14 Using Financial Information and Accounting

Accounting Basics

Accounting is the process of collecting, recording, classifying, summarizing, reporting, and analyzing financial activities. It results in reports that describe the financial condition of an organization. All types of organizations—businesses, hospitals, schools, government agencies, and civic groups—use accounting procedures. Accounting provides a framework for looking at past performance, current financial health, and possible future performance. It also provides a framework for comparing the financial positions and financial performances of different firms. Understanding how to prepare and interpret financial reports will enable you to evaluate two companies and choose the one that is more likely to be a good investment.

The accounting system shown in Exhibit 14.3 converts the details of financial transactions (sales, payments, purchases, and so on) into a form that people can use to evaluate the firm and make decisions. Data become information, which in turn becomes reports. These reports describe a firm’s financial position at one point in time and its financial performance during a specified period. Financial reports include financial statements, such as balance sheets and income statements, and special reports, such as sales and expense breakdowns by product line.

Who Uses Financial Reports?

The accounting system generates two types of financial reports, as shown in Exhibit 14.4: internal and external. Internal reports are used within the organization. As the term implies, managerial accounting provides financial information that managers inside the organization can use to evaluate and make decisions about current and future operations. For instance, the sales reports prepared by managerial accountants show how well marketing strategies are working, as well as the number of units sold in a specific period of time. This information can be used by a variety of managers within the company in operations as well as in production or manufacturing to plan future work based on current financial data. Production cost reports can help departments track and control costs, as well as zero in on the amount of labor needed to produce goods or services. In addition, managers may prepare very detailed financial reports for their own use and provide summary reports to top management, providing key executives with a “snapshot” of business operations in a specific timeframe.

Financial accounting focuses on preparing external financial reports that are used by outsiders—that is, people who have an interest in the business but are not part of the company’s management. Although they provide useful information for managers, these reports are used primarily by lenders, suppliers, investors, government agencies, and others to assess the financial strength of a business.

To ensure accuracy and consistency in the way financial information is reported, accountants in the United States follow generally accepted accounting principles (GAAP) when preparing financial statements. The Financial Accounting Standards Board (FASB) is a private organization that is responsible for establishing financial accounting standards used in the United States.

Currently there are no international accounting standards. Because accounting practices vary from country to country, a multinational company must make sure that its financial statements conform to both its own country’s accounting standards and those of the parent company’s country. Often another country’s standards are quite different from U.S. GAAP. In the past, the U.S. Financial Accounting Standards Board and the International Accounting Standards Board (IASB) worked together to develop global accounting standards that would make it easier to compare financial statements of foreign-based companies. However, as of this writing, the two organizations have not agreed on a global set of accounting standards. 

 

Financial statements are the chief element of the annual report, a yearly document that describes a firm’s financial status. Annual reports usually discuss the firm’s activities during the past year and its prospects for the future. Three primary financial statements included in the annual report are discussed and shown later in this chapter:

• The balance sheet
• The income statement
• The statement of cash flows

Public Accountants

Independent accountants who serve organizations and individuals on a fee basis are called public accountants. Public accountants offer a wide range of services, including preparation of financial statements and tax returns, independent auditing of financial records and accounting methods, and management consulting. Auditing, the process of reviewing the records used to prepare financial statements, is an important responsibility of public accountants. They issue a formal auditor’s opinion indicating whether the statements have been prepared in accordance with accepted accounting rules. This written opinion is an important part of a company’s annual report.

The largest public accounting firms, called the Big Four, operate worldwide and offer a variety of business consulting services in addition to accounting services. In order of size, they are Deloitte, PwC (PricewaterhouseCoopers), EY (Ernst & Young), and KPMG International.³ A former member of this group, Arthur Andersen, disbanded in 2002 as a result of the Enron scandal.

To become a certified public accountant (CPA), an accountant must complete an approved bachelor’s degree program and pass a test prepared by the American Institute of CPAs (AICPA). Each state also has requirements for CPAs, such as several years’ on-the-job experience and continuing education. Only CPAs can issue the auditor’s opinion on a firm’s financial statements. Most CPAs first work for public accounting firms and later may become private accountants or financial managers. Of the more than 418,000 accountants who belong to the AICPA, 47 percent work in public accounting firms and 39 percent in business and industry.⁴

Private Accountants

Accountants employed to serve one particular organization are private accountants. Their activities include preparing financial statements, auditing company records to be sure employees follow accounting policies and procedures, developing accounting systems, preparing tax returns, and providing financial information for management decision-making. Whereas some private accountants hold the CPA designation, managerial accountants also have a professional certification program. Requirements to become a certified management accountant (CMA) include passing an examination.

Reshaping the Accounting Environment

Although our attention was focused on big-name accounting scandals in the late 1990s and early 2000s, an epidemic of accounting irregularities was also taking place in the wider corporate arena. The number of companies restating annual financial statements grew at an alarming rate, tripling from 1997 to 2002. In the wake of the numerous corporate financial scandals, Congress and the accounting profession took major steps to prevent future accounting irregularities. These measures targeted the basic ways, cited by a report from the AICPA, that companies massaged financial reports through creative, aggressive, or inappropriate accounting techniques, including:

• Committing fraudulent financial reporting
• Stretching accounting rules to significantly enhance financial results
• Following appropriate accounting rules but using loopholes to manage financial results

Why did companies willfully push accounting to the edge—and over it—to artificially pump up revenues and profits? Looking at the companies involved in the scandals, some basic similarities have emerged:

• A company culture of arrogance and above-average tolerance for risk
• Interpretation of accounting policies to their advantage and manipulation of the rules to get to a predetermined result and conceal negative financial information
• Compensation packages tied to financial or operating targets, making executives and managers greedy and pressuring them to find sometimes-questionable ways to meet what may have been overly optimistic goals
• Ineffective checks and balances, such as audit committees, boards of directors, and financial control procedures, that were not independent from management
• Centralized financial reporting that was tightly controlled by top management, increasing the opportunity for fraud
• Financial performance benchmarks that were often out of line with the companies’ industry
• Complicated business structures that clouded how the company made its profits
• Cash flow from operations that seemed out of line with reported earnings (You’ll learn about this important difference between cash and reported earnings in the sections on the income statement and statement of cash flows.)
• Acquisitions made quickly, often to show growth rather than for sound business reasons; management focused more on buying new companies than making the existing operations more profitable⁵

Companies focused on making themselves look good in the short term, doing whatever was necessary to top past performance and to meet the expectations of investment analysts, who project earnings, and investors, who panic when a company misses the analysts’ forecasts. Executives who benefited when stock prices rose had no incentive to question the earnings increases that led to the price gains.

These number games raised serious concerns about the quality of earnings and questions about the validity of financial reports. Investors discovered to their dismay that they could neither assume that auditors were adequately monitoring their clients’ accounting methods nor depend on the integrity of published financial information.

Better Numbers Ahead

Over the past 15 years, a number of accounting reforms have been put in place to set better standards for accounting, auditing, and financial reporting. Investors, now aware of the possibility of various accounting shenanigans, are avoiding companies that use complicated financial structures and off-the-books financing.

In 2002, the Sarbanes-Oxley Act (commonly referred to as SOX) went into effect. This law, one of the most extensive pieces of business legislation passed by Congress, was designed to address the investing public’s lack of trust in corporate America. It redefines the public corporation–auditor relationship and restricts the types of services auditors can provide to clients. The Act clarifies auditor-independence issues, places increased accountability on a company’s senior executives and management, strengthens disclosure of insider transactions (an employee selling stock based on information not known by the public), and prohibits loans to executives.

An independent five-member Public Company Accounting Oversight Board (PCAOB) was given the authority to set and amend auditing, quality control, ethics, independence, and other standards for audit reports. The Act specifies that all PCAOB members be financially literate. Two members must have their CPA designation, and the other three cannot be or have been CPAs. Appointed and overseen by the Securities and Exchange Commission (SEC), the PCAOB can also inspect accounting firms; investigate breaches of securities law, standards, competency, and conduct; and take disciplinary action. The corporate Board registers public accounting firms, as the Act now requires. Altering or destroying key audit documents now carries felony charges and increased penalties.

Other key provisions of the Act cover the following areas:

• Auditing standards: The Board must include in its standards several requirements, such as maintaining audit work papers and other documentation for audit reports for seven years, the review and approval of audit reports by a second partner, and audit standards for quality control and review of internal control procedures.
• Financial disclosure: Companies must clearly disclose all transactions that may have a material current or future effect on their financial condition, including those that are off the books or with unconsolidated entities (related companies whose results the company is not required to combine with its own financial statements under current accounting rules). Management and major stockholders must disclose transactions such as sales of company stock within two days of the transaction. The company must disclose its code of ethics for senior financial executives. Any significant changes in a company’s operations or financial condition must be disclosed “on a rapid and current basis.”
• Financial statement certification: Chief executive officers and chief financial officers must certify company financial statements, with severe criminal and civil penalties for false certification. If securities fraud results in a restatement of financial reports, these executives will lose any stock-related profits and bonuses they received prior to the restatement.
• Internal controls: Each company must have appropriate internal control procedures in place for financial reporting, and its annual report must include a report on implementation of those controls to ensure the integrity of financial reports.
• Consulting work: The Act restricts the non-auditing work auditors may perform for a client. In the past, the large accounting firms had expanded their role to include a wide range of advisory services that went beyond their traditional task of validating a company’s financial information. Conflicts of interest arose when the same firm earned lucrative fees for both audit and consulting work for the same client.⁶

Other regulatory organizations also took steps to prevent future abuses. In September 2002, the AICPA Auditing Standards Board (ASB) issued expanded guidelines to help auditors uncover fraud while conducting audits. The New York Stock Exchange stiffened its listing requirements so that the majority of directors at listed companies must be independent and not employees of the corporation. Nor can auditors serve on clients’ boards for five years. Companies listed in the Nasdaq marketplace cannot hire former auditors at any level for three years.

In response to the passage of Sarbanes-Oxley and other regulations, companies implemented new control measures and improved existing ones. The burdens in both cost and time have been considerable. Many companies had to redesign and restructure financial systems to improve efficiency. Some finance executives believe that their investment in increased controls has improved shareholder perceptions of their company’s ethics. Others, however, reported that costs depressed earnings and negatively affected stock prices. Despite the changes and costs associated with SOX compliance, 15 years after the law’s implementation, many business executives believe that the process has helped them fine-tune financial activities and reporting while addressing dynamic changes in the market and other economic challenges.⁷

The Accounting Equation

The accounting procedures used today are based on those developed in the late 15th century by an Italian monk, Brother Luca Pacioli. He defined the three main accounting elements as assets, liabilities, and owners’ equity. Assets are things of value owned by a firm. They may be tangible, such as cash, equipment, and buildings, or intangible, such as a patent or trademarked name. Liabilities—also called debts—are what a firm owes to its creditors. Owners’ equity is the total amount of investment in the firm minus any liabilities. Another term for owners’ equity is net worth.

The relationship among these three elements is expressed in the accounting equation:

The accounting equation must always be in balance (that is, the total of the elements on one side of the equals sign must equal the total on the other side).

Suppose you start a coffee shop and put $10,000 in cash into the business. At that point, the business has assets of $10,000 and no liabilities. This would be the accounting equation:

The liabilities are zero and owners’ equity (the amount of your investment in the business) is $10,000. The equation balances.

To keep the accounting equation in balance, every transaction must be recorded as two entries. As each transaction is recorded, there is an equal and opposite event so that two accounts or records are changed. This method is called double-entry bookkeeping.

Suppose that after starting your business with $10,000 cash, you borrow another $10,000 from the bank. The accounting equation will change as follows:

Now you have $20,000 in assets—your $10,000 in cash and the $10,000 loan proceeds from the bank. The bank loan is also recorded as a liability of $10,000 because it’s a debt you must repay. Making two entries keeps the equation in balance.

The Accounting Cycle

The accounting cycle refers to the process of generating financial statements, beginning with a business transaction and ending with the preparation of the report. Exhibit 14.5 shows the six steps in the accounting cycle. The first step in the cycle is to analyze the data collected from many sources. All transactions that have a financial impact on the firm—sales, payments to employees and suppliers, interest and tax payments, purchases of inventory, and the like—must be documented. The accountant must review the documents to make sure they’re complete.

 

Next, each transaction is recorded in a journal, a listing of financial transactions in chronological order. The journal entries are then recorded in ledgers, which show increases and decreases in specific asset, liability, and owners’ equity accounts. The ledger totals for each account are summarized in a trial balance, which is used to confirm the accuracy of the figures. These values are used to prepare financial statements and management reports. Finally, individuals analyze these reports and make decisions based on the information in them.

 

Technological Advances

Over the past decade, technology has had a significant impact on the accounting industry. Computerized and online accounting programs now do many different things to make business operations and financial reporting more efficient. For example, most accounting packages offer basic modules that handle general ledger, sales order, accounts receivable, purchase order, accounts payable, and inventory control functions. Tax programs use accounting data to prepare tax returns and tax plans. Point-of-sale terminals used by many retail firms automatically record sales and do some of the bookkeeping. The Big Four and many other large public accounting firms develop accounting software for themselves and for clients.

Accounting and financial applications typically represent one of the largest portions of a company’s software budget. Accounting software ranges from off-the-shelf programs for small businesses to full-scale customized enterprise resource planning systems for major corporations. Although these technological advances in accounting applications have made the financial aspects of running a small business much easier, entrepreneurs and other small-business owners should take to time to understand underlying accounting principles, which play an important role in evaluating just how financially sound a business enterprise really is.

Assets

Assets can be divided into three broad categories: current assets, fixed assets, and intangible assets. Current assets are assets that can or will be converted to cash within the next 12 months. They are important because they provide the funds used to pay the firm’s current bills. They also represent the amount of money the firm can quickly raise. Current assets include:

• Cash: Funds on hand or in a bank
• Marketable securities: Temporary investments of excess cash that can readily be converted to cash
• Accounts receivable: Amounts owed to the firm by customers who bought goods or services on credit
• Notes receivable: Amounts owed to the firm by customers or others to whom it lent money
• Inventory: Stock of goods being held for production or for sale to customers

Fixed assets are long-term assets used by the firm for more than a year. They tend to be used in production and include land, buildings, machinery, equipment, furniture, and fixtures. Except for land, fixed assets wear out and become outdated over time. Thus, they decrease in value every year. This declining value is accounted for through depreciation. Depreciation is the allocation of the asset’s original cost to the years in which it is expected to produce revenues. A portion of the cost of a depreciable asset—a building or piece of equipment, for instance—is charged to each of the years in which it is expected to provide benefits. This practice helps match the asset’s cost against the revenues it provides. Because it is impossible to know exactly how long an asset will last, estimates are used. They are based on past experience with similar items or IRS guidelines for assets of that type. Notice that, through 2018, Delicious Desserts has taken a total of $16,000 in depreciation on its bakery equipment.

Intangible assets are long-term assets with no physical existence. Common examples are patents, copyrights, trademarks, and goodwill. Patents and copyrights shield the firm from direct competition, so their benefits are more protective than productive. For instance, no one can use more than a small amount of copyrighted material without permission from the copyright holder. Trademarks are registered names that can be sold or licensed to others. One of Delicious Desserts’ intangible assets is a trademark valued at $4,500. Goodwill occurs when a company pays more for an acquired firm than the value of its tangible assets. Delicious Desserts’ other tangible asset is goodwill of $7,000.

Liabilities

Liabilities are the amounts a firm owes to creditors. Those liabilities coming due sooner—current liabilities—are listed first on the balance sheet, followed by long-term liabilities.

Current liabilities are those due within a year of the date of the balance sheet. These short-term claims may strain the firm’s current assets because they must be paid in the near future. Current liabilities include:

• Accounts payable: Amounts the firm owes for credit purchases due within a year. This account is the liability counterpart of accounts receivable.
• Notes payable: Short-term loans from banks, suppliers, or others that must be repaid within a year. For example, Delicious Desserts has a six-month, $15,000 loan from its bank that is a note payable.
• Accrued expenses: Expenses, typically for wages and taxes, that have accumulated and must be paid at a specified future date within the year although the firm has not received a bill
• Income taxes payable: Taxes owed for the current operating period but not yet paid. Taxes are often shown separately when they are a large amount.
• Current portion of long-term debt: Any repayment on long-term debt due within the year. Delicious Desserts is scheduled to repay $5,000 on its equipment loan in the coming year.

Long-term liabilities come due more than one year after the date of the balance sheet. They include bank loans (such as Delicious Desserts’ $10,000 loan for bakery equipment), mortgages on buildings, and the company’s bonds sold to others.

Owners’ Equity

Owners’ equity is the owners’ total investment in the business after all liabilities have been paid. For sole proprietorships and partnerships, amounts put in by the owners are recorded as capital. In a corporation, the owners provide capital by buying the firm’s common stock. For Delicious Desserts, the total common stock investment is $30,000. Retained earnings are the amounts left over from profitable operations since the firm’s beginning. They are total profits minus all dividends (distributions of profits) paid to stockholders. Delicious Desserts has $48,750 in retained earnings.

Revenues

Revenues are the dollar amount of sales plus any other income received from sources such as interest, dividends, and rents. The revenues of Delicious Desserts arise from sales of its bakery products. Revenues are determined starting with gross sales, the total dollar amount of a company’s sales. Delicious Desserts had two deductions from gross sales. Sales discounts are price reductions given to customers that pay their bills early. For example, Delicious Desserts gives sales discounts to restaurants that buy in bulk and pay at delivery. Returns and allowances are the dollar amount of merchandise returned by customers because they didn’t like a product or because it was damaged or defective. Net sales is the amount left after deducting sales discounts and returns and allowances from gross sales. Delicious Desserts’ gross sales were reduced by $4,500, leaving net sales of $270,500.

Expenses

Expenses are the costs of generating revenues. Two types are recorded on the income statement: cost of goods sold and operating expenses.

The cost of goods sold is the total expense of buying or producing the firm’s goods or services. For manufacturers, cost of goods sold includes all costs directly related to production: purchases of raw materials and parts, labor, and factory overhead (utilities, factory maintenance, machinery repair). For wholesalers and retailers, it is the cost of goods bought for resale. For all sellers, cost of goods sold includes all the expenses of preparing the goods for sale, such as shipping and packaging.

Delicious Desserts’ cost of goods sold is based on the value of inventory on hand at the beginning of the accounting period, $18,000. During the year, the company spent $109,500 to produce its baked goods. This figure includes the cost of raw materials, labor costs for bakery workers, and the cost of operating the bakery area. Adding the cost of goods manufactured to the value of beginning inventory, we get the total cost of goods available for sale, $127,500. To determine the cost of goods sold for the year, we subtract the cost of inventory at the end of the period:

The amount a company earns after paying to produce or buy its products but before deducting operating expenses is the gross profit. It is the difference between net sales and cost of goods sold. Because service firms do not produce goods, their gross profit equals net sales. Gross profit is a critical number for a company because it is the source of funds to cover all the firm’s other expenses.

The other major expense category is operating expenses. These are the expenses of running the business that are not related directly to producing or buying its products. The two main types of operating expenses are selling expenses and general and administrative expenses. Selling expenses are those related to marketing and distributing the company’s products. They include salaries and commissions paid to salespeople and the costs of advertising, sales supplies, delivery, and other items that can be linked to sales activity, such as insurance, telephone and other utilities, and postage. General and administrative expenses are the business expenses that cannot be linked to either cost of goods sold or sales. Examples of general and administrative expenses are salaries of top managers and office support staff; utilities; office supplies; interest expense; fees for accounting, consulting, and legal services; insurance; and rent. Delicious Desserts’ operating expenses totaled $115,100.

Net Profit or Loss

The final figure—or bottom line—on an income statement is the net profit (or net income) or net loss. It is calculated by subtracting all expenses from revenues. If revenues are more than expenses, the result is a net profit. If expenses exceed revenues, a net loss results.

Several steps are involved in finding net profit or loss. (These are shown in the right-hand column of Table 14.2.) First, cost of goods sold is deducted from net sales to get the gross profit. Then total operating expenses are subtracted from gross profit to get the net profit before taxes. Finally, income taxes are deducted to get the net profit. As shown in Table 14.2, Delicious Desserts earned a net profit of $32,175 in 2018.

It is very important to recognize that profit does not represent cash. The income statement is a summary of the firm’s operating results during some time period. It does not present the firm’s actual cash flows during the period. Those are summarized in the statement of cash flows, which is discussed briefly in the next section.

Liquidity Ratios

Liquidity ratios measure the firm’s ability to pay its short-term debts as they come due. These ratios are of special interest to the firm’s creditors. The three main measures of liquidity are the current ratio, the acid-test (quick) ratio, and net working capital.

The current ratio is the ratio of total current assets to total current liabilities. Traditionally, a current ratio of 2 ($2 of current assets for every $1 of current liabilities) has been considered good. Whether it is sufficient depends on the industry in which the firm operates. Public utilities, which have a very steady cash flow, operate quite well with a current ratio well below 2. A current ratio of 2 might not be adequate for manufacturers and merchandisers that carry high inventories and have lots of receivables. The current ratio for Delicious Desserts for 2018, as shown in Table 14.4, is 1.4. This means little without a basis for comparison. If the analyst found that the industry average for small bakeries was 2.4, Delicious Desserts would appear to have low liquidity.

The acid-test (quick) ratio is like the current ratio except that it excludes inventory, which is the least-liquid current asset. The acid-test ratio is used to measure the firm’s ability to pay its current liabilities without selling inventory. The name acid-test implies that this ratio is a crucial test of the firm’s liquidity. An acid-test ratio of at least 1 is preferred. But again, what is an acceptable value varies by industry. The acid-test ratio is a good measure of liquidity when inventory cannot easily be converted to cash (for instance, if it consists of very specialized goods with a limited market). If inventory is liquid, the current ratio is better. Delicious Desserts’ acid-test ratio for 2018 is 1.1. Because the bakery’s products are perishable, it does not carry large inventories. Thus, the values of its acid-test and current ratios are fairly close. At a manufacturing company, however, inventory typically makes up a large portion of current assets, so the acid-test ratio will be lower than the current ratio.

Net working capital, though not really a ratio, is often used to measure a firm’s overall liquidity. It is calculated by subtracting total current liabilities from total current assets. Delicious Desserts’ net working capital for 2018 is $23,050. Comparisons of net working capital over time often help in assessing a firm’s liquidity.

Profitability Ratios

To measure profitability, a firm’s profits can be related to its sales, equity, or stock value. Profitability ratios measure how well the firm is using its resources to generate profit and how efficiently it is being managed. The main profitability ratios are net profit margin, return on equity, and earnings per share.

The ratio of net profit to net sales is the net profit margin, also called return on sales. It measures the percentage of each sales dollar remaining after all expenses, including taxes, have been deducted. Higher net profit margins are better than lower ones. The net profit margin is often used to measure the firm’s earning power. “Good” net profit margins differ quite a bit from industry to industry. A grocery store usually has a very low net profit margin, perhaps below 1 percent, whereas a jewelry store’s net profit margin would probably exceed 10 percent. Delicious Desserts’ net profit margin for 2018 is 11.9 percent. In other words, Delicious Desserts is earning 11.9 cents on each dollar of sales.

 

The ratio of net profit to total owners’ equity is called return on equity (ROE). It measures the return that owners receive on their investment in the firm, a major reason for investing in a company’s stock. Delicious Desserts has a 40.9 percent ROE for 2018. On the surface, a 40.9 percent ROE seems quite good. But the level of risk in the business and the ROE of other firms in the same industry must also be considered. The higher the risk, the greater the ROE investors look for. A firm’s ROE can also be compared to past values to see how the company is performing over time.

Earnings per share (EPS) is the ratio of net profit to the number of shares of common stock outstanding. It measures the number of dollars earned by each share of stock. EPS values are closely watched by investors and are considered an important sign of success. EPS also indicates a firm’s ability to pay dividends. Note that EPS is the dollar amount earned by each share, not the actual amount given to stockholders in the form of dividends. Some earnings may be put back into the firm. Delicious Desserts’ EPS for 2018 is $3.22.

Activity Ratios

Activity ratios measure how well a firm uses its assets. They reflect the speed with which resources are converted to cash or sales. A frequently used activity ratio is inventory turnover. The inventory turnover ratio measures the speed with which inventory moves through the firm and is turned into sales. It is calculated by dividing cost of goods sold by the average inventory. (Average inventory is estimated by adding the beginning and ending inventories for the year and dividing by 2.) Based on its 2018 financial data, Delicious Desserts’ inventory, on average, is turned into sales 6.8 times each year, or about once every 54 days (365 days ÷ 6.8). The acceptable turnover ratio depends on the line of business. A grocery store would have a high turnover ratio, maybe 20 times a year, whereas the turnover for a heavy equipment manufacturer might be only three times a year.

Debt Ratios

Debt ratios measure the degree and effect of the firm’s use of borrowed funds (debt) to finance its operations. These ratios are especially important to lenders and investors. They want to make sure the firm has a healthy mix of debt and equity. If the firm relies too much on debt, it may have trouble meeting interest payments and repaying loans. The most important debt ratio is the debt-to-equity ratio.

The debt-to-equity ratio measures the relationship between the amount of debt financing (borrowing) and the amount of equity financing (owners’ funds). It is calculated by dividing total liabilities by owners’ equity. In general, the lower the ratio, the better. But it is important to assess the debt-to-equity ratio against both past values and industry averages. Delicious Desserts’ ratio for 2018 is 89.1 percent. The ratio indicates that the company has 89 cents of debt for every dollar the owners have provided. A ratio above 100 percent means the firm has more debt than equity. In such a case, the lenders are providing more financing than the owners.

Cloud-Based Services

The internet and cloud technology continue to disrupt many industries, including accounting, and clients expect their accountants to be up to speed on how financial data and other accounting information can be entered, accessed, and discussed in a very short period of time. For the most part, gone are the days when accountants and their support staff spend hours manually inputting data that gets “re-hydrated” into standardized accounting and financial statements, and reams of paper generate a company’s weekly, monthly, or yearly reports.

According to recent research, cloud-based accounting firms add five times more clients than traditional accounting firms because businesses expect their accountants to be able to use technology to create the company’s financial picture in real time, while assisting them in decision-making about where to go next in terms of profitability, sales, expansion, etc. In addition, it is estimated that more than 90 percent of small- and medium-sized companies use cloud-based accounting software, which helps them synthesize the information they collect for their many important financial statements. This use of computerized accounting programs offers many opportunities to accountants to shift their focus when it comes to attracting and retaining business clients.⁹

Automation

In addition to cloud-based services, automation will continue to play an important role in the accounting industry, particularly in auditing services, where the manual gathering and inputting of information can be an inefficient and sometimes inaccurate process. Being able to automate this process will help generate complete sets of data that will improve the overall details of the auditing process. In addition, accountants who can use a client’s data files from their business operations and import this information into a tax or accounting software package will streamline the overall accounting process and lessen the tedious work of data entry.¹⁰

Staffing Challenges

As these and other disruptive technologies change the focus of accounting work, the challenge of hiring the right staff to use these new tools intensifies. With accounting processes becoming automated and less time-intensive, some accounting firms are becoming more connected to their clients and increasing their advisory services when it comes to daily business operations. This change in approach will likely have an impact on the type of experienced employees accountants hire in the future. In addition, because most services are now cloud-based and financial data is available rather quickly, businesses are apt to change accounting firms faster than in the past if they are unsatisfied with the services they receive. Accountants have a great opportunity to expand their business portfolios and increase their client list by leveraging technology as part of their overall corporate strategies.¹¹