Accounting for Prudent Choice
4. Accounting for business choices

Paul should to be perfectly prudent do some basic accounting when he faces choices, especially big ones like buying a car or buying a house. And businesses surely must do the same. When a manager faces hiring new employees or investing in a new office building he have to know how the business is doing. He needs to know his financial constraints---obviously. That's one reason why prudent managers maintain elaborate accounts of their business, in particular a balance sheet and an income/expenditure statement. Another reason is that they will go to jail if they don't. The Internal Revenue Service (the "service" is that of extracting taxes from you), the Securities Exchange Commission, and the courts hold managers literally to account. The IRS uses a business's balance sheets and income statements to determine how much tax it owes, and whether it will bring criminal charges against a manager who fiddle with the books to evade taxes. Stockholders use them to determine whether they want to stay invested in a particular business.

Consider Paciolo, Inc., an auto-parts manufacturing corporation partly owned by Paul's father. He just invented a little plastic engine fan which he thinks will become standard in American autos, and then he "went public," as it is put. That is, he sold stock in the company to outsiders, and used the money to invest in the plant and equipment to make the fans. He kept a lot of the stock for himself, actually 51%, which gives him, we say, a "controlling interest." In a corporation, known expressively in Britain as a "joint stock company," some or all of the stock certificates---nicely engraved pieces of paper saying "one share of Paciolo stock"---carry the right to vote on who is on the board of directors. If Paul's father owned only 49% of the stocks he would be said to have "lost control" of the company, though in practice with such a large share he could outvote other stockholders, divided as they are.

As the "Inc." ("incorporated") indicates, Paciolo is a public company: a corporation. In Britain the same concept is signaled by a "Ltd" (limited liability company = a corporation) and in France by "S. A." (Société Anonyme = literally, "anonymous society," that is, a corporation with a bunch of shareholders). The corporation sold shares of stock to the public. The owners of the shares are the owners of the company. What they "share" in for their shares is share the company's profit.

In an unincorporated company, called a "sole proprietorship" or a "partnership" depending on how many people are involved, the owner/owners own all of the company's wealth. There are no shareholders. A "private company" is a middle ground, in which stocks are issued (sold or just given out) but are not for sale to outsiders. It's also called, appropriately, a "closely held corporation," such as a family company in which cousins and uncles own stocks but no one else. The ordinary Inc., such as Paciolo, Inc., is called by contrast a public corporation.

For any business, however it is owned, profit is analogous to the savings on Paul's income statement:

A company's profit equals total income minus total expenses. A loss (negative profit) occurs when expenses exceed income.

The share of profits distributed each year to the company's owners is called a dividend. Another part of profit - the corporate income tax - goes to the government. (Some accountants argue that the corporate income tax is an expense, not really part of the company's profit. But that's another and complicated story.) A third part of profit, called retained earnings, is kept by the company for, say, investment purposes. In other words, retained earnings are the company's savings.

A company's profit = dividends + corporate income taxes + retained earnings.

The wealth of a company---its net worth---consists of the value of its shares plus the retained earnings it has accumulated over the years. Retained earnings are not immediately paid out to the stockholders of Paciolo, Inc., but they increase the company's value if they are intelligently and responsibly invested. Paciolo, Inc., for example, might retain earnings in 2008 to invest in computer-controlled cutters that will allow it to produce cheaper engine fans for years to come. The cheaper method means lower costs and, Paul's father dearly hopes, larger profits for Paciolo. So retained earnings, which sound at first like a bad deal for stockholders, benefit the company's stockholders in the long run. In fact actual dividends are a minor part of the gain that stockholders depend on. Mostly they buy a stock in expectation that its price will rise because of retained earnings being intelligently invested that at some date far in the future will result in actual dividends paid out!

The business definition of wealth is the same as for a household:

The wealth (or net worth) of a company = assets - liabilities.

The company's wealth is equal to the cash that would be left over if it were to sell all of its assets and pay off all of it debts.

Look at the balance sheet in Table 2.4. Remember, a balance sheet is a snapshot of ones wealth. It shows the assets, liabilities, and net worth (or "wealth") for Paciolo, Inc. on December 31, 2008. Notice that the company's balance sheet doesn't have any place on the asset side for Paul's dad's Paciolo stock certificates, because those are his personal assets, not the company's. The stocks are of course, liabilities of the company, not assets. The company's assets consist of cash, the correctly depreciated value of its plant and equipment, its unsold product still in Paciolo's warehouse ("inventory"), and the unpaid bills of Paciolo's customers ("accounts receivable" they are called: Paciolo is saying that it can reasonably expect to get paid by the auto-company customers, e.g., Ford Motor Company, which bought the fans on credit). Its liabilities include bills owed to other companys (accounts payable, say to a maker of the raw plastic used to make the fans), a short-term loan, and a sizable IOU to the public (a "bond" is an IOU for a long-term loan). It total wealth is the difference between its assets and liabilities, and sits on the liability side. If the accounting has been done correctly the company's wealth will equal the total value of its stock, that is the financial value of all the stock it has issued on, say, the New York Stock Exchange, plus all past retained earnings. It sits on the liability side because it's what Paciolo, Inc. "owes" to its owners, such as Paul's dad.

Table 2.4a Balance sheet for Paciolo, Inc. (on December 31, 2008)

Assets Liabilities
Current assets
Cash and bank account $25,000
Inventory $160,000
Accounts receivable $62,000

Capital assets
Equipment $350,000
Buildings $1,210,000

Total assets $1,807,000
Current liabilities
Accounts payable $40,000
Short-term loan $145,000

Long-term liabilities
Bonds $860,000

Total liabilities (A) $1,045,000

Stockholders' equity
(wealth or net worth)

Shares (original value) $600,000
Retained earnings (total) $162,000

Total equity (B) $762,000

Total liabilities and stockholder equity (A+B) $1,807,000

Everyone interested in Paciolo, Inc. will want to examine its balance sheet to see what the company owns and what it owes. They will also, of course, want to know how well the company has done, that is, how large its sales where relative to its expenses. But that's on its income/expenditure statement, not on the balance sheet. What were Paciolo's sales in 2008? What was its profit? Look at the income statement. Under income are listed "gross sales," the "revenues" (as economists prefer to put it) from selling fans. The gross sales oddly include sales taxes, which the company has to pay to the government---but the taxes are later subtracted as an expense. The "interest" item is the interest the company pays on its bonds and short-term loans. Depreciation, as we've explained in Paul's personal case, is the cost of using (consuming, wearing out, letting grow old and out-of-date) capital assets.

Table 2.4b. Income statement for Paciolo, Inc. (for year ending December 31, 2008)

Expenses Income
Materials $ 270,000
Wages and salaries $ 830,000
Sales taxes $ 50,000
Interest $ 80,000
Depreciation $ 200,000
Total expenses (A) $1,430,000

Profit before tax (B-A) $ 90,000
Less: Corporate income tax $ 40,000
Profit after tax $ 50,000
Less: Dividends to shareholder $ 40,000
Retained Earnings $ 10,000
Gross sales $1,520,000
Total income (B) $1,520,000

The phrase "the bottom line" refers to the company's profit before taxes, corporate taxes or just plain taxes. In actual income/expenditure statements you can get nowadays from public companies the figure does not always appear literally at the bottom of the income statement. In the good old days it did, which as we said is the origin of the expression.

Paciolo, Inc. did not do badly in its bottom line in 2008, at any rate for a little company with prospects. Even after paying the corporate income tax, it has enough left to pay dividends of $40,000 (a reasonable return on shares whose value was $600,000 when issued) and hold on to $10,000 of retained earnings.

The retained earnings of a company are what's left after expenses on its income statement, similar to savings on an individual income statement. They equal total profit minus corporate income taxes and corporate dividends.

Concept Check 8: In accounting terms, what do people mean when they say that their business is "making money" (assuming that their business is not making counterfeit $20 bills!)?

Maria: Fine. I've got it. But what am I supposed to do with all of these numbers? I haven't learned anything about how businesses make choices, have I?

Ziliak: Getting the accounting situation correct makes for prudent decisions. Think of the analogy with Paul's accounts. If you don't know "the financials," as they say, the magnitudes of flows in and out of your financial bathtub, and its level, you can't make smart decisions about your next project of turning on the faucet, or opening the drain plug. The financials will keep coming later, when we analyze the decisions businesses make.