Accounting and Its Use in Business Decisions

In this chapter, you will learn why accounting is important to the business community. You will learn the different types of businesses and how daily transactions are posted and how they affect the financial statements. This chapter also demonstrates how to prepare the income statement, balance sheet, and statement of stockholders' equity. Pay close attention to the steps involved in the accounting cycle from beginning to end. This chapter will introduce you to the framework of the entire accounting process, which may also be called the accounting equation. The fundamental accounting equation is the basic equation that accountants use to record business transactions. The equation states "assets = liabilities + owners' equity". This section gives the direct and alternative identifications of these elements to help you speak the language of accounting. Assets are things that expect to have future value to the company. For example, if the company buys a new car, this car has future value to the company. Liabilities are promises to pay. Some companies may not have all of the money to pay cash for the car, so they will typically finance, or obtain credit for, and borrow the difference between the down payment and the final price of the car. If approved, the company now promises to pay back the bank or business entity who gave the company money. Owners' equity is the owners' claims on assets. This basically means that, as an owner of the company, you have a claim on the asset that is now identified as the new car the company owns.

Analyzing and using the financial results - the equity ratio

The two basic sources of equity in a company are stockholders and creditors; their combined interests are called total equities. To find the equity ratio, divide stockholders' equity by total equities or total assets, since total equities equals total assets. In formula format:

Equity ratio = Stockholders 'equity Total equities

The higher the proportion of equities (or assets) supplied by the owners, the more solvent the company. However, a high portion of debt may indicate higher profitability because quite often the interest rate on debt is lower than the rate of earnings realized from using the proceeds of the debt. An example illustrates this concept: Suppose that a company with USD 100,000 in assets could have raised the funds to acquire those assets in these two ways:

Case 1 Assets	$100,000	Liabilities Stockholders' equity	$20,000 $80,000
Case 2 Assets	$100,000	Liabilities Stockholders' equity	$80,000 $20,000

When a company suffers operating losses, its assets decrease. In Case 1, the assets would have to shrink by 80 per cent before the liabilities would equal the assets. In Case 2, the assets would have to shrink only 20 per cent before the liabilities would equal the assets. When the liabilities exceed the assets, the company is said to be insolvent. Therefore, creditors are safer in Case 1 and will more readily lend money to the company.

However, if funds borrowed at 10 per cent are used to produce earnings at a 20 per cent rate, Case 2 is preferable in terms of profitability. Therefore, owners are better off in Case 2 if the borrowed funds can earn more than they cost.

Next, we examine the recent equity ratios of some actual companies:

Name of Company	Stockholders' Equity ($ millions)	Total Equities ($ millions)	Equity Ratio
Johnson & Johnson	$ 23,734	$ 37,053	64.1%
3M Corporation	6,166	15,205	40.6
General Electric Company	53,597	460,097	11.6

As you can see from the preceding data, the equity ratios of actual companies vary widely. Companies such as Johnson & Johnson and 3M Corporation employ a higher proportion of stockholders' equity (a lower proportion of debt) than GE in an effort to have stronger balance sheets (more solvency). GE employs a greater proportion of debt, possibly in an attempt to increase profitability. Every company must strike a balance between solvency and profitability to ensure long- run survival. The correct balance between proportions of stockholder and creditor equities depends on the industry, general business conditions, and management philosophy.

Chapter 1 has introduced two important components of the accounting process - the accounting equation and the business transaction. In Chapter 2, you learn about debits and credits and how accountants use them in recording transactions. Understanding how data are accumulated, classified, and reported in financial statements helps you understand how to use financial statement data in making decisions.

An accounting perspective: Uses of technology

When you apply for your first job after graduation, prospective employers will expect you to know how to use a PC to perform many tasks. Therefore, before you graduate you should be able to use word processing, spreadsheet, and database software. You should be able to use the Internet to find useful information. In many universities, you can learn these skills in courses taken for credit. If your school does not offer credit courses, take noncredit courses or attend a training center.