Ch. 1: Reporting About Resources 1
Chapter 1
Introduction: Reporting About Resources
In this chapter you will begin learning about the purpose and process of accounting. You will see that the information produced by a company's accounting system is aimed at answering specific questions about the company's resources. Information for answering the questions is often provided in the form of financial statements.
Goals
A goal is something to work toward. It is something you try to achieve. For example, right now you may be trying to prepare yourself to earn a high grade in this accounting course. On the other hand, your goal for the next few minutes might simply be to stay awake until it's time to go to dinner! People have numerous goals. Many people strive to develop and maintain happy families. Some people work to get the highest paying job possible. Some people try to be in perfect health, or at least in great physical shape. Still other people have earning a high-quality education as their goal.
Similar to people, companies have goals. Health centers and medical practices have as their goal the providing of quality, affordable health care. Broadway theaters strive to provide diverse, live entertainment. Clothing stores try to sell blouses, slacks, shirts, pants, and sweaters to customers. Automobile companies attempt to manufacture and sell cars. For an example of one company's goals, see the following brief discussion of AT&T Inc.
AT&T Inc.
In its 2006 annual report to owners, AT&T listed the following goals. Build on our success in wireless by continuing to addsubscribers, generating higher data revenues andboosting margins. Deliver the value of the BellSouth acquisition. Strengthen our ability to compete in the video marketas we scale our new video services.Grow our enterprise business. Continue to build AT&T as the brand that our currentand future customers rely on to meet all of theircommunications and entertainment needs. Most important, we’ll continue to work hard to deliver valueto our stockholders.
Goals and Resources
How do people and companies achieve their goals? The obvious answer is through hard work. However, if hard work is the only requirement many more people and companies would be successful. Some of the most important requirements for companies and people to achieve their goals are resources. Resources are the things you have to work with. Personally, your resources consist of things like cash, textbooks, pencils, notebooks, clothes, car, stereo, and CDs. A company's resources include cash, land, buildings, and machines.
Resources and Personal Goals Why do people want resources? If cash is a resource in which you are interested, consider what you can do with more of it. If you had only $25, you would be quite concerned about how you could buy food, clothes, gasoline, or pay your rent. On the other hand, if you had $10,000, buying food or clothes probably wouldn't be a problem for a while. Furthermore, if you had $10,000,000, you would definitely not be concerned about food or clothes, but would be able to consider such things as buying property, taking trips, providing for your relatives, or helping friends.
How do resources help you achieve your goals? Consider, for example, your goal of achieving a high-quality education. Without sufficient resources you might have to work at a part-time job 15-20 hours per week to attend school. If you had sufficient resources, you could avoid the part-time job and use the hours to study. The availability of enough resources would give you more time to study and could lead to the achievement of your goal of earning a high-quality education.
Resources and Business Goals Companies want resources for the same basic reason people do: the more resources a company has, the more alternatives the company has and the better are its chances of achieving its goals. For example, if a company has resources of only $50,000, it may be limited in the size of the building space it can buy or rent, the number of employees it can hire, and the volume of products and services it can buy. If the same company had $50,000,000 of resources, it could afford to buy or rent much more space, hire many more employees, and buy many more products and services.
In a simplistic way, a company's desire for resources can be understood by remembering your experiences with the game Monopoly. To win at Monopoly, you either eliminated all other players or accumulated more cash at the end of the game than any other player. As you played the game, you tried to acquire property, houses, and hotels so that you could charge more rent. Without property, you could not charge rent. Without buildings, you could only charge a small amount of rent. In other words, as you acquired more resources, the alternatives available to you increased. As you acquired more property and buildings and if you were fortunate enough to avoid your competitors' property while they landed on yours, your resources increased. If your resources increased enough, you eventually won the game.
Businesses want resources for the same reason you wanted property, houses, and hotels when you played Monopoly. The more resources a company has, the more alternatives or opportunities it has. Without resources, it is virtually impossible for a company to achieve its goals. A health center cannot provide medical care without examining rooms and medical supplies. An automobile manufacturer cannot produce cars without buildings, equipment, and materials.
To get an idea of the importance of resources to companies, examine Exhibit 1-1, in which the December 31, 2006 resources of three companies are shown. The three companies had very large amounts of resources, with Citigroup alone having over $1.8 trillion in resources.
Exhibit 1-1Company Resources
as of December 31, 2006
Company / Resources in Billions
Citigroup / $1,884.3
General Motors / $186.2
Verizon Communications / $188.8
Sources of Resources
Companies obtain resources in three ways: (1) some resources are borrowed, (2) some resources are invested by owners, and (3) some resources are generated through management's operation of the companies.
Borrowed Resources Borrowing is one important way companies obtain resources. When resources are borrowed, the resources or an equal amount of cash must be repaid to the person or company from whom the resources were borrowed. In many cases, an additional dollar amount, called interest, is paid by the borrower for the use of the resources. Companies borrow resources in several ways, such as bank loans, issuing bonds and notes, and credit purchases.
Bank Loans Banks commonly lend money to companies. To obtain a loan, a company usually must present an organized plan detailing what the money will be used for and how the money will be repaid. An important feature of a loan is the fee, or interest, charged for the amount loaned by the bank. For example, if a company borrows $10,000 from a bank at the rate of 8% per year, the company would have to pay the bank $800 ($10,000 x .08) per year interest for the use of the bank's money. At some agreed upon time, the company would also have to return the $10,000 to the bank. An idea of the importance of borrowing as a source of resources can be seen by examining Exhibit 1-2, in which the December 31, 2006 amounts loaned to companies by three banks are presented. For example, Wachovia Corporation had provided over $171 billion of resources to companies.
Exhibit 1-2Commercial Loans
as of December 31, 2006
Bank / Loans in Billions
J. P. Morgan Chase / $121.2
Wachovia / $171.3
Wells Fargo / $70.4
Bonds and Notes Companies often borrow resources from other companies and individuals by issuing bonds and notes. Bonds and notes are agreements or contracts in which companies promise to pay interest and a certain lump sum amount in return for cash. For example, a bond might require a company to pay interest of $5,000 a year and a lump sum payment of $50,000 at the end of five years. The process of issuing bonds or notes and obtaining cash is very organized in the United States and is covered in detail in Chapter 11. Exhibit 1-3 shows the large amounts of resources obtained by three companies through long-term debt, such as bonds and notes. For example, IBM had obtained approximately $14 billion of resources through the use of long-term debt.
Exhibit 1-3Resources Obtained through Long-term
Debt as of December 31, 2006
Company / Resources in Billions
Coca-Cola / $1.3
IBM / $13.8
United Parcel Service / $3.1
Credit Purchases A third way companies often borrow resources is to purchase items on credit. For example, a company might buy $3,000 of supplies by promising to pay the $3,000 within 30 days after the supplies are purchased. In effect, the company buying the supplies is borrowing $3,000 of resources. Of course, if the company does not pay for the supplies within the 30 days, it could be charged interest or, under certain conditions, may be required to return the supplies. Exhibit 1-4 shows the large amounts of resources three companies purchased in 2006 to sell to their customers. For example, Wal-Mart obtained resources of approximately $266 billion through purchases.
Exhibit 1-4Merchandise Purchased in 2006
Company / Resources in Billions
Home Depot / $62.5
Kroger / $50.3
Wal-Mart / $265.9
Owner Invested Resources The second major way in which companies obtain resources is through investments by owners. One important reason people invest their money in companies is that, as owners of the companies, they have a right to all the resources generated through management operations. For example, if a company starts with $100,000 and management generates an additional $20,000 by providing services or products to customers, the owners have a right to the $20,000. The more resources management generates through operations, the more the rights of the owners increase. It is important to note that owners do not have a right to borrowed resources. The companies from which the resources were borrowed have a right to those. Exhibit 1-5 reports the dollar amount of resources invested by owners of three companies. The data show that owners provide companies with many resources. For example, owners provided AT&T with approximately $98 billion of resources as of December 31, 2006.
Exhibit 1-5Resources Obtained from Owners
As of December 31, 2006
Company / Resources in Billions
AT&T / $97.8
Xerox / $4.7
Mattel / $2.1
Resources Generated Through Management Operations The third major way companies obtain resources is they generate them through management's daily operations. For example, in 2006, Exxon Mobil's management generated resources of over $39 billion by doing such things as refining oil and distributing gasoline and oil to companies and individuals. Exxon Mobil's owners have a right to this $39 billion of resources generated through management operations in 2006. It is important to note that Exxon Mobil's owners did not actually receive the $39 billion in cash. The owners received approximately $8 billion, called dividends, and the company kept the remaining amount, approximately $31 billion, in the company for management to use to generate more resources in future years. Examples of the amounts of resources generated through management operations of three companies are shown in Exhibit 1-6.
Exhibit 1-6Resources Generated Through Management Operations
for the 12 Months Ended December 31, 2006
Company / Resources in Billions
Exxon Mobil / $39.5
General Electric / $20.8
Intel / $5.1
Resources and Financial Reporting
The importance of resources to the goals of companies has had a significant
impact on the development of financial reporting. Financial reporting is concerned with gathering, organizing, and communicating information about a company. Resources and where they came from are at the heart of modern financial reporting systems. They are the basis around which the accounting system explored in this text is organized.
Since a company's resources must have come from somewhere, the accounting system can be represented as the following simple equation.
The total dollar amount of a company's resources / = / The total dollar amount of resources obtained from its sources of resourcesor, more simply
Resources / = / Sources of ResourcesAs stated earlier, a company may acquire resources in three ways: resources may be borrowed, resources may be invested by owners, or resources may be generated through management's operation of the company. Thus, the above equation can be expanded to the following.
The total dollar amount of a company's resources / = / the dollar amount of resources borrowed / + / the dollar amount of resources invested by owners / + / the dollar amount of resources generated through management operationsor, more simply
TotalResources / = / Sources of
Borrowed
Resources / + / Sources of Owner
Invested
Resources / + / Sources of Management
Generated
Resources
The above equation, by showing the relationship between resources and their sources, provides information used to answer four basic questions: (1) what is the company's total dollar amount of resources, (2) where did the company get its resources (were they borrowed, invested by owners, or generated through management operations), (3) what did the company's management do with the resources (did they use them to generate more resources), and (4) what did the company do with the resources generated through management operations (were the resources given to owners or were they kept in the business). Each of these questions will be examined more fully in the following sections. A fifth question, which is concerned specifically with the company's cash resources, will be discussed in detail in Chapter 14.
** You now have the background to do exercises 1.1 and 1.2.
Financial Reporting Illustrated
Let's assume that Nick Parks decides to use his knowledge of computers by starting his own computer repair company on July 1. We will examine how several events of the Parks Computer Service Corporation can be viewed in terms of the company's resources and sources of resources. You will see how the financial reporting system generates information to show what the company's resources are on July 31, where they came from, what the company's management did with the resources during July, and what the company did with the resources generated by management. Before we examine the Parks Computer Service Corporation it is important that you notice that our questions relate to a specific time period or point in time. We are interested in what happened to the company during July and how the company is at the end of July. As a result, the accounting reports we will produce will relate directly to the company's July activities. We will not, for example, consider what happens to the company in August or December.
Getting resources from the owner On July 1, Nick Parks invests $5,000 of his own cash in his new company, Parks Computer Service Corporation. Nick invests his cash by opening a checking account in the company's name at the Somerville National Bank. This event will have the following effects on the company's resources and sources of resources.
Resources / = / Sources of resources+ $5,000 / = / + $5,000
As shown above, when the company receives the $5,000 its resources increase. This effect seems pretty straightforward: the company's resources go from $0 to $5,000. Similarly, the resources must come from somewhere: the $5,000 do not just magically appear. Thus, the sources of resources must also increase by $5,000. Since the company receives the $5,000 as a result of the owner's investment, the effects could be shown as follows.
Event / Total Resources / = / Sources ofBorrowed
Resources / + / Sources of Owner
Invested
Resources / + / Sources of Management
Generated
Resources
Owner's cash investment / + $5,000 / + $5,000
Totals / $5,000 / = / $0 / + / $5,000 / + / $0
After the first event occurred, you can see the equation shows that the company has $5,000 of resources and that the $5,000 were obtained from the owner. At this point, the company has not borrowed any resources, nor has it generated any resources through management providing computer services.
Suppose that in addition to wanting to know the company's total resources and where they came from, we want to know more about what the specific resources are and where they came from. In other words, does the company have cash resources or does it have a building or a car? To answer these questions, we might want to change our equation to include more detail, as follows.
Total Resources / = / Sources ofBorrowed
Resources / + / Sources of Owner
Invested
Resources / + / Sources of Management
Generated
Resources
Event / Cash / = / Common
Stock
Owner's cash investment / + $5,000 / + $5,000
Totals / $5,000 / = / $0 / + / $5,000 / + / $0
Notice in the above equation, the $5,000 increase in resources is shown as a + $5,000 in the cash column and the $5,000 increase in sources of resources is shown as a + $5,000 in the common stock column. The equation is in balance because we added $5,000 to both sides: $5,000 were added to resources and $5,000 were added to sources of resources. Using this system, we can see the company has resources of $5,000 cash. The resources came from the owner's investment. In return for his $5,000, since the company was established as a corporation, the owner received shares of common stock. Corporations and common stock are examined in detail in Chapter 12. At this point you should simply be aware of the fact that the owner's interest in a corporation is represented by stock certificates. Stock certificates may be printed on paper or recorded in computer files. Hopefully, by the end of Chapter 12 you will know much more about stock and corporations.
In accounting systems, the terms cash and common stock are known as accounts. An account can be anything about which you want to gather information. As you will see as we examine more events of the Parks Computer Service Corporation, we can add appropriate accounts as we need them.
Using resources to buy other resources On July 3, the Parks Computer Service Corporation pays $25 cash for supplies to be used to service customers. Nick needs supplies such as paper, pens, pencils, envelopes, stamps, and books. Most of the supplies will be used up in two or three months. Since cash and supplies are both resources, but are not the same resource, this event increases resources when the supplies are bought and decreases resources when the cash is paid, as follows.
Resources / = / Sources of resources$5,000 / = / $5,000
+ $25
- $25
$5,000 / = / $5,000
In order to provide information about the cash resource separate from information about the supplies resource, we would add a supplies account to our system, as follows.