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1.3 Using Financial Accounting for Wise Decision Making

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. List the predictions that investors and potential investors want to make about a business organization.
  2. List the predictions that creditors and potential creditors want to make about a business organization.
  3. Explain the reporting of monetary amounts as a central focus of financial accounting.
  4. Explain how financial accounting information is enhanced and clarified by verbal explanations.
  5. Understand the function played by the annual report published by many businesses and other organizations.

Financial Accounting Information and Investments in Capital Stock

Question: Investors are interested (sometimes almost obsessively interested) in the financial information that is produced by a business organization according to the rules and principles of financial accounting. They want to use this information to make wise investing decisions. What do investors actually hope to learn about a business by analyzing published financial information?

 

Answer: The information reported by financial accounting is similar to a giant, complex portrait painted of the organization. There are probably hundreds, if not thousands, of aspects of the picture that can be examined, analyzed, and evaluated to help assess the financial health and future prospects of the model. Theories abound as to which pieces of information are best to use when studying a business. One investor might prefer to focus on a particular portion of the data almost exclusively (such as profitability) whereas another may believe that entirely different information is most significant (such as the sources and uses of cash).

Ultimately, in connection with the buying and selling of capital stock, all investors are trying to arrive at the same two insights. They are attempting to use the provided financial accounting data to estimate the following:

  1. The price of the corporation’s capital stock in the future
  2. The amount of cash dividends that will be paid over time by the business

Despite the complexity of the information, these two goals are rather simplistic. If an investor owns capital shares of a business and feels that the current accounting information signals either a rise in stock prices or strong dividend distributions, holding the investment or even buying more shares is probably warranted. Conversely, if careful analysis indicates a possible drop in stock price or a reduction in dividend payments, sale of the stock is likely to be the appropriate action.

Interestingly, by the very nature of the market, any exchange of ownership shares means that the buyer has studied available information and believes the future to be relatively optimistic for the business in question. In contrast, the seller has looked at similar data and arrived at a different, more pessimistic outlook.

Test Yourself

Question:

An investor is currently studying the financial information produced by Company A and also by Company B. The investor holds ownership shares of Company A but not Company B. After studying all the available data, the investor sells her shares of Company A and uses the proceeds to buy shares of Company B. What is the most likely explanation for these actions?

  1. Company B has been more profitable than Company A in the past.
  2. Company B has paid a larger dividend than Company A in the past.
  3. Last year, the price of Company B’s stock rose faster than that of Company A.
  4. Company B is poised to be more profitable than Company A in the future.

Answer:

The correct answer is choice d: Company B is poised to be more profitable than Company A in the future.

Explanation:

Investors use data to anticipate changes in stock prices and dividend payments. Such events are affected by an organization’s financial health and future prospects. Historical data, such as profitability, dividends, and stock prices, are helpful but only if they provide guidance as to what will happen in the future. If Company B is expected to be more profitable in the coming year, that outcome may well translate into a strong appreciation in the price of the stock or high dividend payments.

Financial Accounting Information and Other Interested Parties

Question: Are there reasons to analyze the financial accounting information produced by a particular business other than to help investors predict stock prices and cash dividend payments?

 

Answer: The desire to analyze an organization’s financial situation is not limited to investors in the stock market. For example, as discussed previously, a loan might be requested from a bank, or one business could be considering the sale of its merchandise to another on credit. Such obligations require eventual payment. Therefore, another portion of the individuals and groups that study the financial information reported by an organization wants to assess the likelihood that money will be available in the future to pay debts. Stock prices and cash dividend distributions are much less significant to a creditor.

The same financial data utilized by investors who are buying or selling capital stock will also be of benefit to current and potential creditors. However, this group is likely to focus attention on particular elements of the information such as the sheer amount of the debt owed, when that debt is scheduled to come due, and the perceived ability to generate sufficient cash to meet those demands in a timely fashion. Ultimately, creditors attempt to anticipate the organization’s future cash flows to measure the risk that debt principal and interest payments might not be forthcoming when due.Cash flows also influence stock prices and dividend payments and would, thus, be information useful for potential investors in the capital stock of a company as well as its creditors.

Therefore, millions of individuals and groups use reported financial information to assess business organizations in order to make three predictions:

  • Future stock market prices for the capital shares issued by the business
  • Future cash dividend distributions
  • Future ability to generate sufficient cash to meet debts as they mature

The first two relate to investors in the capital stock issued by the corporation; the third is of more significance to the creditors of that organization.

The Nature of Financial Information

Question: The term “financial information” comes up frequently in these discussions. What is meant by financial information?

 

Answer: Financial information reported by and about an organization consists of data that can be measured in monetary terms. For example, if a building costs $4 million to acquire, that is financial information, as is the statement that a debt of $700,000 is owed to a bank. In both cases, relevant information is communicated to decision makers as a monetary balance. However, if a business has eight thousand employees, that fact might be interesting, but it is not financial information. The figure is not a dollar amount; it is not stated in the form that is most useful for decision-making purposes by either investors or creditors. Assuming that those workers were paid a total of $500 million during the most recent year, then that number is financial information because it reflects the amount of money spent.

Likewise, a men’s clothing store does not include in its financial accounting information that it holds ten thousand shirts to be sold. Instead, the business reports that it currently owns shirts for sale (frequently referred to as inventoryA current asset bought or manufactured for the purpose of selling in order to generate revenue.) with a cost of, perhaps, $300,000. Or, after having sold these items to customers, it could explain that total sales of $500,000 were made during the period.

Financial Accounting and Verbal Explanations

Question: The value of reported data seems somewhat restricted if only amounts measured in dollars is included. Is financial accounting information limited solely to figures that can be stated in monetary terms?

 

Answer: Although financial accounting starts by reporting balances as monetary amounts, the communication process does not stop there. Extensive verbal explanations as well as additional numerical data are also provided to clarify or expand the monetary information where necessary. To illustrate, assume that an organization is the subject of a lawsuit and estimates an eventual loss of $750,000. This is financial information that must be reported based on the rules of financial accounting. However, the organization should also communicate other nonfinancial information such as the cause of the lawsuit and the likelihood that the loss will actually occur. The dollar amount alone does not provide sufficient information for either investors or creditors.

Thus, accounting actually communicates to decision makers in two distinct steps:

  1. Financial information is provided in monetary terms
  2. Further explanation is given to clarify and expand on those monetary balances

The Annual Report

Question: Businesses and other organizations must have some structural method for conveying financial information and additional verbal explanations to outside decision makers. If a potential investor or creditor wants to assess a business organization such as Johnson & Johnson or Colgate-Palmolive, in what form is that information delivered?

 

Answer: Most companies regardless of size prepare and distribute an annual report shortly after the end of each year. For example, the 2010 annual report of the McDonald’s Corporation can be downloaded from the Internet at http://www.aboutmcdonalds.com/mcd/investors/annual_reports.html.The annual report for the McDonald’s Corporation can also be found by following these steps:

  1. Go to http://www.mcdonalds.com.
  2. Scroll to the bottom of the page and click on “Corporate.”
  3. At the top of the next screen, click on “Investors” at the top of the page.
  4. A picture of McDonald’s latest annual report should be on the next screen. Click on that picture for it to download.

This publication is over fifty pages in length and contains virtually any financial accounting information that a potential investor or creditor could need to make an estimation of the future stock price for the capital stock issued by McDonald’s as well as future dividend distributions and cash inflows and outflows. For example, here are some of the most relevant pieces of information included in the company’s 2010 annual report.

  • Pages 1 through 3 is a letter to shareholders from the chief executive office, the person who is the head of McDonald’s management.
  • Page 4 is a letter to shareholders from the chair of the board of directors.
  • Pages 9 through 25 present management’s discussion and analysis of the company’s financial condition and results of operations.
  • Pages 26 through 29 contain the financial accounting information formally reported by McDonald’s.
  • Pages 30 through 42 provide verbal explanations and other additional information to help clarify the monetary balances reported on pages 26 through 29.
  • Page 46 identifies the executive members of management and the officers who work for McDonald’s.
  • Page 47 lists the members of the board of directors.

This textbook will focus on helping students gain an understanding of the financial accounting information that is produced by a business organization as exemplified by McDonald’s on pages 26 through 29 and then explained further in pages 30 through 42. Those seventeen pages form the heart of the financial reporting process for this organization. Here in Chapter 1 "What Is Financial Accounting, and Why Is It Important?", most students will understand very little of the available data about McDonald’s. However, with careful reading, thought, and work, by the conclusion of Chapter 17 "In a Set of Financial Statements, What Information Is Conveyed by the Statement of Cash Flows?", students should have a working knowledge of financial accounting and its rules and procedures. They will then be able to analyze a good percentage of the information reported by any business as a basis for making wise decisions about the buying and selling of its capital stock and the extension of credit and loans.

Key Takeaway

Throughout the world each day, investors buy and sell the capital stock shares of thousands of businesses. Other individuals choose to loan money or grant credit to these same organizations. Such decisions are based on assessing potential risks and rewards. Financial accounting provides information to these decision makers to help them evaluate the possibility of capital stock price appreciation, cash dividend distributions, and the business’s ability to generate cash to meet obligations as they come due. This information is financial in nature, meaning that it is stated in monetary terms. However, numerical data alone is of limited value. Thus, financial accounting provides monetary balances as well as clarifying verbal explanations to assist users in assessing the financial health and future prospects of a particular business. This information is made available to interested parties as one portion of the annual report that most business corporations produce each year.

Talking with a Real Investing Pro

Kevin G. Burns is a partner in his own registered investment advisory firm, the LLBH Private Wealth Management Group, an organization that specializes in asset management, concentrated stock strategies, and wealth transfer. LLBH consults on investing strategies for assets of nearly $1 billion. Before starting his own firm in October 2008, he was first vice president of Merrill Lynch Private Banking and Investment Group. Burns began his career on Wall Street in 1981 at Paine Webber. He has also worked at Oppenheimer & Co. and Smith Barney. Burns has appeared several times on the CBS Evening News. He has been kind enough to agree to be interviewed about his opinions and experiences in using financial accounting information. His thoughts will appear at the end of each chapter. His firm’s Web site is http://www.LLBHprivatewealthmanagement.com.

 

Question: You majored in accounting in college but you never worked in the accounting field. Instead, you became an investment advisor. If you never planned to become an accountant, why did you major in that subject?

Kevin Burns: In my view, accounting is the backbone of any business major in college. Being able to translate the information that a company provides, prepare a budget, understand the concept of revenues and expenses, and the like has been enormously helpful in my investment management business. Anyone majoring in any aspect of business needs that knowledge. I also liked being able to know I had the right answers on the tests that my accounting professors gave me when all the numbers added up properly.

 

Question: Why do you prefer to invest in the capital stock of a business rather than put your client’s money in other forms of investment such as gold or real estate?

KB: I think it is very important to diversify investments. In my world, that includes stocks as well as other types of investments. Of course, there is a place for investments in real estate, commodities, and the like. My personal preference is to invest only in very liquid assets; those—such as capital shares—that can be turned into cash quickly through trades on a stock exchange. I like to know, even if I am investing for the long term, that I can sell my investments five minutes after I buy them should I change my mind. I simply prefer liquid investments. Real estate is not very liquid as the housing market has recently shown. Gold, of course, is liquid. However, while it has appreciated lately, it was selling for around $800 an ounce when I was in high school and is now about $1,800 an ounce. Over a thirty-year period of time, that is not a very big profit. If my clients earned that small of a return on their money over thirty years, they would fire me.

What Was Truly Important?

To students of Financial Accounting:

You have now read Chapter 1 "What Is Financial Accounting, and Why Is It Important?". What were the five points that you discovered in this chapter that seemed most important to you? A lot of information is provided here. What stood out as truly significant? After you make your choices, go to the following link and watch a short video clip where Professor Joe Hoyle will choose his top five points from Chapter 1 "What Is Financial Accounting, and Why Is It Important?". You can learn his rationale for these picks and see whether you agree or disagree with those selections.

Video Clip

(click to see video)

Professor Joe Hoyle talks about the five most important points in Chapter 1 "What Is Financial Accounting, and Why Is It Important?".