Accounting as the Language of Business
Financial Performance & Management Control - TUHH Institute of Management Accounting & Simulation, Hamburg · part of my Technology Management MBA · study notes for revision.
Every other module in this MBA eventually lands on a number: a margin, a budget, a return on capital. This module is about where those numbers come from. Its declared aim is that we understand the concepts and the language of financial performance and management control well enough to use them as a working tool for communication, monitoring and allocating resources. The slogan the whole course hangs on is accounting as the language of business - and like any language it has vocabulary (earnings, equity, depreciation, provisions, EBIT and EBITDA, ROCE), grammar (the accounting equation) and regional dialects (HGB, IFRS, US-GAAP).
The module has three parts. Part I, financial accounting: fundamentals, the balance sheet, the income statement, IFRS, accounting for specific items such as property, plant and equipment or inventory, and financial statement analysis. Part II, management accounting and control: cost terms, costing and pricing, cost-volume-profit analysis, performance measurement and the balanced scorecard. Part III, finance and simulation: time value of money, cash-flow and project analysis, NPV, IRR and payback, WACC, the leverage effect and a simulation lab. Grading is 30% case studies and reflection, 30% assignments, 40% open-book final exam; the textbook is Horngren’s Accounting (the financial chapters), chapter 1 for this session.
This first chapter asks four questions: what financial accounting is (as opposed to management accounting), why it exists at all, who uses the information and for what, and whether accounting is shaped by history and social context. Then we stop theorising and play Monopoly - with a twist: every roll becomes a business transaction, and at the end each team has to produce a balance sheet and an income statement.
1 · What a firm actually does - the value-chain view
Section titled “1 · What a firm actually does - the value-chain view”Before we can measure performance we need a picture of the thing being measured. The course opens with a plain value-chain sketch of an organisation. On the left sits the sourcing market (the factor market, where suppliers live); on the right sits the selling market (the demand market, where customers live). In between, the firm procures resources, transforms them and commercialises the result.
So what does performance mean in this picture? A firm is a machine that turns resources bought on one market into offerings sold on another. Performance is simply how well that machine works: is what comes out worth more than what went in, and is the stock of resources the firm controls growing or shrinking? Those two questions are exactly the ones the income statement (a flow over a period) and the balance sheet (a stock at a date) are built to answer. Accounting is the measuring device bolted onto the value chain.
2 · Two kinds of accounting, one language
Section titled “2 · Two kinds of accounting, one language”The word “accounting” covers two systems that share data but serve different masters.
- Produces standardised financial information about a company or a group of companies
- Aimed at external reporting - people outside the firm
- Directed by authoritative guidelines (laws and standards) - you do not get to choose the format
- Backward-looking by nature: it reports what happened in the period
- Measures and reports financial and non-financial information (units, hours, defect rates, customer data)
- Meant primarily to help managers reach the goals of the organisation
- No external rulebook - whatever format helps a decision is the right format
- Often forward-looking: budgets, forecasts, what-if analyses
Cost accounting is the bridge between the two. It starts from the same recorded transactions as financial accounting, but re-sorts the expenses by product, department or process so that managers can steer with them (Part II of the course); some of its results flow back into the financial statements too, for example when own-produced inventory has to be valued.
One more distinction: financial reporting is the wider term. It builds on financial accounting information but puts a stronger emphasis on disclosure - getting the information out to the people who need it. Its core job is to reduce the information asymmetry between well-informed insiders (above all the managers) and the firm’s external contract partners.
3 · Who reads the numbers - insiders, outsiders and the information gap
Section titled “3 · Who reads the numbers - insiders, outsiders and the information gap”Inside the firm, managers and employees know what is going on. Outside it, a whole crowd of parties has money, jobs or claims riding on the firm without being able to look inside. Financial reporting is the pipe that carries trustworthy information from the first group to the second.
Notice how varied the outsiders are. A bank deciding on a loan, a tax office assessing a return, a union preparing a wage round and a supplier wondering whether it will be paid all read the same annual report - and each of them wants something slightly different from it. That variety is the root of most of the tensions in accounting.
4 · What the information is for - three purposes
Section titled “4 · What the information is for - three purposes”The slides frame it neatly: information for external users is either an end in itself (someone just wants to know) or the base for further legal or contractual consequences (something is triggered by the number). That gives three purposes.
Information. For investors the key word is decision usefulness: does the report help me decide whether to put money in? For management the key word is stewardship: the report is management’s account to the owners of how it looked after their resources. For customers, suppliers and employees it is self-information - checking for themselves whether the firm is a safe partner to sell to, buy from or work for.
Documentation. Accounting also conserves evidence. When a firm goes bankrupt, when owners fall out, or when the tax office asks questions, the books are the record of what was there and what happened to it.
Distribution and taxation. Here the number has teeth. The profit figure decides what may leave the firm as dividends. Creditors want distributions kept to a minimum so that the asset cushion behind their claims stays inside the company (creditor protection); shareholders want the maximum paid out, or at least a guarantee that management cannot hoard everything (shareholder protection). And in Germany the commercial accounts are the starting point for the tax accounts - the authoritative principle - so the same profit figure feeds income tax, corporate tax and trade tax.
Stewardship vs decision usefulness
Section titled “Stewardship vs decision usefulness”These two are worth separating in your head because they pull the rules in different directions. Stewardship looks backward: did management handle the owners’ money properly? It rewards caution and verifiability. Decision usefulness looks forward: what will the firm be worth, should I invest? It rewards relevance and current values, even at the price of some estimation. A rulebook built for stewardship looks different from one built for investor decisions - which is the seed of the HGB vs IFRS contrast later in the course.
5 · Three concepts underneath every statement
Section titled “5 · Three concepts underneath every statement”Whatever the rulebook, three ideas sit under every set of accounts.
| Concept | What it fixes | Detail |
|---|---|---|
| Accounting entity (reporting entity, business entity) | About whom the accounts inform | Either a legal entity (an AG, GmbH or Corp.) which gives single financial statements, or an economic entity (a group of companies, such as a car-maker with all its subsidiaries) which gives consolidated financial statements |
| Accounting period | For which stretch of time the entity is observed | Normally one fiscal year (the annual statement); listed firms also report per quarter (the quarterly statement) |
| Generally Accepted Accounting Principles (GAAP) | By which rules the numbers are produced | A common set of standards so that the information is comparable and standardised |
The origin of GAAP differs by legal tradition. In common-law (Anglo-Saxon) countries the standards are set by private standard setters; in code-law countries they are codified in law. Either way the result is the same: accounting becomes a standardised information instrument, which is precisely what outsiders need.
All three sets of rules are freely downloadable, and the course will use IFRS as its main lens in chapter 4.
6 · The financial reporting system
Section titled “6 · The financial reporting system”Financial accounting is one part of a wider financial reporting system - all the financial information a company discloses, whether through a regulator’s filing system (the US-SEC’s EDGAR database) or its own investor relations pages. It has four layers.
| Layer | What it contains | Germany | US-SEC |
|---|---|---|---|
| Annual report | An unaudited free part, the single and/or consolidated financial statements, the management discussion and analysis (MD&A), the auditor’s report | Required by HGB, AktG, BörsG, BörsZulV | Form 10-K (domestic), Form 20-F (foreign issuers) |
| Interim financial reporting | Reports covering three or six months with condensed financial statements | § 44b BörsG | Form 10-Q, Form 6-K |
| Timely disclosure of material events | Ad-hoc announcements of events that could materially move the share price | § 15 WpHG | Form 8-K, Form 6-K |
| Other | Press releases, corporate reports, presentations | - | - |
The layers trade depth for speed: the annual report is complete and audited but slow; interim reports are lighter and quicker; ad-hoc disclosure is instant but covers only single events. Together they keep the information gap from re-opening between annual reports.
7 · Auditing - why someone checks the numbers
Section titled “7 · Auditing - why someone checks the numbers”An audit is an examination of a company’s transactions and the financial statements that result from them. The reason it became compulsory is a story, and the story is the point of this section.
Before the 1929 stock market crash, senior managers were partly rewarded on the basis of what the financial statements showed - and those same managers prepared the statements. Built-in potential for bias. After the crash, the SEC Act of 1934 required public companies to have their statements audited by independent outside auditors who are CPAs (certified public accountants) and to file the results with the SEC. For shareholders the value is simple: an audit report adds credibility to the statements they base decisions on.
- Introduction - what exactly was audited (which statements, which entity, which period).
- Scope - how the audit was conducted, i.e. the standards and procedures the auditor followed.
- Opinion - two judgements: are the statements presented fairly, and to what degree was GAAP followed?
- Other topics - for example changes in accounting principles, or the adequacy of management’s review of internal controls.
Those four elements make up the standard audit report. The market for large audits is dominated by the Big Four: Deloitte Touche Tohmatsu, Ernst & Young, KPMG International and PricewaterhouseCoopers. Roughly 97% of the firms listed on the New York Stock Exchange are clients of one of these four - a concentration worth remembering when we talk about auditor independence.
8 · Accounting is shaped by history and social context
Section titled “8 · Accounting is shaped by history and social context”The lessons-learned slide pulls the chapter together in four lines, which I rephrase here because they are exam-ready:
- Financial accounting addresses external users; management accounting supplies management.
- Financial accounting produces standardised financial information about a company and exists to reduce information asymmetry between insiders and external contract partners.
- Accounting information serves different purposes, and the purposes determine the design. A system built for creditor protection and taxation comes out conservative (the HGB tradition); a system built for capital-market investors aims at a true and fair view (the IFRS and US tradition).
- Auditing shows that accounting is a product of social evolution: a market crash produced a law, the law produced a profession, and the profession changed what a set of accounts means.
So the answer to the fourth opening question is yes: accounting is not a neutral mirror. It is a set of conventions that grew out of specific crises, legal traditions and power balances between owners, lenders and the state. Two rulebooks can report two different profits for one firm, and both can be “right” by their own purpose.
9 · Let’s simulate business - Accounting Monopoly
Section titled “9 · Let’s simulate business - Accounting Monopoly”The theory is abstract until you try to record a business yourself, which is what the session’s game is for.
Setup. Groups of seven: three teams, each with a roller (the CEO, who plays) and a recorder (the CFO, who writes everything down), plus one banker who runs the bank and settles rule disputes. Play, and keep a narrative of every roll and move, numbered by round. The slides give the style:
- Round 1: land on Oxford Street and buy it (price 300).
- Round 2: land on Liverpool Station and pay rent of 25.
- Round 3: put a mortgage on Kings Cross Station (mortgage value 100).
The instruction is to describe as clearly as possible every “thing” that happens to the team. When the stop signal comes, each team has ten minutes to record its end result. The teaching notes hand out a chart of accounts to sort the mess into:
| Balance sheet accounts | Income statement accounts |
|---|---|
| Assets: cash, land, receivables, investments in railroads, investments in utilities, buildings (houses) and their accumulated depreciation, buildings (hotels) and their accumulated depreciation, other assets | Revenues: rental revenue from land, rental revenue from houses and hotels, salary revenue, investment revenue from utilities, investment revenue from railroads, interest revenue, miscellaneous revenue |
| Liabilities: mortgage payable, interest payable, taxes payable | Expenses: rent, tax, fines and penalties, repairs and maintenance, interest, depreciation, miscellaneous |
| Equity: common stock, retained earnings | Gains and losses: gains or losses on sale of property, other gains and losses |
Discussion questions afterwards - these are really the questions of the whole of Part I:
- How was it to record transactions and results, and what made it hard?
- What should be recorded and what not?
- How do you account for the status quo and how do you measure performance?
- Which team was more successful - and on what basis can that judgement be made objective?
Worked example
Section titled “Worked example”The workbook walks one team’s game through to full statements. I reproduce it step by step because it is the cleanest small example of the three statements fitting together that I have seen.
- Opening balance sheet. Each team starts with 1,500 of cash, contributed by the “owners”. Assets: cash 1,500. Equity: common stock 1,500. Total 1,500 on both sides.
- The period’s events (the example data). Buy Oxford Street 300, Bond Street 320, Park Lane 350, Kings Cross Station 200, Water Works 150 and Mayfair 400. Pay 25 rent at Liverpool Station and 100 at Trafalgar Square. Build one house each on Mayfair and Park Lane (200 apiece). Collect rent twice on Oxford Street (26 each), once on Bond Street (28), once on Park Lane with its house (350), twice on Kings Cross (25 each), and once on Water Works with a dice roll of ten (4 × 10 = 40). Depreciate each house by 20. Mortgage Kings Cross for 100. Land on income tax (200). Receive a get-out-of-jail-free card. Pay street repairs (40 per house = 80) and a school fee of 50. Pass Go four times (200 each = 800).
- Inventory at the stop signal. Cash 345; the four streets; the station and the utility; two houses at 200 less 20 each; a mortgage of 100 on Kings Cross; the card.
- Sort into the chart of accounts, then build the closing balance sheet, the income statement, and finally a cash-flow split.
Closing balance sheet
| Assets | Liabilities and equity | ||
|---|---|---|---|
| Cash | 345 | Mortgage payable (Kings Cross Station) | 100 |
| Land (Park Lane 350, Mayfair 400, Bond Street 320, Oxford Street 300) | 1,370 | Interest payable (accrued on the mortgage) | 10 |
| Investments in railroads (Kings Cross Station) | 200 | Total liabilities | 110 |
| Investments in utilities (Water Works) | 150 | Common stock | 1,500 |
| Buildings, houses (2 × 200 less 2 × 20 depreciation) | 360 | Retained earnings | 815 |
| Other assets (get-out-of-jail card: not recognised) | 0 | Total equity | 2,315 |
| Total assets | 2,425 | Total liabilities and equity | 2,425 |
Income statement for the period
| Revenues | Expenses | ||
|---|---|---|---|
| Rental revenue, land (Oxford Street 2 × 26 = 52, Bond Street 28) | 80 | Rent expense (Liverpool Station 25, Trafalgar Square 100) | 125 |
| Rental revenue, houses (Park Lane with one house) | 350 | Tax expense (income tax square) | 200 |
| Salary revenue (passed Go 4 × 200) | 800 | Repairs and maintenance (street repairs, 2 houses × 40) | 80 |
| Investment revenue, utilities (Water Works, 4 × 10) | 40 | Depreciation expense (2 houses × 20) | 40 |
| Investment revenue, railroads (Kings Cross 2 × 25) | 50 | Miscellaneous expense (school fee 50 plus the 10 of accrued mortgage interest) | 60 |
| Total revenues | 1,320 | Total expenses | 505 |
Gains and losses on property sales: none (nothing was sold). Earnings = 1,320 - 505 = 815.
revenues 1,320 - expenses 505 = 815opening 0 + earnings 815 - dividends 0 = 815common stock 1,500 + retained earnings 815 = 2,315assets 2,425 = liabilities 110 + equity 2,315Two things to see here. First, the income statement’s bottom line is the balance sheet’s retained earnings: the period’s profit is the growth in the owners’ claim. Second, the equation balances because every event was recorded on both sides - that is not luck, it is the structure of double entry (chapter 2).
Where did the cash go? The team made 815 of profit yet its cash fell from 1,500 to 345. The cash-flow split explains it:
| Cash flow | Amount | What sits inside |
|---|---|---|
| Operating activities (CFO) | +865 | All 1,320 of revenue was cash; cash expenses were rent 125, tax 200, repairs 80 and school fee 50 = 455; depreciation (40) and the accrued interest (10) cost no cash |
| Investing activities (CFI) | -2,120 | Land 1,370 + railroad 200 + utility 150 + two houses 400 |
| Financing activities (CFF) | +100 | The mortgage taken on Kings Cross |
| Net change in cash | -1,155 | 1,500 opening - 1,155 = 345 closing |
earnings 815 + depreciation 40 + interest accrued but unpaid 10 = 865865 - 2,120 + 100 = -1,155 → 1,500 - 1,155 = 345Profit is not cash. The team is 815 richer by the accounting measure and 1,155 poorer in cash, and both statements are correct. The difference is that the cash went into assets that are still there (land, station, utility, houses) - an investment, not an expense - while a mortgage brought cash in without making the team any richer. This single example is the reason companies publish three statements, not one.
Case corner
Section titled “Case corner”Why recording is harder than it looks. The moment you start writing down a Monopoly game as transactions, three questions bite. What counts? Rolling the dice is not a transaction; landing on Go and collecting 200 is. Buying a street changes the balance sheet but not the profit; paying rent changes both. When? Depreciation of the houses is a transaction even though no money moved; the 10% interest that will be due on the Kings Cross mortgage is accrued now as interest payable even though nothing has been paid yet. At what value? Land goes in at the price paid (historical cost), houses at cost less depreciation; a mortgaged property stays on the asset side at its full cost, with the mortgage shown separately as a liability rather than netted off. Every one of these judgement calls is a real accounting rule in disguise, and every team makes them slightly differently until a common chart of accounts forces consistency - which is GAAP in miniature.
Why the get-out-of-jail card is not recognised. It clearly has some economic value - it will save a fine one day. But it cost nothing, it cannot be sold in the game, and there is no reliable way to put a money figure on it. An item that cannot be measured reliably in money terms stays out of the balance sheet, so the “other assets” line stays empty. The same logic later explains why a firm’s self-created brand or its motivated workforce is not on its balance sheet.
How to judge which team won. Cash is the wrong yardstick: a team that bought nothing would end with the most cash and the weakest position. Two better measures follow from the statements. The balance sheet shows the status quo - total equity of 2,315 versus 1,500 at the start; the income statement shows performance - earnings of 815 for the period. Since nothing was distributed, the two agree: the winner is the team whose equity grew the most, i.e. the highest earnings. And because every team applies the same recognition and measurement rules, that comparison is objective in exactly the sense the discussion question asks for. Standardised rules are what turn “we feel richer” into a number two teams can argue about.
Key terms
Section titled “Key terms”| Term | What it means in plain words |
|---|---|
| Value chain | The firm seen as procure, transform, commercialise: resources bought on the sourcing market become offerings sold on the selling market |
| Financial accounting | Standardised financial information about a company or group, produced under authoritative rules for people outside the firm |
| Management accounting | Financial and non-financial information produced, in whatever form helps, for managers inside the firm |
| Cost accounting | The bridge: re-sorts recorded expenses by product, department or process so managers can steer |
| Financial reporting | The disclosure side of accounting; its job is to reduce information asymmetry between insiders and outside contract partners |
| Information asymmetry | Insiders know more than outsiders; reporting narrows the gap so outsiders can deal with the firm on fair terms |
| Decision usefulness | Information that helps an investor decide whether to invest - the investor-focused purpose |
| Stewardship | Management’s account to the owners of how it looked after their resources - the accountability-focused purpose |
| Authoritative principle | In Germany the commercial (HGB) accounts are the starting point for the tax accounts |
| Accounting entity | The unit the accounts describe: a legal entity (single statements) or an economic group (consolidated statements) |
| Accounting period | The stretch of time observed: normally a fiscal year, or a quarter for interim reports |
| GAAP | Generally accepted accounting principles: the shared rulebook, set privately in common-law countries and codified in code-law countries |
| Audit | Independent examination of transactions and statements by outside CPAs, compulsory for US public companies since the SEC Act of 1934 |
| Retained earnings | Profits kept in the business; the link between the income statement and the balance sheet |
Test yourself
Section titled “Test yourself”- Using the value-chain picture, explain what the “performance” of a firm means and why a measuring system is needed to judge it.
- Contrast financial and management accounting on three dimensions: users, rules and the kind of information reported. Where does cost accounting sit?
- Name the three purposes of financial accounting information and give one concrete example of each. Which of them is an end in itself?
- Define accounting entity, accounting period and GAAP. How does the origin of GAAP differ between common-law and code-law countries, and which standard belongs to which tradition?
- Why did the United States begin requiring independent audits, and what four elements does a standard audit report contain?
- A Monopoly team starts with 1,500 cash. At the end it holds cash 345, land 1,370, investments 350 and houses of 360 net, and owes a mortgage of 100 plus 10 of interest. Compute total assets, total liabilities, equity, retained earnings and the period’s earnings. Then explain in one sentence why the cash fall of 1,155 is not a loss.
Revision summary
Section titled “Revision summary”Next: The Balance Sheet → - the snapshot of what a business owns and owes.