Short Introduction to Accounting An introduction to the fundamentals of accounting and how it is used that will help students apply accounting as a usable, everyday business tool. It adopts an intuitive, informal approach to describe basic principles – what they are, why they exist and how they are used – to help students see the connections between different parts of accounting and the rest of the business world. Written by an award-winning teacher, it encourages students to engage with the material by using questions and worked examples to test knowledge and understanding as they read. It includes a glossary of i nancial terms that is a useful guide to the language of business. RICHARD BARKER is Senior Lecturer in Accounting at the Judge Business School, University of Cambridge, and Visiting Professor in Accounting at the Saïd Business School, University of Oxford. Cambridge Short Introductions to Management Series editors: Cary L. Cooper CBE, Lancaster University Thomas G. Cummings, University of Southern California The purpose of this innovative series is to provide short, authoritative, reasonably priced books for students taking a i rst course in Management, particularly at MBA and Master’s level. The books include concise coverage of the key concepts taught in the core subjects, as well as suggestions for further study. Written by a team of experts from the world’s leading business schools, these books are highly recommended for anyone preparing to study for an advanced management qualii cation. For supplementary materials, visit the series website: w ww.cambridge.org/csi About the series editors: Cary L. Cooper is Distinguished Professor of Organizational Psychology and Health, and Pro Vice-Chancellor at Lancaster University. He is the author/editor of over 120 books and is a frequent contributor to national newspapers, TV and radio. Professor Cooper is a past president of the British Academy of Management, a companion of the Chartered Management Institute and one of the i rst UK-based fellows of the (American) Academy of Management. In 2001, Professor Cooper was awarded a CBE in the Queen’s Birthday Honours List for his contribution to occupational safety and health. Thomas G. Cummings is a leading international scholar and consultant on strategic change and designing high-performance organisations. He is Professor and Chair of the Department of Management and Organization at the Marshall School of Business, University of Southern California. He has authored over 70 articles and 22 books. Professor Cummings was the 61st President of the Academy of Management, the largest professional association of management scholars in the world with a total membership of over 19,000. Short Introduction to Accounting Richard Barker CAMBRIDGE UNIVERSITY PRESS Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo, Delhi, Tokyo, Mexico City Cambridge University Press The Edinburgh Building, C ambridge CB2 8RU, UK Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: w ww.cambridge.org/9781107610118 © Richard Barker 2 011 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2011 Printed in the United Kingdom at the University Press, Cambridge A catalogue record for this publication is available from the British Library Library of Congress Cataloguing in Publication data Barker, Richard. Short introduction to accounting / Richard Barker. ISBN 978-1-107-01551-7 (hardback) 1. Accounting. I. Title. HF5636.B37 2011 657–dc22 2011002699 ISBN 978-1-107-01551-7 Hardback ISBN 978-1-107-61011-8 Paperback Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party Internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate. Contents List of fi gures vi List of tables v ii Introduction 1 Part I Introduction to Part I 1 A guided tour of the i nancial statements 1 3 2 The need for i nancial information 2 7 3 Keeping track of economic activity 47 4 Summary of the foundations of accounting 6 5 Part II Introduction to Part II 5 The accounts as a lens on growth 87 6 Measuring value creation 99 7 Understanding risk 111 8 Building a corporate valuation model 1 28 Appendix 1 Glossary of accounting terms 1 42 Appendix 2 Further reading 1 53 Index 1 55 v Figures 7.1 Breakeven analysis 115 7.2 C ost categories 1 18 vi Tables 1.1 A lbert’s cash l ow statement for the past i nancial year 14 1.2 Albert’s income statement for the past i nancial year 1 7 1.3 A lbert’s balance sheet on his i rst day of business 21 1.4 Albert’s balance sheet at the end of the i nancial year 2 1 1.5 R etail company 2 4 2.1 Sarah’s bank statement 3 0 2.2 Sarah’s cash l ow statement 3 2 2.3 O perating cash l ow plus accruals equals proi t 37 2.4 O pening balance sheet 4 0 2.5 P iecing together all of Sarah’s i nancial activities 4 2 2.6 Sarah’s summary i nancial statements 4 4 3.1 I mpact of Sarah’s transactions and events on the balance sheet 4 9 3.2 Summary of changes to Sarah’s balance sheet 5 1 3.3 C hanges to the balance sheet 52 3.4 Different types of change to the balance sheet 5 5 3.5 ‘T’ accounts 5 9 3.6 S arah’s general ledger 6 0 3.7 C onsulting i rm’s general ledger 63 3.8 C onsulting i rm’s i nancial statements 63 4.1 Journal entries for the i rst year 74 4.2 Financial statements for the i rst year 7 6 4.3 J ournal entries for the second year 8 1 4.4 F inancial statements for the second year 8 2 5.1 Nine different routes to zero net cash l ow 89 5.2 A summary of the nine different routes to zero net cash l ow 9 1 5.3 Balance sheets for the nine companies 9 2 5.4 B alance sheets with depreciation and increase in accounts receivable 9 5 5.5 Income statements 9 6 6.1 Proi tability and growth 1 02 vii 6.2 Economic proi t 1 08 6.3 V ariation in economic proi t 1 08 7.1 Operating leverage 1 12 7.2 E ffects of operating leverage 1 14 7.3 Financial leverage 120 7.4 E ffects of i nancial leverage 125 7.5 Financial leverage when buying a house 126 8.1 I ncome statement 1 31 8.2 B alance sheet 1 32 8.3 Cash l ow statement 134 8.4 D etermining free cash l ow 1 35 8.5 Valuation of cash l ows 1 36 8.6 Corporate valuation 1 40 viii List of tables Introduction Accounting: a subject widely important yet not widely understood Your choice to read this book is probably determined by a perception that accounting is important, coupled with a sense that your own knowledge of accounting, at least at present, is insufi cient for your needs. In this introductory chapter, we will explore these motivations – in effect, why you are reading this book. This will be important in setting the scene for the rest of the book. The focus will be on you, on why an understanding of accounting is important for you, and on how best you can get your mind around the subject. We will i rst explore w hy knowledge of accounting is important. This will help in motivating your study and in contextualising and making sense of the content of this book. We will then explore why accounting is typically perceived to be a difi cult and impenetrable subject. This concerns a more subtle motivation for you, namely that you have probably chosen an introductory book because anything else might feel daunting. Such feelings are typical, but actually may not be well placed. Understanding why people typically i nd accounting difi cult, or perhaps more accurately why they perceive it to be difi cult, will help greatly in making it simpler and in giving you coni dence in your learning. Before continuing reading, it will be helpful to pause, and for you to ask yourself why you think that accounting is important. Why do you want to learn about it? What do you expect to be able to understand or do, having read this book, that you cannot currently understand or do? Why do you feel that your current knowledge is insufi cient for your needs? Are there specii c issues that you have in mind, or do you simply feel a general sense that your understanding is not what you would like it to be? These questions are important. If you have a clear objective in mind in reading this book, and if that objective is reasonable and achievable, then you are in good shape. It will be straightforward to judge whether the book has the content that you need, and whether your expectations are likely to be met. It is more likely, however, that the purpose of Introduction 1 learning accounting is not entirely clear. You may believe the accepted wisdom, held among peers and others, that accounting is important, yet it might not be clear why this is so. In what ways, for example, does accounting actually help in understanding business performance and making better decisions? It is important, as we will see, to try to explore these issues more fully. By so doing, we will establish a more powerful foundation for learning. WWhhyy iiss aaccccoouunnttiinngg iimmppoorrttaanntt?? There is a very simple reason why accounting is important. As a society, we care about wealth, including whether wealth is increasing or decreasing, and whether it is distributed equitably. In order to keep track of wealth, we need a measurement system. Accounting i s this system. If we want to know the proi t or loss made by an organisation, we refer to its accounts; we are seeking to understand fi nancial performance , which is reported in an income statement (otherwise known as a proi t and loss account). If we want to know the wealth of an organisation, we also refer to its accounts; our concern here is with fi nancial position , which is reported in a balance sheet. Now, there is a lot more to be said about accounting than this, of course, but in essence the importance of accounting is simply that it measures i nancial activity. It is the measurement system with which we evaluate i nancial performance and i nancial position. This simple conclusion is likely to have several implications for you, and for the value to you in reading this book. These can be summarised as follows. Financial decision making A ccounting data provide the input to a whole range of decisions, for example the pricing and costing of products and services, the acquisition or divestment of businesses, the evaluation of business plans, and the issue of loans or shares. In order for you to be able to make good use of accounting information in the context of these decisions, it is important for you to understand whether and how that information can be relied upon – i.e. to understand the strengths and weaknesses of accounting as a measurement system. Information that is not understood is apt to be used incorrectly, leading to decisions with adverse economic consequences. Performance measurement I t is almost certainly the case that the evaluation of your own job performance relies, in one way or another, 2 Short Introduction to Accounting