THE POWER OF ACCOUNTING The Power of Accounting: What the Numbers Mean and How to Use Them provides a highly readable text for non-financial managers. It explores accounting’s uses and limitations in the management process. The text is intended for users of accounting information as opposed to preparers. It focuses on aiding the reader in understanding what accounting numbers mean, what they do not mean, when and how they can be used for decision making and planning and when they cannot. Larry Lewis is a Professor of Accounting at the University of Portland’s Pamplin School of Business, USA. He earned his B.A. and M.A. from the University of Missouri, and his Ph.D. from the University of Nebraska. He served as the Dr. Robert B. Pamplin, Jr. School of Business Dean from June of 2001 to June of 2006. He currently teaches accounting at both the graduate and undergraduate levels and is a consultant to businesses, government organizations, and non profits. THE POWER OF ACCOUNTING What the Numbers Mean and How to Use Them Larry Lewis First published 2012 by Routledge 711 Third Avenue, New York, NY 10017 Simultaneously published in the UK by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Routledge is an imprint of the Taylor & Francis Group, an informa business © 2012 Taylor & Francis The right of Larry Lewis to be identified as author of this work has been asserted by him in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. Library of Congress Cataloging-in-Publication Data Lewis, Larry (Lawrence D.), 1941– The power of accounting : what the numbers mean and how to use them / Larry Lewis. p. cm. Includes index. 1. Accounting. I. Title. HF5636.L49 2011 657—Sdc23 2011033066 ISBN: 978–0–415–88430–3 (hbk) ISBN: 978–0–415–88431–0 (pbk) ISBN: 978–0–203–12909–8 (ebk) Typeset in Baskerville by Swales & Willis Ltd, Exeter, Devon Printed and bound in the United States of America on acid-free paper by Edwards Brothers, Inc. To my wife, Adele, without whose support, encouragement and considerable editing skills this book would not have been possible. CONTENTS Acknowledgments x Introduction 1 Terminology 5 Financial versus Managerial Accounting 6 Summary 7 1 The Basics 9 Chapter Overview 9 Accrual Accounting 12 Cash Accounting 13 Equations 13 Income Statement 14 Balance Sheet 16 Source and Use of Funds Statement 25 Footnotes to Financial Statements 29 Summary 30 Exercises 31 2 Costs, Cost Behavior and Cost Analysis 33 Chapter Overview 33 Cost Classifications 34 Summary 39 Exercises 40 viii CONTENTS 3 Cost-Volume-Profit Analysis 41 Chapter Overview 41 Contribution Margin versus Traditional Income Statements 42 Some Basic Math 43 Cost-Volume-Profit Analysis Illustrated 45 Assumptions 50 Sensitivity Analysis 51 Operating Leverage 52 Summary 53 Exercises 54 4 Decision Making I: The Basics 57 Chapter Overview 57 Basic Decision Model 58 Reliable and Relevant Information 59 Opportunity Costs 61 Examples 62 Summary 68 Exercises 68 5 Decision Making II: Capital Budgeting Decisions 71 Chapter Overview 71 Short Term versus Long Term 72 Capital Budgeting Decisions 72 The Time Value of Money 73 Estimating Future Cash Flows 74 Present Value 76 Capital Investment Decision Models 78 Summary 86 Exercises 86 6 Planning and Budgeting 91 Chapter Overview 91 Developing the Operating Budget 94 Pro Forma Income Statement 95 Pro Forma Balance Sheet 97 CONTENTS ix Illustration of Budgeting Process 103 Summary 108 Exercises 108 7 Control 111 Chapter Overview 111 Flexible Budgets 113 Different Layers of Analysis 113 Summary 121 Exercises 122 8 Allocation 124 Chapter Overview 124 Necessity of Allocations 126 Approaches to Allocation 127 Allocating Overhead 128 Summary 140 Exercises 140 9 Financial Statement Analysis 143 Chapter Overview 143 Liquidity Ratios 146 Financial Leverage Ratios 149 Activity Ratios 151 Profitability Ratios 153 Summary 157 Exercises 158 Appendix A – Portions of Columbia Sportswear’s 2009 10-K Report 159 Appendix B – Glossary 210 Appendix C – Answers to End-of-Chapter Exercises 225 Index 241 ACKNOWLEDGMENTS I wish to thank publisher John Szilagyi, his very able administrative assistant Sara Werden, copy-editor Helen Moss, Tamsin Ballard at Swales and Willis and the editorial staff at Routledge for their gener- ous help and support. I also want to thank the reviewers who took the time and effort to provide useful comments, suggestions and valuable critiques. Special thanks go to some very capable persons who had a direct hand in editing, organizing, gathering data and providing invalu- able aid in helping me navigate the electronic jungle. They are Adele Lewis, Kat Cottrell, Kacia Hicks, Joy Huff, Alex Kenefick and Sarah Klemsz. Any mistakes in the text are solely mine. I welcome your com- ments and suggestions for further improvement. We are drowning in information while starving for wisdom. (E.O. Wilson, Consilience) There will be companies that excel. And occasionally they will excel because of luck. But usually they excel because of brains. (Warren Buffett, speaking about Apple’s Steve Jobs on Fox Business Network) Mors ultima ratio. [Death is the final accounting.] (Anonymous – Latin) [...]... accounting and finance One is from the perspective of the preparers of accounting information (CPAs and others) The other is from the perspective of the users of that information This text is primarily concerned with both the preparation and the use of accounting information * * * * * Accounting poses as being exact Not so When you look at a firm’s income statement and see the firm “earned” $2,561,500 last... Financial Accounting Standards Board (FASB) Together, they establish the rules for financial accounting These rules are the so-called “Generally Accepted Accounting Principles” (GAAP) Other organizations such as the American Institute of Certified Public Accountants (AICPA), the Institute of Management Accountants (IMA) and the American Accounting Association (AAA) play a lesser role in establishing accounting. .. in front They don’t want you rooting around buying the freshest, most recently purchased They want the first milk purchased to be the first milk sold When you think of LIFO, think of a barrel of nails When you go to the hardware store, you are not going to dig down to the bottom of the barrel to get the oldest nails You will gingerly take a handful from the top That is, the last ones put in the barrel... has purchased another firm and paid more for it than the market value of its individual assets Goodwill can be thought of as representing the superior earning power of the purchased firm’s assets Liabilities and Stockholders’ Equity Moving over to the other side of the balance sheet we find the sources of financing for the firm’s assets, that is, liabilities and stockholders’ equity THE BASICS 23 Current... ending; like others, it can be a horror show The opening scene, that is, the first item on the income statement, shows what the firm’s revenues are, that is, what it earned from the sale of its principal products or services Cost of goods sold follows If the company in question is a retail or wholesale firm, cost of goods sold represents the cost to the firm of the merchandise it sold plus all the related... Owners’ equity represents the owners’ financial interests in the firm’s assets The total amount of owners’ equity is the result of how much owners have invested in the firm, either through a direct contribution (stock purchase, etc.) or through the firm’s earnings that have been kept (retained) in the business and not paid out to the owners in the form of dividends or other payments If the firm has suffered... planning, and controlling the operations of their organizations Furthermore, their performance is often judged on the basis of accounting information One of the difficulties people often encounter with understanding accounting and finance literature is its terminology Different authors use different terms to mean the same thing Learning the language 8 INTRODUCTION becomes the key When coming across terms you... inflows of cash, increases in other assets or the settlement of liabilities resulting from the sale of goods and services that constitute an organization’s principal operations Title (Cash, Accounts Payable, Sales, etc.) Debit Figure 1.1 Credit 12 • • • • THE BASICS Expenses are the outflows of cash, the decreases in other assets or the incurrence of liabilities resulting from the performance of activities... understand the game of baseball, you need to understand its lingo So it is with business and its language Accounting is part of the bedrock of our culture and economic system Consider the following: Most of us were brought into this world in a very sophisticated, complex organization – a hospital The clothes we wear, the food we eat, the cars we drive, the gasoline we put in those cars and the education... qualities You can’t hold, touch, smell or paint them but they are nevertheless very real and often very valuable Their value comes from the fact that they give the firm some right or advantage that other firms do not have For example, they might give their owner the exclusive right to publish a book or use a certain trademark Goodwill is the most intangible of intangibles It will appear on a firm’s balance . success. There are a couple of different ways to study accounting and finance. One is from the perspective of the preparers of accounting information (CPAs and others). The other is from the perspective. THE POWER OF ACCOUNTING The Power of Accounting: What the Numbers Mean and How to Use Them provides a highly readable text for non-financial managers. It explores accounting s. regulated by the SEC and the Financial Accounting Standards Board (FASB). Together, they establish the rules for financial accounting. These rules are the so-called “Gen- erally Accepted Accounting