1.1Introduction to the Nature and Purpose of Financial Accounting
Accounting is the recording of the day-to-day financial activities of a company and the organization of that information into summary reports used to evaluate the company’s financial status.
The focus of financial accounting is the three primary financial statements: the balance sheet, the income statement, and the statement of cash flows.
Among the users of financial accounting information are lenders, investors, company management, suppliers, customers, employees, competitors, government agencies, politicians, and the press.
The practice of accounting involves adherence to established accounting rules as well as the use of judgment. U.S. accounting rules are established by the FASB.
In addition to the FASB, other important accounting-related organizations are the SEC, the AICPA, the PCAOB, the IRS, and the IASB.
Three factors have combined to make right now a time of significant change in accounting. The three factors are the rapid advance in information technology, the international integration of worldwide business, and the increased scrutiny associated with the large corporate accounting scandals.
In its first decade of operation, McDonald’s Corporation spent over $3 million on research to perfect its french fries.
Ray Kroc, a 51-year-old milkshake machine distributor, first visited the McDonald brothers’ drive-in in San Bernardino, California, in July 1954 because he wanted to know why a single “hamburger stand” needed ten milkshake machines. That first day, Kroc spent the lunch rush hour watching the incredible business volume the small drive-in was able to handle.1 Before leaving town, Kroc had received a personal briefing on the McDonald’s Speedee System by Dick and Mac McDonald and had secured the rights to duplicate the system throughout the United States. Ray Kroc soon discovered that duplicating the McDonald’s system in his first outlet in Chicago involved more than just signing a licensing agreement. Kroc’s french fries, for example, were mushy even though he closely copied the McDonald brothers’ process. Feverish detective work finally revealed that Dick and Mac McDonald had been storing their potatoes in an outside bin before turning them into french fries.2 This aging process allowed some of the natural sugars in the potatoes to turn into starch, resulting in fries that would cook all the way through without burning. Further research revealed the optimal temperature for the cooking oil, the best type of potato to use, and how to make frozen french fries that taste as good as fresh. The end product, the McDonald’s french fry, was instrumental in establishing the McDonald’s reputation for consistent quality.
If the McDonald brothers had renewed the original licensing agreement instead of selling their interest for $2.7 million in 1961, their 2019 licensing fee alone, equal to 0.5 percent of McDonald’s sales, would have been $500 million.
By 1961, the friendly relations between Ray Kroc and the McDonald brothers had soured. The original licensing agreement had stipulated that Kroc could make no changes to the McDonald’s Speedee System without written approval from the brothers. However, in order to adapt the single-location, Southern California operating procedure for use on a nationwide scale, Kroc made hundreds of unapproved changes, such as changing the approved building design by adding a furnace and enclosing service window areas to protect workers and customers from the cold. These changes were merely technical violations of the licensing agreement, but they put Kroc's growing McDonald’s network on shaky legal ground. Therefore, Kroc was pleased in 1961 when the McDonald brothers proposed that he buy them out. At least he was pleased until he heard their price—$2.7 million. This was a huge amount, completely dwarfing the $77,000 in profit that Kroc’s McDonald’s Corporation had reported the year before. The only way to complete the buyout was for Kroc’s company to borrow the $2.7 million. A group of lenders (headed by the endowment fund of Princeton University) was found, but the lenders were nervous about making such a large loan to an upstart company in the volatile restaurant business. Kroc had to agree to a loan contract that resulted in an effective annual interest rate on the loan of nearly 50 percent. But when the buyout was completed, Kroc was free to expand and adapt the McDonald’s system in any way he saw fit.
As the number of McDonald’s locations expanded (to 38,000 at the end of 2019), so did the menu. Originally, the McDonald’s menu contained just hamburgers (15¢), french fries (12¢), milkshakes (20¢), cheeseburgers, soft drinks (three flavors), milk, coffee, potato chips, and pie. The first addition to this menu was the Filet-O-Fish sandwich in the early 1960s. The Big Mac started in Pittsburgh in 1967, and the Egg McMuffin debuted in Santa Barbara in 1971. Not all of the McDonald’s menu innovations caught on—among the items that have died a merciful death are the McLean Deluxe (a low-fat hamburger held together with a seaweed-based filler) and the Hulaburger, one of Ray Kroc’s favorites (a cheeseburger with a big slice of pineapple).
The essence of McDonald’s business seems fairly simple:
Revenues come from selling Big Macs, Happy Meals, Chicken McNuggets, and so on.
Operating costs are the costs of the raw materials to produce the food items plus labor costs, building rentals, income taxes, and so forth.
But the following three accounting facts illustrate that the world of business is a bit more complex and interesting than you might have thought, and that an understanding of the language of accounting used to describe that world is essential:
Sales at all McDonald’s restaurants in 2019 (see Figure 1.1) totaled $100.2 billion. However, McDonald’s Corporation reported less than one-quarter of this amount in its income statement for the year.
Actual net cash income (accountants call this “cash from operations”) for 2019 was $8.122 billion. However, application of accounting rules resulted in reported net income of only $6.025 billion. By the way, this is the income reported to the stockholders—the income reported to the IRS and to foreign tax authorities is computed differently.
The economic value of the McDonald’s brand name and reputation has been estimated at $45.4 billion, and this reputation is by far the corporation’s most valuable resource. However, U.S. accounting rules require that the total brand name and reputation value reported in McDonald’s financial statements be $0.3
In this introductory course, you will learn to speak and understand accounting—the language of business. You will become comfortable with accounting terminology such as “cash flow,” “off-balance-sheet,” and “return on equity.” Also, discussion of the business environment in which accounting is used will increase your understanding of general business concepts such as corporation, lease, annuity, leverage, derivative (the financial kind, not the calculus kind), and so forth.
You will see how accountants organize and condense the economic activity of a company into summary reports called financial statements: the balance sheet, the income statement, and the statement of cash flows. You will also become skilled at interpreting these financial statements in order to analyze the financial status of a company.
You will become convinced that accounting is not “bean counting.” Time after time you will see that accountants must exercise judgment about how to best summarize and report the results of business transactions. As a result, you will gain a respect for the complexity of accounting as well as a skepticism about the precision of any financial reports you see.
Finally, you will see the power of accounting. Financial statements are not just paper reports that get filed away and forgotten. You will see that financial statement numbers and, indirectly, the accountants who prepare them determine who receives loans and who does not, which companies attract investors and which do not, which managers receive salary bonuses and which do not, and which companies are praised in the financial press and which are not.
So let’s get started.