

Learn
Why financial intelligence matters
If you work at a for-profit company, your job is to help the company make money—preferably,
more money each year. If you work for a nonprofit or a government agency, it’s still vital that
you monitor how much money comes into the organization and where it gets spent.
You can help your organization make money and spend it wisely by reducing costs, increasing
revenues, or both. But to do that, you need to strengthen your financial intelligence. And that
starts with understanding the basic tools organizations use to depict their financial condition:
financial statements.
When you understand your organization’s financial statements, you find answers to questions
like:
 Does my employer have enough cash to make payroll?
 How profitable are the products or services I work on?
 Will a proposed capital expenditure—an investment in property, plant, or
equipment— generate the intended returns?
 Is my company manipulating financial performance data to look like it’s
doing better than it really is?
EXAMPLE

A big telecommunications company has an ongoing strategy to grow through

acquisitions. But it’s not generating enough cash for the acquisitions it wants to make.
So it uses stock as its currency and pays for the businesses it acquires partly with
company shares. That means it has to keep its share price high. Otherwise, the
acquisitions would be too expensive. And to keep its share price high, it must keep its
profits high.

The company has also paid for the acquisitions by borrowing from banks. This is another
reason to keep its profits up; otherwise, the banks will stop lending it money.

Severe pressure to report high profits compels the company to resort to fraud. It
artificially boosts profits through accounting tricks like understating expenses and
treating operating costs as capital expenditures. When analysts, investors, and
regulators learn that the business isn’t as profitable as it has claimed, the whole
scheme collapses. But even if the company hadn’t resorted to fraud, its ability to
generate cash was out of step with its growth-by-acquisitions strategy. It could live on
borrowing and using stock as a currency for a while—but not forever. *
Accounting methods
Before you can understand the financial statements, your organization uses, you need to
understand the accounting methods companies use. But this and other aspects of financial
intelligence are hard to talk about without examples and data.
So, throughout this topic, the Kitchen Storage Solutions (KSS) case will be used to illustrate
financial concepts. KSS manufactures hanging racks for pots and pans, spice racks, and racks for
storing kitchen tools. It sells mostly to retailers but also directly to some other companies, such
as custom kitchen design firms.
There are two accounting methods that are important to know about:
 Accrual accounting
 Cash-basis accounting
Accrual accounting
Most companies use accrual accounting. Income and expenses are booked when they’re
incurred, regardless of when payment from customers has actually been received or suppliers’
invoices have actually been paid.
EXAMPLE

At KSS, the revenue for a customer order is booked as each rack ships—not when the
customer pays for the order. Similarly, if KSS receives 2,000 brass hooks from a
supplier, those hooks are not all expensed at once. Rather, they are expensed on a per-
unit basis, as each rack made with hooks is shipped out to a customer.
With accrual accounting:
 Revenues are recognized during the period in which the sales activity
occurred.
 Expenses are recognized in the same period as their associated revenues.
 

Cash accounting
Some companies, usually very small ones, start out using cash accounting. With this
method, a company records transaction when cash actually changes hands.
This practice is less conservative when it comes to recognizing expenses. That is, more items can
be counted as expenses than under accrual accounting. But cash accounting can be more
conservative than accrual accounting when it comes to recognizing revenue. The differences in
expense and revenue recognition between the two methods have tax implications.
As companies grow in size and complexity, it becomes more important to match revenues and
expenses in the appropriate time periods. So companies tend to switch from cash accounting to
accrual accounting.
That’s because accrual accounting records revenues and expenses in the same time period based
on their causal relationships. This enables managers to measure the business’s performance
without including mistimed transactions that distort the reported figures.
EXAMPLE
A business that uses cash accounting spends $20,000 to make products intended for
sale. The entire sum is recorded as a one-time expense once the cash changes hands to
pay for the production of the products, even if the products are sold piecemeal across
eight subsequent months. If the business used accrual accounting, it would account for
the initial production as an exchange of cash for products intended for sale. It would
then treat acquisition costs as expenses as each unit is sold and the deduction is made
from the asset account. *