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extraordinary gains and losses that should be recorded in the period).
Profit measurement depends on the reliability of a business™s accounting
FL
system and the choices of accounting methods by the business. Caution:
A business may engage in certain manipulations of its accounting meth-
AM


ods, and managers may intervene in the normal course of operations for
the purpose of improving the amount of profit recorded in the period,
which is called earnings management, income smoothing, cooking the
books, and other pejorative terms.
TE




internal accounting controls Refers to forms used and procedures
established by a business”beyond what would be required for the
record-keeping function of accounting”that are designed to prevent
errors and fraud. Two examples of internal controls are (1) requiring a
second signature by someone higher in the organization to approve a
transaction in excess of a certain dollar amount and (2) giving cus-
tomers printed receipts as proof of sale. Other examples of internal
control procedures are restricting entry and exit routes of employees,
requiring all employees to take their vacations and assigning another
person to do their jobs while they are away, surveillance cameras, sur-
prise counts of cash and inventory, and rotation of duties. Internal con-
trols should be cost-effective; the cost of a control should be less than
the potential loss that is prevented. The guiding principle for designing
internal accounting controls is to deter and detect errors and dishon-
esty. The best internal controls in the world cannot prevent most fraud
by high-level managers who take advantage of their positions of trust
and authority.

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APPENDIX A


internal rate of return (IRR) The precise discount rate that makes the
present value (PV) of the future cash returns from a capital investment
exactly equal to the initial amount of capital invested. If IRR is higher
than the company™s cost-of-capital rate, the investment is an attractive
opportunity; if less, the investment is substandard from the cost-of-
capital point of view.

inventory shrinkage A term describing the loss of products from inven-
tory due to shoplifting by customers, employee theft, damaged and
spoiled products that are thrown away, and errors in recording the pur-
chase and sale of products. A business should make a physical count and
inspection of its inventory to determine this loss.

inventory turnover ratio The cost-of-goods-sold expense for a given
period (usually one year) divided by the cost of inventories. The ratio
depends on how long products are held in stock on average before they
are sold. Managers should closely monitor this ratio.

inventory write-down Refers to making an entry, usually at the close of a
period, to decrease the cost value of the inventories asset account in
order to recognize the lost value of products that cannot be sold at their
normal markups or will be sold below cost. A business compares the
recorded cost of products held in inventory against the sales value of the
products. Based on the lower-of-cost-or-market rule, an entry is made to
record the inventory write-down as an expense.

investing activities One of the three classes of cash flows reported in the
statement of cash flows. This class includes capital expenditures for
replacing and expanding the fixed assets of a business, proceeds from
disposals of its old fixed assets, and other long-term investment activities
of a business.

management control This is difficult to define in a few words”indeed, an
entire chapter is devoted to the topic (Chapter 17). The essence of man-
agement control is “keeping a close watch on everything.” Anything can
go wrong and get out of control. Management control can be thought of
as the follow-through on decisions to ensure that the actual outcomes
happen according to purposes and goals of the management decisions
that set things in motion. Managers depend on feedback control reports
that contain very detailed information. The level of detail and range of
information in these control reports is very different from the summary-
level information reported in external income statements.

mark to market Refers to the accounting method that records increases
and decreases in assets based on changes in their market values. For

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APPENDIX A


example, mutual funds revalue their securities portfolios every day based
on closing prices on the New York Stock Exchange and Nasdaq. Gener-
ally speaking, however, businesses do not use the mark-to-market method
to write up the value of their assets. A business, for instance, does not
revalue its fixed assets (buildings, machines, equipment, etc.) at the end
of each period”even though the replacement values of these assets fluc-
tuate over time. Having made this general comment, I should mention
that accounts receivable are written down to recognize bad debts, and a
business™s inventories asset account is written down to recognize stolen
and damaged goods as well as products that will be sold below cost. If
certain of a business™s long-term operating assets become impaired and
will not have productive utility in the future consistent with their book
values, then the assets are written off or written down, which can result
in recording a large extraordinary loss in the period.

market capitalization, or market cap Current market value per share of
capital stock multiplied by the total number of capital stock shares out-
standing of a publicly owned business. This value often differs widely from
the book value of owners™ equity reported in a business™s balance sheet.

negative cash flow The cash flow from the operating activities of a busi-
ness can be negative, which means that its cash balance decreased from
its sales and expense activities during the period. When a business is
operating at a loss instead of making a profit, its cash outflows for
expenses very likely may be more than its cash inflow from sales. Even
when a business makes a profit for the period, its cash inflow from sales
could be considerably less than the sales revenue recorded for the
period, thus causing a negative cash flow for the period. Caution: This
term also is used for certain types of investments in which the net cash
flow from all sources and uses is negative. For example, investors in
rental real estate properties often use the term to mean that the cash
inflow from rental income is less than all cash outflows during the
period, including payments on the mortgage loan on the property.

net income (also called the bottom line, earnings, net earnings, and net
operating earnings) This key figure equals sales revenue for a period
less all expenses for the period; also, any extraordinary gains and losses
for the period are included in this final profit figure. Everything is taken
into account to arrive at net income, which is popularly called the bottom
line. Net income is clearly the single most important number in business
financial reports.

net present value (NPV) Equals the present value (PV) of a capital invest-
ment minus the initial amount of capital that is invested, or the entry cost

306
APPENDIX A


of the investment. A positive NPV signals an attractive capital investment
opportunity; a negative NPV means that the investment is substandard.

net worth Generally refers to the book value of owners™ equity as reported
in a business™s balance sheet. If liabilities are subtracted from assets, the
accounting equation becomes: assets ’ liabilities = owners™ equity. In this
version of the accounting equation, owners™ equity equals net worth, or
the amount of assets after deducting the liabilities of the business.

operating activities Includes all the sales and expense activities of a busi-
ness. But the term is very broad and inclusive; it is used to embrace all
types of activities engaged in by profit-motivated entities toward the
objective of earning profit. A bank, for instance, earns net income not
from sales revenue but from loaning money on which it receives interest
income. Making loans is the main revenue operating activity of banks.

operating cash flow See cash flow from operating activities.

operating leverage A relatively small percent increase or decrease in
sales volume that causes a much larger percent increase or decrease in
profit because fixed expenses do not change with small changes in sales
volume. Sales volume changes have a lever effect on profit. This effect
should be called sales volume leverage, but in practice it is called oper-
ating leverage.

operating liabilities The short-term liabilities generated by the operating
(profit-making) activities of a business. Most businesses have three types
of operating liabilities: accounts payable from inventory purchases and
from incurring expenses, accrued expenses payable for unpaid expenses,
and income tax payable. These short-term liabilities of a business are
non-interest-bearing, although if not paid on time a business may be
assessed a late-payment penalty that is in the nature of an interest
charge.

operating profit See earnings before interest and income tax (EBIT).

overhead costs Overhead generally refers to indirect, in contrast to direct,
costs. Indirect means that a cost cannot be matched or coupled in any
obvious or objective manner with particular products, specific revenue
sources, or a particular organizational unit. Manufacturing overhead
costs are the indirect costs in making products, which are in addition to
the direct costs of raw materials and labor. Manufacturing overhead
costs include both variable costs (electricity, gas, water, etc.), which vary
with total production output, and fixed costs, which do not vary with
increases or decreases in actual production output.

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APPENDIX A


owners™ equity Refers to the capital invested in a business by its share-
owners plus the profit earned by the business that has not been distrib-
uted to its shareowners, which is called retained earnings. Owners™
equity is one of the two basic sources of capital for a business, the other
being borrowed money, or debt. The book value, or value reported in a
balance sheet for owners™ equity, is not the market value of the business.
Rather, the balance sheet value reflects the historical amounts of capital
invested in the business by the owners over the years plus the accumula-
tion of yearly profits that were not paid out to owners.

present value (PV) This amount is calculated by discounting the future
cash returns from a capital investment. The discount rate usually is the
cost-of-capital rate for the business. If PV is more than the initial amount
of capital that has to be invested, the investment is attractive. If less,
then better investment alternatives should be found.

price/earnings (P/E) ratio This key ratio equals the current market price
of a capital stock share divided by the earnings per share (EPS) for the
stock. The EPS used in this ratio may be the basic EPS for the stock or its
diluted EPS”you have to check to be sure about this. A low P/E may sig-
nal an undervalued stock or may reflect a pessimistic forecast by
investors for the future earnings prospects of the business. A high P/E
may reveal an overvalued stock or reflect an optimistic forecast by
investors. The average P/E ratio for the stock market as a whole varies
considerably over time”from a low of about 8 to a high of about 30.
This is quite a range of variation, to say the least.

product cost This is a key factor in the profit model of a business. Product
cost is the same as purchase cost for a retailer or wholesaler (distribu-
tor). A manufacturer has to accumulate three different types of produc-
tion costs to determine product cost: direct materials, direct labor, and
manufacturing overhead. The cost of products (goods) sold is deducted
from sales revenue to determine gross margin (also called gross profit),
which is the first profit line reported in an external income statement
and in an internal profit report to managers.

profit The general term profit is not precisely defined; it may refer to net
gains over a period of time, or cash inflows less cash outflows for an
investment, or earnings before or after certain costs and expenses are
deducted from income or revenue. In the world of business, profit is
measured by the application of generally accepted accounting principles
(GAAP). In the income statement, the final, bottom-line profit is generally
labeled net income and equals revenue (plus any extraordinary gains)
less all expenses (and less any extraordinary losses) for the period. Inter-

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APPENDIX A


nal management profit reports include several profit lines: gross margin,
contribution margin, operating profit (earnings before interest and
income tax), and earnings before income tax. External income state-
ments report gross margin (also called gross profit) and often report one
or more other profit lines, although practice varies from business to
business in this regard.

profit and loss statement (P&L statement) This is an alternative moniker
for an income statement or for an internal management profit report.
Actually, it™s a misnomer because a business has either a profit or a loss
for a period. Accordingly, it should be profit or loss statement, but the
term has caught on and undoubtedly will continue to be profit and loss
statement.

profit module This concept refers to a separate source of revenue and
profit within a business organization, which should be identified for
management analysis and control. A profit module may focus on one
product or a cluster of products. Profit in this context is not the final, bot-
tom-line net income of the business as a whole. Rather, other measures
of profit are used for management analysis and decision-making pur-
poses”such as gross margin, contribution margin, or operating profit
(earnings before interest and income tax).

profit ratios Ratios based on sales revenue for a period. A measure of
profit is divided by sales revenue to compute a profit ratio. For example,
gross margin is divided by sales revenue to compute the gross margin
profit ratio. Dividing bottom-line profit (net income) by sales revenue
gives the profit ratio that is generally called return on sales.

property, plant, and equipment This label is generally used in financial
reports to describe the long-term assets of a business, which include
land, buildings, machinery, equipment, tools, vehicles, computers, furni-

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