Chapter 1: Accounting in the business environment

This first chapter explains why accounting is called the language of business. Every decision an investor, lender or manager takes about a company is, in the end, based on numbers that accountants produce. The chapter introduces who uses accounting information, which organisations set the rules, the basic assumptions behind the numbers, the accounting equation on which all of bookkeeping rests, and the four financial statements. Everything in the rest of the course builds on these foundations, so it pays to know them by heart.

Case: the Radboud Coffee Company

The course opens with an experiment. Students receive an imaginary €1,000 and hear a co-founder pitch his coffee company: Vietnamese beans, a sustainable supply chain, support for social causes, a list of well-known retailers and an attractive team. Students then decide to invest or not. Afterwards it is revealed that the company is modelled on a real Los Angeles coffee start-up that raised about $3 million in five funding rounds.

The lessons of the case are the learning goals of the whole course:

1. Investment and business decisions are hard to make.
2. Information helps to make better decisions, but not all information has the same value or weight. A nice story, logos of customers and pictures of coffee fields say little about whether the company earns money.
3. Making a sound business decision without accounting or financial data is nearly impossible. What you would have wanted to see is revenue, costs, profit, cash and debt.
4. Therefore understanding accounting helps you make better decisions, and that is exactly why accounting is the language of business.

What accounting is and who uses it

Accounting is the information system that measures business activities, processes that information into reports and communicates the results to decision makers. The decision makers fall into two groups, and each group has its own branch of accounting:

Chapters 1 to 10 of this course are financial accounting; chapters 11 to 16 are managerial accounting.

The organisations and rules that govern accounting

Because outsiders must be able to trust and compare financial statements, financial accounting follows agreed rules called Generally Accepted Accounting Principles (GAAP).

• In the United States the Financial Accounting Standards Board (FASB) creates the standards and the Securities and Exchange Commission (SEC) supervises the financial markets.
• In Europe the International Accounting Standards Board (IASB) publishes the International Financial Reporting Standards (IFRS), used or required in more than 166 jurisdictions; smaller companies may follow national GAAP. Supervision lies with the European Securities and Markets Authority (ESMA) and national authorities (in the Netherlands the AFM).

Useful accounting information has two fundamental qualities: it is relevant (it can make a difference to a decision) and it gives a faithful representation (complete, neutral and free from error).

Basic assumptions and principles

• Economic entity assumption. The business is a separate unit, apart from its owners. The owner's private car is not on the company's books. An entity can be a sole proprietorship, a partnership, a corporation or a limited-liability company (LLC).
• Cost principle. Acquired assets and services are recorded at their actual (historical) cost, the price actually paid, not at what someone thinks they are worth.
• Going concern assumption. The entity is expected to keep operating for the foreseeable future. That is why a building is valued at cost minus depreciation and not at what it would fetch in a fire sale.
• Monetary unit assumption. All items are measured in one monetary unit (dollars, euros), and changes in its purchasing power are ignored.

A corporation, the form used in the textbook, has typical features: it is a separate legal entity, it has continuous life and ownership is easily transferred, there is no mutual agency (a stockholder cannot bind the company), stockholders have limited liability, ownership and management are separated, the corporation pays its own taxes and it is subject to more government regulation.

The accounting equation

The accounting equation is the basic tool of accounting. It says that the resources of a business are always exactly equal to the claims on those resources:

• An asset is an economic resource that is expected to benefit the business in the future: cash, merchandise inventory, furniture, land.
• A liability is a debt owed to creditors. Many liabilities have payable in their name: accounts payable, notes payable, salaries payable.
• Equity (stockholders' equity) is the owners' claim on the assets: what remains after the liabilities are paid. It has two parts: contributed capital (paid-in capital, money the owners put in, recorded as common stock) and retained earnings (profits earned and kept in the business, not paid out).

Equity increases through owner contributions and revenues (amounts earned by delivering goods or services). Equity decreases through dividends (distributions of earnings to stockholders) and expenses (the costs of selling goods or services). That gives the expanded equation:

When revenues exceed expenses the company has a net income; when expenses exceed revenues it has a net loss. Note that dividends are not an expense: they are a distribution of profit, not a cost of earning it.

Analysing transactions

Every transaction affects at least two items, and after each transaction the equation still balances. The textbook follows Smart Touch Learning, an e-learning company. Its first month:

End balances: cash $9,000, accounts receivable $1,000, supplies $500, land $20,000, so total assets are $30,500. On the other side: accounts payable $200, common stock $30,000 and retained earnings $300 (revenues 8,500 − expenses 3,200 − dividends 5,000), also $30,500.

The four financial statements

Financial statements are business documents that communicate the information needed for decisions. They are prepared in a fixed order because each feeds the next.

For Smart Touch Learning's first month: net income = 8,500 − 3,200 = $5,300. Retained earnings: 0 + 5,300 − 5,000 = $300, which appears on the balance sheet. The cash flow statement shows operating cash flows of +$4,000 (5,500 + 2,000 received minus 3,200 + 300 paid), investing −$20,000 (land) and financing +$25,000 (30,000 from the owner minus 5,000 dividends): together +$9,000, exactly the cash on the balance sheet.

Evaluating performance: return on assets

One of many tools to judge performance is return on assets (ROA): how much profit the company earns on each dollar of assets it uses.

Example from the slides: the retailer Kohl's reported 2018 net income of $801 million, beginning total assets of $13,389 million and ending total assets of $12,469 million. Average total assets = (13,389 + 12,469) / 2 = $12,929 million, so ROA = 801 / 12,929 = 6.2%. The average is used because net income is earned over the whole year, while assets are measured at two moments.

An accounting riddle

A thief steals a €100 note from a shop's cash register. He uses that note to buy €70 of goods in the same shop and receives €30 change. Outside he loses €10, which another person finds and donates to charity. How much did the shop owner lose? Think like an accountant and record only what happens to the shop: cash first goes down €100 (theft), then up €100 (the note comes back as payment) and down €30 (change), and inventory goes down €70. In total the shop loses €100: €30 in cash and €70 in goods. The lost and donated €10 has nothing to do with the shop's books (economic entity assumption).