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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
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