3. Do you see the job of the non-profit financial manager getting easier or more difficult in the fu-ture? Where might you get facts to support your conclusions?

The current trend in government is to transfer more and more social services from government to the private sector. This means that there will be increasing need for financial management. There is also growing scrutiny of the way non-profits handle their finances. The position of non-profit financial man-ager can only get more challenging.

4. How can a financial manager at a non-profit make better use of Web capabilities to enhance the financial position of the organization?Many excellent websites exist for non-profit organizations. One, foundation.org, features articles

available to download covering such topics as developing expense categories and completing necessary tax forms.


BONUS CASE 12-3

Chicago Rush: When the Goal Line Meets the Bottom Line (Video Case)

(NOTE: This case can be used with the Video on DVD for this chapter.)

There are a lot of statistics to gather in any sport. Football is no exception. There are the ones that the average fan follows most closely, like win-loss records and the number of passes completed given the number of tries. For the Chicago Rush of the Arena Football League, the regular season statistics were not so wonderful in the 2006 season. They won only seven games and lost nine. Nonetheless, that record was good enough to win them a wildcard spot in the playoffs. Much to their credit, the team went on the win the Foster Trophy.

There are other important statistics for a football team to follow. You can’t keep playing the game unless you make enough money to pay the players and keep the games going. Therefore, like all compa-nies, the Chicago Rush has to keep careful accounting records. At the top of the income statement, rev-enues are a key. Winning a championship should improve that number and, after all costs and expenses are deducted, that bigger number should carry right down to the bottom line—profit after taxes.

A new team in a relatively new sport can’t expect the bottom line to be huge. Investing in a team can be a major commitment. So the bottom line score is often as important as the scores on the field. And the person keeping those scores is a major player. That person at the Chicago Rush is Maggie Wirth. She goes through the same six-step accounting process outlined in this chapter.

Accounting can be an interesting and challenging occupation when you consider how important it is to the team and all its owners, players, and fans. When it comes time to be paid, the players are inter-ested in whether or not the cash flow is sufficient. Costs and expenses have to be kept in line—and that includes player salaries. What seem like mere data to the average person turns out to be more important in the long run than wins and losses and championships won. Without the money, the game is over.

With increased revenue comes the opportunity to increase marketing. There are many competing sports in Chicago, and many teams have been around for years. To attract fans, the Rush must consis-tently provide exciting games and fun entertainment during those games. As in any sports program, the team is looking for revenue from all sorts of sources: parking, various food concessions, team merchan-dise, and more. Growth often is accompanied by more expenses, including higher-cost players. Going in-ternational adds its own expenses, for airline fees, hotels, and related items.

Keeping track of revenues, expenses, and other details may seem a rather remote part of team planning, but, as you can see from this case, such details are at the heart of the enterprise. Just as the of-fense and the defense need to have their plans and their appraisals over time, the fiscal health (profit and loss) of the team must be measured as well. And, just as there is a football team, there is a financial team. Keeping score is more than keeping track of first downs and touchdowns. In the background are people keeping score of how many fans are coming vs. last year, how many hot dogs and sodas were sold, and how much it cost to clean the uniforms and clean the stadium.

Boring statistics? Hardly. They determine whether or not the team can stay in business. There are lots of people relying on the results. The same is true in all businesses. The managers, employees, in-vestors, and others are all following the accounting scores as closely as whatever score-keeping the com-pany does (usually sales or profit).



1. Does accounting seem more interesting and important when analyzed in the context of a major sport?

2. Player salaries are a major expense to a sports team. What role might accounting play in helping managers and coaches talk to the players about salaries? Does the fact that arena football is a rela-tively new sport have anything to do with such negotiations?

3. Do different groups, like managers and stockholder and players and fans, want different figures compiled by the accounting department? What are those differences?


1. Does accounting seem more interesting and important when analyzed in the context of a major sport?

Accounting is interesting and important to all companies. Often students can’t see the big picture because so much focus is placed in accounting statements and things like double-entry bookkeeping. This case offers and opportunity to explore how important accounting is to businesses and how challenging the job is. After all, it is accounting that measures the bottom line—and no figure is more important to a firm or a team.

2. Player salaries are a major expense to a sports team. What role might accounting play in helping managers and coaches talk to the players about salaries? Does the fact that arena football is a relatively new sport have anything to do with such negotiations?

This question gives you a chance to talk about costs and expenses in general and specifically the costs associated with employees (players). It might even lead to a discussion of the minimum wage and how raising salaries affects the bottom line and, therefore, hiring practices. Putting accounting into a whole new context opens many new opportunities for a fresh look at the processes involved.

3. Do different groups, like managers and stockholder and players and fans, want different figures compiled by the accounting department? What are those differences?

This question creates an opportunity to discuss managerial versus financial accounting. Managers need to know things like whether or not expenses are being kept in line. They should be kept informed about cash flow issues and actual revenues. Investors and players, on the other hand, are more interested in the bottom line (profit after taxes). Fans are concerned about rising parking fees and ticket prices and want to know why such increases are necessary. The difference between managerial and financial ac-counting has more relevance in this setting.


BONUS CASE 12-4

The Best Laid Plans Often Go Awry

How you report revenues on the income statement makes a big difference in how profitable a company looks. The problem is that stockholders are often fooled into investing in a firm that is not nearly as profitable as they think. A good example is that of Thousand Trails Campground. It sold camp-ground memberships for owners of recreation vehicles. It used the usual expensive promotions to get po-tential buyers to come to the campgrounds. Once a potential customer was at the site, there was a lot of pressure to buy now, and the campgrounds were quite attractive. Once a customer got home and reconsid-ered the investment, though, some backed out of the commitment, and that is where Thousand Trails got into difficulty.

The company recorded the full price of a membership (about $7,500) as revenue, even though members paid only 40% down on average. Marketing expenses were running higher than payments, so more cash flowed out than flowed in. To get cash, Thousand Trails sold its receivables.

In one year, Thousand Trails used $52 million more cash than it produced, a definite cash flow problem. Nevertheless, it reported record earnings of $19.1 million, and the stock price went up to over $29.

Two years later, the stock had fallen to less than $5, reflecting a 90% drop in earnings reported (from 19 million dollars to less than 2 million dollars). What happened was that a lot of campground members dropped out before paying in full. So Thousand Trails had to write off $11 million in paper rev-enues. Marketing expenses were two times greater than down payments. Debt reached a horrendous 244% of stockholder’s equity.

Meanwhile, stockholders were left wondering what happened to the company that was growing so fast and making such good profits (at least on the income statement).


1. Thousand Trails did nothing illegal in its reporting of revenues and profits. What does that tell you about the need to carefully read and analyze income statements before you invest?

2. Can you see how cash flow problems can grow to unbelievable proportions in just a short time, even when profits look good?


1. Thousand Trails did nothing illegal in its reporting of revenues and profits. What does that tell you about the need to carefully read and analyze income statements before you invest?The fact is that income statements and balance sheets are very hard to analyze. Auditors go over

them to check for legality, but that doesn’t prevent deception of stockholders. One way to invest and not worry about doing your own analysis is to buy mutual funds and leave the digging to professionals.

2. Can you see how cash flow problems can grow to unbelievable proportions in just a short time, even when profits look good?Yes, cash flow problems plague businesses, especially the ones that grow rapidly. The problem is

that the fast-growing firms are also the most attractive as investments. A firm cannot keep borrowing and growing without careful cash-flow analysis or they are bound to get caught with too little cash and too


many bills to pay. If the bank refuses the business any more loans, the result, more often than not, is bankruptcy.


BONUS CASE 12-5

Managing by the Numbers

Katherine Potter knew a good thing when she saw it. At least, it seemed so at first. She was trav-eling in Italy when she spotted pottery shops that made beautiful products ranging from ashtrays to lamps. Some of the pottery was stunning in design.

Katherine began importing the products to the United States, and sales took off. Customers im-mediately realized the quality of the items and were willing to pay top price. Katherine decided to keep prices moderate to expand rapidly, and she did. Sales in the second three months were double those of the first few months. Sales in the second year were double those of the first year.

Every few months, Katherine had to run to the bank to borrow more money. She didn’t really dis-cuss her financial situation with her banker because she had no problems getting larger loans. You see, she always paid promptly. To save on the cost of buying goods, Katherine always took trade discounts. That is, she paid all bills within 10 days to save the 2% offered by her suppliers for paying so quickly.

Most customers bought Katherine’s products on credit. They would buy a couple of lamps and a pot, and Katherine would allow them to pay over time. Some were very slow in paying her, taking six months or more.

After three years, Katherine noticed a small drop in her business. The local economy was not do-ing well, and many people were being laid off from their jobs. Nonetheless, Katherine’s business stayed level. One day, the bank called Katherine and told her she was late in her payments. She told them she had been so busy that she didn’t notice the bills. The problem was that Katherine had no cash available to pay the bank. She frantically called several customers for payment, but they were not able to pay her, ei-ther. Katherine was in a classic cash flow bind.

Katherine immediately raised her prices and refused to make sales on credit. She started delaying payment on her bills and paid the extra costs. Then she went to the bank and went over her financial con-dition with the banker. The banker noted her accounts receivable and assets. He then prepared a cash bud-get and loaned Katherine more money. Her import business grew much more slowly thereafter, but her fi-nancial condition improved greatly. Katherine had nearly gone bankrupt, but she recovered at the last minute.

i Sources: Andrea L. Charters, “The Sarbanes-Oxley Act Enforces Three Major Stock Market Reforms,” St. Louis Business Journal, April 18-24, 2002, p. 45; “Rules Adopted on Auditing Firm Services,” United Press International, January 23, 2003; Stacy A. Teicher, “Job of Policing Companies May Fall More to Insiders,” The Christian Science Monitor, March 31, 2003, p. 18; “Ex-Andersen Auditor’s Sentencing Delayed,” AP Online, May 8, 2003; Carrie Johnson, “Corporate Audit Panels to Gain Power; SEC Passes New Reforms,” The Washington Post, April 2, 2002, p. E02; Ed McCarthy, “Tips for the Sarbanes-Oxley Learning Curve,” Journal of Accountancy; June 1, 2004; and U.S. Sen. Paul Sarbanes, “Living up to its Promise Sarbanes-Oxley Pays Dividends by Keeping Companies Honest,” Denver Rocky Mountain News; April 8, 2006.

ii Source: Scott Waller, “Whistleblower Tells Her Story,” The Clarion-Ledger, April 29, 2006.

iii Source: Bobbie Gossage, “Cranking Up the Earnings,” Inc. Magazine, October 2004.

iv Source: Bo Burlingham, “What’s Your Culture Worth?,” Inc. Magazine, September 30, 2001, pp. 124-132

v Sources: John Case, “The Surprise Economy,” Inc. Magazine, September 2002, p. 38; and Rachel Brand, “Non-profits Feel Effects of Corporate Scandals,” Denver Rocky Mountain News, July 30, 2002, p. 24B.



1. How is it possible to have high sales and high profits and run out of cash?

2. Why did Katherine do better when she raised her prices and refused to sell on credit?

3. What was the nature of Katherine’s problem? Was she correct to go to the banker for help, even though she owed the bank money? How could she have prevented some of the problems she eventually found herself faced with?


1. How is it possible to have high sales and high profits and run out of cash? That is the classic description of a poor cash flow. A firm sells lots of merchandise on credit and

buys more, paying promptly. Credit sales are great, and the firm buys more merchandise on credit. One day the creditors ask for money, and the firm cannot collect its accounts receivable fast enough; it is cash poor. It could go bankrupt if it can’t borrow money someplace to cover until accounts receivable are col-lected.

2. Why did Katherine do better when she raised her prices and refused to sell on credit?

Higher prices increase cash flow when the terms are cash and slow the need to borrow funds to buy on credit. Too rapid growth often leads to cash flow problems because the growth is all financed and there is not enough cash available to back it up.

3. What was the nature of Katherine’s problem? Was she correct to go to the banker for help, even though she owed the bank money? How could she have prevented some of the problems she even-tually found herself faced with? Katherine had a classic cash flow problem, and, yes, a bank is an excellent place to turn for help.

The bank can provide funds, help in designing a cash budget, and provide further guidance to avoid cash flow problems in the future. What got Katherine in trouble in the first place was being too free to grant credit to customers and not being more insistent about collecting overdue accounts. To slow business, she could have raised prices and given credit only to her best customers.


ENDNOTES


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