Assume your grandparents have just given you $20,000 on the condition that you invest the money in the stock market

Investing in the Stock Market
Assume your grandparents have just given you $20,000 on the condition that you invest the money in the stock market. As you contemplate making your investment choices... what accounting information do you want to help identify companies that will have high future rates of return?

The ability to read and understand financial statements will tell you where a company has been. All of the following might help you see where the company is heading from here: reading analyst reports that discuss financial issues; studying trend analysis in stock prices, dividend yields; understanding and applying business ratios; reading comparative financial data of competitor companies.

Creditor and Investor Information Needs
Ink Spot is a small company that has been in business for two years. Wilford Smith, the president of the company, has decided that it is time to expand. He needs $10,000 to purchase additional equipment and to pay for increased operating expenses. Wilford can either apply for a loan at First City Bank, or he can issue more stock (1,000 shares are outstanding) to new investors.

1. Assuming that you are the loan officer at First City Bank, what information would you request from Ink Spot before deciding whether to make the loan?
The loan officer should ask for copies of financial statements for the current year with comparatives to the startup year. He might ask for accounts receivable and accounts payable listings as well as more specific information on the use of the funds. Borrowing money to pay to pay for increased operating expenses is not a good thing. That might kill the deal right there because revenue should be increasing as expenses increase.

2. As a potential investor in Ink Spot, what information would you need to make a good investment decision?
Assuming an investor is a savvy financial person and not just a friend from down the street, the investor should ask for the very same information as the loan officer. In addition, the investor would like to know how much and when he might receive a return on investment (ROI) in the form of a dividend. The loan officer will have a collateral position in the new equipment, but the investor has no such protection.

General Questions
? How does understanding the mechanics of accounting help a businessperson who has no intention of practicing accounting?
Understanding how financial numbers work together and come together will give a manager the ability to ask intelligent questions about financial data, understand how changes would affect the various schedules included in a set of financial statements, give the manager the ability to supervise the function and to discuss it with stakeholders (bankers, investors, and creditors). I really think a couple of accounting classes is good for any business manager.

I might add that many business managers try their hand at 'practicing accounting' by attempting to manipulate the numbers. Obviously, it is easier to plan moves to enhance the look of financial statements if a manager understands the impact a move will make.

? What is a chart of accounts? What is its purpose?
A chart of accounts is a list of all accounts tracked by a single accounting system, and should be designed to capture financial information to make good financial decisions. Each account in the chart is assigned a unique identifier, typically an account number. Each account in the Anglo-Saxon chart is classified into one of the five categories: Assets, Liabilities, Equity, Income and Expenses. http://en.wikipedia.org/wiki/Chart_of_accounts

The purpose of a chart of accounts is to classify transactions within a business framework by type in order to accumulate financial data for a balance sheet, statement of income and statement of cash flows. The chart of accounts is unique for each business.

? When are revenues generally recognized (recorded)?
Revenues are recorded as revenue (recognized) when earned. Two examples: you sell something today on credit. Have you earned the revenue? Yes, even though you haven't collected the cash. Second example: you collect an advance payment for a product you will make and deliver. You haven't earned the revenue yet and it won't be recognized until you deliver the goods.

? Explain why accrual-basis accounting is more appropriate than cash-basis accounting for most businesses.
Accrual accounting gives a more accurate reading of the finances of a company by matching revenue to expenses. It more accurately reports changes to the net worth of the business. Using my credit sale from the last question: in cash basis, the transaction would be ignored, but you might have paid wages and bought materials for the product. Your financial statement would be distorted with expenses and no revenue. The matching concept isn't matching and the revenue recognition principle is being ignored.

Also the balance sheet would not include all the assets of a company: no accounts receivable, no inventory, no prepaid expenses. Similarly, the liabilities would be understated with no accounts payable, no payroll payable, no accrued expenses.

? Why are supplies not considered inventory? What type of account is Supplies on Hand?
Supplies are not part of inventory because they don't become part of the product. Example would be cleaning rags in a washing machine factory. Rags would be needed in the manufacturing process, but they do not combine into the product. Inventory is defined as product that will be sold.

The Supplies on hand account is actually an inventory account on the balance sheet in the current asset section, but it is not inventory to be resold. The asset account for supplies will be reduced as the supplies are consumed.

? Explain why there are alternative ways of recording certain transactions, either as assets or expenses, or as liabilities or revenues.
The judgment about whether a transaction is reported as an asset or an expense has to do with its usefulness. If it is normally consumed during the accounting period (a month), then it is directly expensed. Let's say you pay your current month phone bill on the last day of the month. It is directly expensed because there is no value to carry forward. On the other hand, if you buy a prepaid phone card, you have future value and you would report the transaction as an increase in an asset - probably prepaid expenses.

Liabilities to revenue can be a little hazy, but let's say you collect rent for the first and last month for a building you own. The first month's rent is earned by the end of the month and you would recognize revenue immediately, but the last month won't be earned until next year. Why is it a liability? Because it is possible you might have to refund it. It is a business liability until you earn it.