4. Implement internal controls to fill gaps and fill them with strong control processes.
5. Monitor and test the controls with an early warning system of performance and management statistics.
All the efforts of Sarbanes-Oxley have not appeared to stem the tide. After implementation of Sarbanes-Oxley, other corporate scandals occurred: rapid mutual-fund trading in 2003 (Putnam, Invesco, and Janus), bid rigging in the insurance industry in 2004 (Marsh & McLennan), and egregious accounting at Fannie Mae in 2004. Even the head of Yale University’s International Institute for Corporate Governance was caught in 2005 in a scandal concerning his expense account.
The subprime mortgage meltdown in 2008 was the granddaddy lapse of ethics on the part of the bond rating agencies, mortgage brokers, bankers, investors, and home owners. In response Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. MBAs need to be aware of the ethical environment that they work in and the ones that they help to create.
KEY ETHICS TAKEAWAYS
Social Responsibility of Business—Concept that businesses are accountable to more than their owners
Relativism and Its Four Forms—Reasons to avoid making ethical decisions
Stakeholder Analysis—A framework considering who is affected by a business decision
Sarbanes-Oxley Act of 2002—A federal law attempting to legislate ethics in corporate America
Day 3
ACCOUNTING
Accounting Topics
Accounting Rules
Accounting Concepts
The Financial Statements
Ratio Analysis
Managerial Accounting
Accounting is the language of business. Corporations need to communicate their results to the world. Their audience includes employees, investors, creditors, customers, suppliers, and communities. Within the company, accounting information provides a means to control, evaluate, and plan operations. Whatever the audience or function, accounting is numbers. Accountants (a-count-ants) “count the beans” so that business activity can be recorded, summarized, and analyzed. Accountants have been around from the beginning of time, and professors don’t let you forget it.
In biblical times the accountants kept track of how much grain was stored in the community’s silos. How do you think King Solomon knew that there was only a thirty-day supply of grain during a drought? It was from the accountants. Throughout the ages accountants have kept track with their fingers, abacuses, and calculators. In modern times accounting has gone beyond the physical count of grain in storage. Accounting answers these basic questions about a business:
What does a company own?
How much does a company owe others?
How well did a company’s operations perform?
How does the company get the cash to fund itself?
“THE PHOENICIANS, OF COURSE, WERE THE FIRST ACCOUNTANTS.”
All corporate activities must eventually be measured in dollars, and that is where accounting comes in, like it or not. Although this area may appear tedious, you must have a working knowledge of accounting to function in the business world. Because knowledge is power, MBAs need to be literate in accounting to understand its function; more important, they must be able to ask for and use accounting information for decision-making purposes. Lawyers with accounting knowledge, for example, can interpret financial statements to get valuable information. In settlement negotiations, they become a force to be reckoned with. Because employee performance is often evaluated with accounting data, a knowledge of accounting is essential.
Having expert knowledge of complex accounting rules, however, is not the MBA’s goal. Therefore, my aim here is to give you the basics, not to make you a CPA. Because every function of business, including finance, operations, and marketing, uses the numbers generated by the accountants, it is important to grasp the fundamentals and read this chapter carefully.
GAAP RULES
Accounting has innumerable rules. You should not attempt to memorize them, but you should become sufficiently familiar with them to communicate with CPAs. Accounting rules set the standards so that financial reports of companies may be compared on an equal basis. Accounting’s governing rules are called Generally Accepted Accounting Principles (GAAP). These “Gap” rules have been developed over the years and are analogous to the precedents in the legal profession.
As new areas of business activity developed, the Financial Accounting Standards Board (FASB) wrote additional rules to deal with these situations. This body had generated over a hundred “Fasbee” rules over the years, and accountants referred to them by number.
In 2009, after decades of pronouncements and hundreds of rules, the FASB finally created the Accounting Standards Codification (ASC). Although it did not change the rules, the ASC organized all the rules into topics for easier reference. Currently, the ASC is considered the single source of Generally Accepted Accounting Principles. Accountants still use the old FASB rule numbers for reference.
Accounting is also an international concern, especially for multinational corporations. The International Accounting Standards Board (IASB) has created its own set of guidelines, called the International Financial Reporting Standards (IFRS). Accountants consider it a less-detailed “principles-based” system of rules, which permits companies to use their judgment. In contrast, the GAAP rules in the United States are “rules based” and companies must adhere to well-defined rules.
In 2002, the FASB and IASB agreed to begin the process of “convergence” of their systems. To date neither the details of the system nor an implementation date have been agreed upon.
THE FUNDAMENTAL CONCEPTS OF ACCOUNTING
To understand accounting, before you get into the numbers you first must become familiar with the underlying concepts. The rules do not tell the whole story. The following seven concepts and vocabulary are not a set of laws, but rather a guiding set of policies that underlie all accounting rules and reporting.
The Entity
Cash and Accrual Accounting
Objectivity
Conservatism
Going Concern
Consistency
Materiality
THE ENTITY
Accounting reports communicate the activities of a specific entity. The parameters covered by an accountant’s report must be clear. A reporting entity can be a single grocery store, a production plant, an entire business, or a conglomerate. For example, Darden Restaurants is a corporate entity. The Red Lobster and Olive Garden chains are also entities within it.
CASH BASIS VERSUS ACCRUAL ACCOUNTING
How the beans are being counted is important. Using cash basis accounting, transactions are recorded only when cash changes hands. Very small businesses can get all the accounting information they need from their checking account register. If a store pays two years’ rent in 2012, all the rent cost would be recorded as a cost in 2012, not over a period of two years. When a small machine shop purchases a power tool, its cost would be recorded when it was purchased, not over the useful life of the tool. Get the idea? Cash accounting tells you when and how much cash changed hands, but it doesn’t try to match the costs of conducting business with their related sales.
Most companies of any significant size use the accrual accounting method. Accrual accounting recognizes the financial effect of an activity when the activity takes place without regard to the movement of cash. Target’s rental costs are recorded each month with the benefits of occupancy. The cost of rivet guns at Boeing’s aircraft factory is recorded over the useful life of the tools as workers use them on the factory floor. Due to the dollar magnitude of Boeing’s purchases, cash accounting would distort its financial statements. Accrual accounting, as a consequence, raises two related issues, allocation and matching, because activity and cash movement most often do not occur at the same time.
Allocations to Accounting Periods. Because profit-and-loss statements reflect activities over a specific time, the per
iod of recognition is very important. If IBM sold a large computer on credit to Ford Motor Company on December 31, 2012, accrual accounting would record the sale in 2012 when the binding contract was signed, not when Ford actually laid out the cash in 2013. The sale could be recorded at that point, because it was then that Ford became legally bound to take delivery of the computer. That was also the period in which IBM’s accounting records would recognize the sale and its related costs and the profits. Ford, on the other hand, would recognize or accrue and allocate the cost of using the computer over its useful life.
Matching. Using the same logic as in allocation, sales made in one period are matched with their related selling costs or cost of goods sold (COGS) in the same accounting period. By matching sales dollars with their related costs, you can figure the profit a company has actually made. For example, when Safeway sells fresh produce on December 31, 2012, but doesn’t pay the supplier’s bill until 2013, accrual accounting will nevertheless record the costs related to those sales in 2012. Safeway’s sales in 2012 caused the expense, and therefore, the sales should have the related costs allocated against them in the same year. Without established policies for allocation and matching, accountants could easily manipulate financial reports by choosing when to record sales or expenses in order to cover up or delay bad results.
TRANSACTION DEFINITION AND OBJECTIVITY
Accounting records only contain transactions that have been “completed” and that have a “quantifiable” monetary value. Sales that have not been completed, but are thought of as “sure things,” cannot be recorded. Even if a trustworthy salesman from CaseIH swears that farmer Jones is a sure bet to buy a combine, the accountant would say no. For his accounting purposes, the sale has not taken place. CaseIH has not delivered the machinery, nor has the farmer signed an enforceable contract.
Accountants also have an objectivity rule to guide them when in doubt. There must be reasonable and verifiable evidence to support the transaction, or else it does not get recorded.
For example, the goodwill generated by a public service campaign cannot be recorded on the books. What value could you put on it? Archer Daniels Midland (ADM) regularly runs TV propaganda telling consumers how cheap food is in America compared with the rest of the world. How could an accountant objectively put a dollar value on the “good feelings” directed toward the company in the hearts of grateful Americans or incumbent congressmen? Patents and inventions are also hard to value. If Du Pont purchases a patent on a new chemical from an inventor for $1,000,000, it would be recorded on the books at $1,000,000. The patent has quantifiable market value. However, if a Du Pont scientist developed a new process in the lab, the accountants could not record the innovation until it was sold. The accountant would need to have a contract and a canceled check to substantiate the entry in the books.
In the case of WorldCom’s collapse in 2002, their telecommunications network assets were overvalued on the books by $3.3 billion. Accountants added the ongoing costs for local access to the value of their network when they should have been ordinary costs to place customers’ long-distance calls through local carriers.
ACCOUNTING CONSERVATION AND HISTORICAL COSTS
When companies incur losses that are probable and that can reasonably be estimated, accountants record them, even if the losses have not actually been realized. When gains are expected, accountants postpone recording them until they are actually realized. If in 2010 the management of International Paper Company anticipated a big profit in 2012 on the sale of their Manhattan corporate headquarters, they could not record their profit until 2012. Their move to Memphis was uncertain. Management could have changed their minds, or the real estate market could have tumbled. But for the sake of argument, let’s assume that International Paper discovered in 2010 that in 2012 it would have to clean a toxic-waste pool beneath its building. Management would have to hire a consultant to estimate the cost of cleanup and record that cost in 2010. In this way, the financial-statement readers would be warned of dark clouds looming over the horizon in 2012. In the same way, the ongoing lawsuits related to asbestos that many companies battle are contingent liabilities that must be reviewed annually and disclosed to ensure readers understand their possible impairment of corporate assets. Accounting conservatism governs the preparation of financial statements. When in doubt, be conservative. Accounting records contain only measurable and verifiable properties, debts, sales, and costs.
Conservatism also dictates that transactions be recorded at their historical costs. International Paper’s New York headquarters appreciated in value during the real estate boom, and yet this gain could not be recognized, even if the company had paid the Indians a few trinkets for it in the 1600s. The records continue to value the real estate at the cost of the beads given to Indians in exchange for the property. In the accountant’s mind, the value of the building may decline by the time it’s sold.
If the value of an asset falls below the recorded cost, that’s another story. Conservatism dictates that the loss be recognized today. To do otherwise could mislead the reader of a financial statement to believe that the assets represented are at least worth their historical cost.
The value of goods held in inventory is also stated at historical cost. Even if prices change, the objective price is that which the business paid historically. There must be verifiable purchase orders and bills to support the cost. For instance, if Staples Office Supplies carries notepaper produced by International Paper on its books, it would value the paper at cost. Even if reorder costs for the same inventory had gone up, the cost of the merchandise on hand would remain at Staples’ historical cost on the books.
GOING CONCERN
Financial statements describe businesses as operating entities. The values assigned to items in the accounting records assume that the business is a going concern. Accountants presume that companies will continue to operate in the foreseeable future; therefore, the values assigned in the financial statements are not “fire sale” prices. They use historical costs, as you already know. Steel-rolling equipment, for example, is expensive to purchase. It may have great value to an ongoing manufacturing company such as US Steel, but put up for sale at a bankruptcy auction, its value would be pennies on the dollar. Used industrial equipment has limited value to outsiders. Accordingly, accounting records use historical costs assuming that the company is using its machinery productively.
CONSISTENCY
The consistency concept is crucial to readers of financial statements. Accounting rules demand that an entity use the same accounting rules year after year. That enables an analyst to compare past with current results. This rule, like the others presented earlier, tries to minimize the temptations of accounting monkey business that businessmen like to engage in to cover up bad results.
The consistency rule insists that companies value their inventory the same way from year to year. The major methods available are a FIFO (First In First Out) or LIFO (Last In First Out) basis. Using FIFO, the oldest purchase costs of goods are recognized as costs “first,” leaving the most recently purchased cost of goods in the value of inventory held for sale. Using LIFO, the “last” costs of goods are recognized as costs first, leaving the oldest costs in the value of inventory. The accounting method is independent of the physical movement of inventory. It is just an accounting method. As you might imagine, if you could change accounting methods at will, a crafty accountant could manipulate the financial statements from year to year. Consistency requires that the same accounting method be used from year to year.
As an example of FIFO and LIFO methods, consider a coin dealer who has only two identical gold coins in his showcase. One he bought in 1965 for $50, and the other he purchased in 2012 for $500. A numismatist comes to his shop and buys one of the coins for $1,000. Using FIFO, the shop owner would record a sale of $1,000, a cost of $50, and a resulting profit of $950 in his accounting records. His remaining inventory would reflect one coin at a historical cost of $500. The
cost of the first coin purchased was the first to be recorded as a cost of goods sold. Using the alternate LIFO method, the owner would record a cost of $500, and a profit of only $500. His inventory records would show a coin with a value of $50. The last cost was used first. Which coin was actually sold, the 1965 or the 2012 acquisition, does not matter. It’s only an accounting method. But the method chosen dramatically affects the way a company calculates profits and values inventory. That does matter.
If a change of accounting method is necessary for a “substantial” reason, the financial statements must state the reason in the footnotes located at the end of the report. The footnotes must also state how the change affected the profits and asset values that year. You can run, but you cannot hide from the accountants.
MATERIALITY
An important caveat of financial statements is that they are not exact to the penny, even though you would expect that tenacious accountants would produce such reports. In fact, they are only materially correct so that a reader can get a fairly stated view of where an entity stands. Financial statements give a materially accurate picture so that a reasonable person can make informed decisions based on the report. For a small soda fountain’s financial statements, a one-hundred-dollar error may materially distort the records, while a ten-dollar error may not. In contrast, huge multinational companies like Coca-Cola may have million-dollar errors in their reports and not materially distort the picture for decision making.
By now you can begin to develop an insight into how accountants think about businesses and possibly why they are, for the most part, conservative even as people. In my previous edition I showed a cartoon that poked fun at the conservatism of accountants. I’d found it on a bulletin board at Arthur Andersen LLP, where I had worked as an auditor. Arthur strayed in the years after I left and collapsed in 2001 in connection with its fraud involving the collapse of Enron. That left only the Big Four accounting firms: PricewaterhouseCoopers LLP, KPMG LLP, Deloitte Touche Tohmatsu LLP, and Ernst & Young LLP. In keeping with the changes I have selected a different cartoon, below.
The Ten-Day MBA 4th Ed. Page 8