Relevant Revenues and Costs
CHAPTER 2:
RELEVANT REVENUES AND COSTS
The primary goal of a firm is to maximize profits. This implies, of course, that each decision a manager makes is consistent with that goal. Although managers are expected to rely on internally-produced reports, such as balance sheets and income statements, to help them make decisions, most of the information that appears on these statements is period-based rather than decision-based. A balance sheet shows the sum total of a firm’s assets and liabilities at a given point in time. If the firm sold off all of its assets at book value and used the proceeds to pay its liabilities, what remains is owner’s equity: the amount that is owed to shareholders. An income statement is the difference between revenues and expenses between two points in time. A myriad of useful pieces of information can be gleaned from these statements: the current ratio, inventory ratio, and liabilities ratio may be determined from balance sheets. Net sales to inventory and net profits to net sales are obtained from income statements. But as useful as this information can be to managers, the critical element is that the balance sheet and income statement represent the results of previous decisions. The balance sheet indicates where the firm stands as a result of all past decisions. The income statement reports the revenues received and expenses incurred between two distinct dates. Some of the revenues may flow from decisions made in previous periods. Some of the expenses that are incurred may not generate revenue until a future time period. There is nothing in the statement that reports the results of a specific decision. But managers need to know how to make profitable decisions. This is the primary focus of this book: to merge economic theory with accounting practices to help managers make better decisions. The target market for this book is business managers more than accountants. Although the theoretical background will be useful
RELEVANT REVENUES AND COSTS
The primary goal of a firm is to maximize profits. This implies, of course, that each decision a manager makes is consistent with that goal. Although managers are expected to rely on internally-produced reports, such as balance sheets and income statements, to help them make decisions, most of the information that appears on these statements is period-based rather than decision-based. A balance sheet shows the sum total of a firm’s assets and liabilities at a given point in time. If the firm sold off all of its assets at book value and used the proceeds to pay its liabilities, what remains is owner’s equity: the amount that is owed to shareholders. An income statement is the difference between revenues and expenses between two points in time. A myriad of useful pieces of information can be gleaned from these statements: the current ratio, inventory ratio, and liabilities ratio may be determined from balance sheets. Net sales to inventory and net profits to net sales are obtained from income statements. But as useful as this information can be to managers, the critical element is that the balance sheet and income statement represent the results of previous decisions. The balance sheet indicates where the firm stands as a result of all past decisions. The income statement reports the revenues received and expenses incurred between two distinct dates. Some of the revenues may flow from decisions made in previous periods. Some of the expenses that are incurred may not generate revenue until a future time period. There is nothing in the statement that reports the results of a specific decision. But managers need to know how to make profitable decisions. This is the primary focus of this book: to merge economic theory with accounting practices to help managers make better decisions. The target market for this book is business managers more than accountants. Although the theoretical background will be useful
References: Healy, P. and Palepu, K. (2003). The Fall of Enron. Journal of Economic Perspectives. 17(2): 3-26. Notes