Module 1

Business Activities and

Accounting Information
PART 1
Learning Objectives
1. Identify the users of accounting information and discuss the costs and benefits of disclosure. (p. 1)

2. Describe a company’s business activities and explain how these activities are represented by the accounting
equation. (p. 4)

Demand for Accounting Information

Accounting can be defined as the process of recording, summarizing, and analyzing financial
LO1 Identify
transactions. While accounting information attempts to satisfy the needs of a diverse set of users, the users of
the accounting information a company produces can be classified into two categories: accounting
Financial accounting—designed primarily for decision makers outside of the company
information and
n discuss the costs
n Managerial accounting—designed primarily for decision makers within the company and benefits of
disclosure.
Financial accounting reports include information about company profitability and financial health.
This information is useful to various economic actors who wish to engage in contracts with the firm,
including investors, creditors, employees, customers, and governments. Managerial accounting in-
formation is not reported outside of the company because it includes proprietary information about
the profitability of specific products, divisions, or customers. Company managers use managerial ac-
counting reports to make decisions such as whether to drop or add products or divisions, or whether
to continue serving different types of customers. This text focuses on understanding and analyzing
financial accounting information.

EXHIBIT 1.1 Information Needs of Decision Makers Who Use Financial and Managerial Accounting

Decision Makers Decisions Information

Accounting
Financial

• Investors and analysts • Buy or sell stock? • Sales and costs

• Creditors • Lend or not? • Cash in and out
• Suppliers and customers • Purchase/sell goods or not? • Assets and liabilities
Accounting
Managerial

• Top management • Develop new strategy? • Product sales and costs

• Marketing teams • Launch a new product or not? • Department performance reports
• Production and operations • Manage operations • Budgets and quality reports

Who Uses Financial Accounting Information?

Demand for financial accounting information derives from numerous users including:
n Shareholders and potential shareholders
n Creditors and suppliers

Copyright 2014 Cambridge Business Publishers

1

01_FABC_ch01.indd 1 6/9/15 2:43 PM

 Module 1: PART 1 | Business Activities and Accounting Information

n Managers and directors

n Financial analysts
n Other users

Shareholders and Potential Shareholders Corporations are the dominant form of busi-
FYI
ness organization for large companies around the world, and corporate shareholders are one im-
Shareholders
of a corporation are
portant group of decision makers that have an interest in financial accounting information. A its owners; although
corporation is a form of business organization that is characterized by a large number of owners managers can own
who are not involved in managing the day-to-day operations of the company.1 A corporation exists stock in the corporation,

as a legal entity that issues shares of stock to its owners in exchange for cash and, therefore, the most stockholders are

owners of a corporation are referred to as shareholders or stockholders.

not managers.

Because the shareholders are not involved in the day-to-day operations of the business, they
rely on the information in financial statements to evaluate management performance and assess the
company’s financial condition.
In addition to corporations, sole proprietorships and partnerships are also common forms of
business ownership. A sole proprietorship has a single owner who typically manages the daily
operations. Small family-run businesses, such as corner grocery stores, are commonly organized
as sole proprietorships. A partnership has two or more owners who are also usually involved in
managing the business. Many professionals, such as lawyers and CPAs, organize their businesses as
partnerships.
Most corporations begin as small, privately held businesses (sole proprietorships or partner-
ships). As their operations expand, however, they require additional capital to finance their growth.
One of the principle advantages of a corporation over sole proprietorships and partnerships is the
ability to raise large amounts of cash by issuing (selling) stock. For example, as Nike grew from a
small business with only two owners into a larger company, it raised the funds needed for expansion
by selling shares of Nike stock to new shareholders. In the United States, large corporations can raise
funds by issuing stock on organized exchanges, such as the New York Stock Exchange (NYSE) or
NASDAQ (which is an acronym for the National Association of Securities Dealers Automated Quo-
tations system). Corporations with stock traded on public exchanges are known as publicly traded
corporations or simply public corporations.
Financial statements and the accompanying footnotes provide information on the risk and return
associated with owning shares of stock in the corporation, and they reveal how well management has
performed. Financial statements also provide valuable insights into future performance by revealing
management’s plans for new products, new operating procedures, and new strategic directions for
the company as well as for their implementation. Corporate management provides this information
because the information reduces uncertainty about the company’s future prospects which, in turn,
increases the market price of its shares and helps the company raise the funds it needs to grow.

Creditors and Suppliers Few businesses rely solely on shareholders for the cash needed FYI Financial
to operate the company. Instead, most companies borrow from banks or other lenders known as statements are typically
creditors. Creditors are interested in the potential borrower’s ability to repay. They use financial required when a
accounting information to help determine loan terms, loan amounts, interest rates, and collateral. business requests a

In addition, creditors’ loans often include contractual requirements based on information found in bank loan.

the financial statements.

Suppliers use financial information to establish credit sales terms and to determine their long-
term commitment to supply-chain relationships. Supplier companies often justify an expansion of
their businesses based on the growth and financial health of their customers. Both creditors and
suppliers rely on information in the financial statements to monitor and adjust their contracts and
commitments with a company.

1
Most countries have business forms that are similar in structure to those of a U.S. corporation, though they are referred
to by different names. For example, while firms that are incorporated in the United States have the extension, “Inc.” ap-
pended to their names, similar firms in the United Kingdom are referred to as a Public Limited Company, which has the
extension “PLC.”

Copyright 2014 Cambridge Business Publishers 2

01_FABC_ch01.indd 2 6/9/15 2:43 PM

 Module 1: PART 1 | Business Activities and Accounting Information

Managers and Directors Financial statements can be thought of as a financial report card
for management. A well-managed company earns a good return for its shareholders, and this is
reflected in the financial statements. In most companies, management is compensated, at least in
part, based on the financial performance of the company. That is, managers often receive cash
bonuses, shares of stock, or other incentive compensation that is linked directly to the information
in the financial statements.
Publicly traded corporations are required by law to have a board of directors. Directors are FYI The Sarbanes-
elected by the shareholders to represent shareholder interests and oversee management. The board Oxley Act requires
hires executive management and regularly reviews company operations. Directors use financial issuers of securities to
accounting information to review the results of operations, evaluate future strategy, and assess disclose whether they

management performance. have a code of ethics

for the senior officers.
Both managers and directors use the published financial statements of other companies to
perform comparative analyses and establish performance benchmarks. For example, managers
in some companies are paid a bonus for financial performance that exceeds the industry average.

B U SIN ESS IN SIGH T

Recent court cases involving corporations such as Enron, Tyco, and WorldCom (now MCI) have found
executives, including several CEOs, guilty of issuing fraudulent financial statements. These executives
have received substantial fines and, in some cases, long jail sentences. These trials have resulted in wide-
spread loss of reputation and credibility among corporate boards.

Financial Analysts Many decision makers lack the time, resources, or expertise to efficiently
and effectively analyze financial statements. Instead, they rely on professional financial analysts,
such as credit rating agencies like Moody’s investment services, portfolio managers, and security
analysts. Financial analysts play an important role in the dissemination of financial information and
often specialize in specific industries. Their analysis helps to identify and assess risk, forecast perfor-
mance, establish prices for new issues of stock, and make buy or sell recommendations to investors.

Other Users of Financial Accounting Information External decision makers include

many users of accounting information in addition to those listed above. For example, prospective
employees often examine the financial statements of an employer to learn about the company be-
fore interviewing for or accepting a new job.
Labor unions examine financial statements in order to assess the financial health of firms
prior to negotiating labor contracts on behalf of the firms’ employees.
Customers use accounting information to assess the ability of a company to deliver products
or services and to assess the company’s long-term reliability. Tax agencies use financial account-
ing to help establish and implement tax policies. Other government agencies rely on accounting
information to develop and enforce regulations, including public protection, price setting, import-
export, and various other policies. Timely and reliable information is crucial to effective regula-
tory policy. Moreover, accounting information is often used to assess penalties for companies that
violate various regulations.

Costs and Benefits of Disclosure

The act of providing financial information to external users is called disclosure. As with every de-
cision, the benefits of disclosure must be weighed against the costs of providing the information.
One reason companies are motivated to disclose financial information to external decision
makers is that it often lowers financing and operating costs. For example, when a company applies
for a loan, the bank uses the company’s financial statements to help determine the appropriate
interest rate. Without adequate financial disclosures in its financial statements, the bank is likely
to demand a higher interest rate or perhaps not make the loan at all. Thus, in this setting, a benefit
of financial disclosure is that it reduces the company’s cost of borrowing.
While there are benefits from disclosing financial information, there are also costs. Besides
the obvious cost of hiring accountants and preparing the financial statements, financial disclosures

Copyright 2014 Cambridge Business Publishers 3

01_FABC_ch01.indd 3 6/9/15 2:43 PM

 Module 1: PART 1 |  Business Activities and Accounting Information

can also result in costs being imposed by competitors. It is common practice for managers to scru-
tinize the financial statements of competitors to learn about successful products, new strategies,
innovative technologies, and changing market conditions. Thus, disclosing too much information
can place a company at a competitive disadvantage. Disclosure can also raise investors’ expecta-
tions about a company’s future profitability. If those expectations are not met, they may bring
litigation against the managers.
There are also political costs that are potentially associated with accounting disclosure. Highly
visible companies, such as defense contractors and oil companies, are often the target of scrutiny by
the public and by government officials. When these companies report unusually large accounting
profits, they are often the target of additional regulation or increased taxes.
Stock market regulators impose disclosure standards for publicly traded corporations, but the
nature and extent of the required disclosures vary substantially across countries. Further, because
the requirements only set the minimum level of disclosure, the quantity and quality of information
provided by firms will vary. This variation in disclosure ultimately reflects differences among com-
panies in the benefits and costs of disclosing information to the public.

Business Activities
Businesses produce accounting information to help develop strategies, attract financing, evaluate
LO2 Describe
investment opportunities, manage operations, and measure performance. Before we can attempt a company’s
to understand the information provided in financial statements, we must understand these business business activities
activities. That is, what does a business actually do? For example: and explain how
these activities
n Where does a company such as Nike find the resources to develop new products and open are represented
new retail stores? by the accounting
n What new products should Nike bring to market? equation.

n How much should Nike spend on product development? On advertising? On executive

compensation?
n How does Nike’s management determine if a product is a success?
Questions such as these define the activities of Nike and other companies.
Exhibit 1.2 illustrates the activities of a typical business. All businesses plan business ac-
tivities, finance those activities, invest resources in those activities, and then engage in operating
activities. Companies conduct all these activities while confronting a variety of external forces,
including competition from other businesses, government regulation, economic conditions and
market forces, and changing preferences of customers. The financial statements provide informa-
tion that helps us understand and evaluate each of these activities.

Exhibit 1.2 Business Activities

g Pla
Competition nin nn
ing Regulation
an
Pl Stock
Certificate

S
Cer tock S
tific
ate Cer tock
tific

Investing
ate

Activities Financing
Activities

Operating
Pla Activities
Customer Preferences nn g Economic Conditions
ing nin
an
Pl

Copyright 2014 Cambridge Business Publishers

4

01_FABC_ch01.indd 4 6/9/15 2:43 PM

 Module 1: PART 1 |  Business Activities and Accounting Information

Planning Activities
A company’s goals, and the strategies adopted to reach those goals, are the product of its planning
activities. Nike, for example, states that its mission is “To bring inspiration and innovation to
every athlete in the world” adding “If you have a body, you are an athlete.” However, in its 2011
annual report to shareholders, Nike management suggests another goal that focuses on financial
success and earning a return for the shareholders.

Our goal is to deliver value to our shareholders by building a profitable global portfolio of
branded footwear, apparel, equipment, accessories and service businesses.

As is the case with most businesses, Nike’s primary goal is to create value for its owners, the
shareholders. How the company plans to do so is the company’s strategy.
A company’s strategic (or business) plan describes how it plans to achieve its goals. The
plan’s success depends on an effective review of market conditions. Specifically, the company
must assess both the demand for its products and services, and the supply of its inputs (both labor
and capital). The plan must also include competitive analyses, opportunity assessments, and con-
sideration of business threats. The strategic plan specifies both broad management designs that
generate company value and tactics to achieve those designs.
Most information in a strategic plan is proprietary and guarded closely by management. How-
ever, outsiders can gain insight into planning activities through various channels, including news-
papers, magazines, and company publications. Understanding a company’s planning activities
helps focus accounting analysis and place it in context.

Investing Activities
Investing activities consist of acquiring and disposing of the resources needed to produce and
sell a company’s products and services. These resources, called assets, provide future benefits
to the company. Companies differ on the amount and mix of these resources. Some companies
require buildings and equipment while others have abandoned “bricks and mortar” to conduct
business through the Internet.
Some assets that a company invests in are used quickly. For instance, a retail clothing store
hopes to sell its spring and summer merchandise before purchasing more inventory for the fall
and winter. Other assets are acquired for long-term use. Buildings are typically used for several
decades. The relative proportion of short-term and long-term investments depends on the type of

Exhibit 1.3 Relative Proportion of Short-term and Long-term Assets

Short-term Assets Long-term Assets

Verizon

Procter & Gamble

PepsiCo

Southwest Airlines

Pfizer

Home Depot

Walgreens

Cisco Systems

Dell

Nike

0% 20% 40% 60% 80% 100%

Copyright 2014 Cambridge Business Publishers

5

01_FABC_ch01.indd 5 6/9/15 2:43 PM

 Module 1: PART 1 | Business Activities and Accounting Information

business and the strategic plan that the company adopts. For example, Nike has relatively few
long-term assets because it outsources most of the production of its products to other companies.
The graph in Exhibit 1.3 compares the relative proportion of short-term and long-term as-
sets held by Nike and nine other companies. Dell has adopted a business model that requires
very little investment in long-term resources. A majority of its investments are short-term as-
sets. In contrast, Verizon, Southwest Airlines, and Procter & Gamble all rely heavily on long-
term investments. These companies hold relatively small proportions of short-term assets.
This mix of long-term and short-term assets is described in more detail in subsequent modules.

Financing Activities B
o
nd

Investments in resources require funding, and financing activities refer to the methods companies
nd
o
B

nd
o
B

use to fund those investments. Financial management is the planning of resource needs, including
the proper mix of financing sources.
Companies obtain financing from two sources: equity (owner) financing and creditor (non-
owner) financing. Equity financing refers to the funds contributed to the company by its owners along FYI Creditors
with any income retained by the company. One form of equity financing is the cash raised from the are those to whom a
sale (or issuance) of stock by a corporation. Creditor (or debt) financing is funds contributed by non- company owes money.
owners, which create liabilities. Liabilities are obligations the company must repay in the future.
One example of a liability is a bank loan. We draw a distinction between equity and creditor fi-
nancing for an important reason: creditor financing imposes a legal obligation to repay, usually
with interest, and failure to repay amounts borrowed can result in adverse legal consequences such
as bankruptcy. In contrast, equity financing does not impose an obligation for repayment.
Exhibit 1.4 compares the relative proportion of creditor and equity financing for Nike and other
companies. Verizon uses liabilities to finance 63% of its resources. In contrast, pharmaceutical FYI It is useful to
company Pfizer relies more heavily on its equity financing, receiving 56% of its financing from separate equity from
creditors. Nike has the lowest proportion of creditor financing in this sample of companies with creditor financing when
just 34% of its assets financed by nonowners. analyzing a company’s
performance.

EXHIBIT 1.4 Relative Proportion of Financing Sources

Credit Financing Equity Financing

Dell

PepsiCo

Verizon

Southwest Airlines

Pfizer

Home Depot

Procter & Gamble

Cisco Systems

Walgreens

Nike

0% 20% 40% 60% 80% 100%

As discussed in the previous section, companies acquire resources, called assets, through
investing activities. The cash to acquire these resources is obtained through financing activities,
which consist of owner financing, called equity, and creditor financing, called liabilities (or debt).
Thus, we have the following basic relation: investing equals financing. This equality is called the
accounting equation, which is expressed as:

Copyright 2014 Cambridge Business Publishers 6

01_FABC_ch01.indd 6 6/9/15 2:43 PM

 Module 1: PART 1 |  Business Activities and Accounting Information

Investing 5 Creditor Financing  Owner Financing

Assets  Liabilities  Equity

At fiscal year-end 2011, the accounting equation for Nike was as follows ($ millions):

$14,998 5 $5,155 1 $9,843

By definition, the accounting equation holds for all companies at all times. This relation is a very
powerful tool for analyzing and understanding companies, and we will use it often throughout the
text.

Operating Activities
Operating activities refer to the production, promotion, and selling of a company’s products
and services. These activities extend from a company’s input markets, involving its suppliers,
to its output markets, involving its customers. Input markets generate operating expenses (or
costs) such as inventory, salaries, materials, and logistics. Output markets generate operating
revenues (or sales) from customers. Output markets also generate some operating expenses
such as for marketing and distributing products and services to customers. When operating
revenues exceed operating expenses, companies report operating income, also called operat-
ing profit or operating earnings. When operating expenses exceed operating revenues, com-
panies report operating losses.
Revenue is the increase in equity resulting from the sale of goods and services to custom-
ers. The amount of revenue is determined before deducting expenses. An expense is the cost
incurred to generate revenue, including the cost of the goods and services sold to customers
as well as the cost of carrying out other business activities. Income, also called net income,
equals revenues minus expenses, and is the net increase in equity from the company’s operat-
ing activities.

Income  Revenues  Expenses

For fiscal year 2011, Nike reported revenues of over $20 billion, yet its reported income was a
fraction of that amount—just over $2.1 billion.

BUSIN ESS IN SIGH T

Each year, Fortune magazine ranks the 500 largest corporations in the United Nike’s Net Income as
a Fraction of Revenue
States based on total revenues. For 2012, which is based on fiscal 2011 fi-
nancial results, Nike ranked 136th on the Fortune 500 list with revenues of just Expenses
90%
over $20 billion. The company also ranked 97th in profits, with net income of
approximately $2.1 billion. For comparison, the largest corporation was Exxon-
10%
Mobil, with revenues of $452.9 billion and $41.1 billion in net income. (Source:
http://money.cnn.com/magazines/fortune/fortune500/2012/full_list/) Net
Income

Summary
Identify the users of accounting information and discuss the costs and benefits of disclosure. (p. 1) LO1

n There are many diverse decision makers who use financial information.
n The benefits of disclosure of credible financial information must exceed the costs of providing the
information.

Copyright 2014 Cambridge Business Publishers

7

01_FABC_ch01.indd 7 6/9/15 2:43 PM

 Module 1: PART 1 |  Business Activities and Accounting Information

Describe a company’s business activities and explain how these activities are represented by the LO2
accounting equation. (p. 4)
■ To effectively manage a company or infer whether it is well managed, we must understand its
activities as well as the competitive and regulatory environment in which it operates.
n All corporations plan business activities, finance and invest in them, and then engage in operations.
n Financing is obtained partly from stockholders and partly from creditors, including suppliers and
lenders.
n Investing activities involve the acquisition and disposition of the company’s productive resources
called assets.
n Operating activities include the production of goods or services that create operating revenues (sales)
and expenses (costs). Operating profit (income) arises when operating revenues exceed operating
expenses.

Copyright 2014 Cambridge Business Publishers

8

01_FABC_ch01.indd 8 6/9/15 2:43 PM