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*Chapter Seventeen

Understanding Accounting

and Financial Information

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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• Accounting -- Recording, classifying, summarizing and interpreting of financial events and transactions in an organization to provide interested parties needed financial information.

• Outside parties - like employees, owners, creditors, unions, investors and the government - make use of a firm’s accounting information.

WHAT’S ACCOUNTING?What is Accounting?

LG1

17-2

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*The ACCOUNTING SYSTEM

What is Accounting?

LG1

17-3

AREAS OF ACCTG

• 1. MANAGERIAL• 2. FINANCIAL• 3. AUDITING• 4. TAX• 5. GOVT/NON PROFIT

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• Managerial Accounting -- Provides information and analysis to managers inside the organization to assist them in decision making.

• Managerial accounting is involved with:

- Costs of production

- Costs of marketing

- Preparation and control of budgets

- Minimizing tax liabilities

MANAGERIAL ACCOUNTINGManagerial Accounting

LG2

17-5

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• Financial Accounting -- Financial information and analyses are generated for people primarily outside the organization. Outside users are interested in these questions:

- Is the organization profitable?

- Is it able to pay its bills?

- How much debt does it owe?

• Annual Report -- A yearly statement of the financial condition, progress, and expectations of the firm.

FINANCIAL ACCOUNTINGFinancial Accounting

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17-6

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• Key things to watch for and read:

HOW to READ an ANNUAL REPORT

Financial Accounting

LG2

- Management’s discussion and analysis of operations

- Balance sheet

- Income statement

- Statement of cash flows

- Auditor’s opinion

17-7

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• Private Accountants -- Work in a single firm, government agency, or nonprofit organization.

• Public Accountants -- Provide accounting services to individuals or businesses.

• Certified Public Accountants (CPAs) -- Accountants who have passed a series of examinations established by the American Institute of Certified Public Accountants (AICPA) and met a states requirements for education and experience.

PUBLIC vs. PRIVATE ACCOUNTANTS

Financial Accounting

LG2

17-8

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*STEPS to CONTROL

ACCOUNTING PRACTICES

Financial Accounting

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17-9

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• Auditing -- Reviewing and evaluating the information used to prepare a company’s financial statements.

• Independent Audit -- An evaluation and unbiased opinion about the accuracy of a company’s financial statements.

• Certified Internal Auditors (CIAs) -- Accountants who have a bachelor’s degree and two years of experience in internal auditing and pass an exam administered by the Institute of Internal Auditors.

AUDITING CHECKS ACCURACYAuditing

LG2

17-10

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• Tax Accountants -- Accountants trained in tax law and are responsible for preparing tax returns or developing tax strategies.

• Government and Not-for-Profit Accounting -- Support for organizations whose purpose is not generating a profit, but serving others according to a duly approved budget.

SPECIALIZED ACCOUNTANTSTax Accounting

LG2

17-11

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• Accounting Cycle -- A six-step procedure that results in the preparation and analysis of the major financial statements.

The ACCOUNTING CYCLEThe Accounting Cycle

LG3

17-12

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• Bookkeeping -- The recording of business transactions. Bookkeepers divide a firm’s transactions into meaningful categories and post them into a record book or computer program called a journal.

• Double-Entry Bookkeeping -- Bookkeepers record all transactions in two places so they can check one list of transactions against the other for accuracy.

BOOKKEEPING’S ROLEThe Accounting Cycle

LG3

17-13

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• Ledger -- A specialized accounting book or program where all information is in one place.

• Trial Balance -- A summary of all the information in the account ledgers.

BOOKKEEPING’S ROLEThe Accounting Cycle

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17-14

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• Financial Statement -- A summary of all the financial transactions that have occurred over a particular period.

FINANCIAL STATEMENTSUnderstanding Key Financial Statements

LG3

• Key financial statements of business are:

- Balance sheet

- Income statement

- Statement of cash flows

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BALANCE SHEET

• Shows what you own and who you owe

• Is a particular date in time (ex. March 31, 2010)

• Broken down into assets, liabilities, and equity

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• Fundamental Accounting Equation -- The basis for the balance sheet.

• The equation must always be balanced and includes the formula:

o Assets = Liabilities + Owners Equity

The FUNDAMENTAL ACCOUNTING EQUATION

The Fundamental Accounting Equation

LG4

17-17

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• Assets -- Economic resources owned by a firm. Items can be tangible or intangible.

• Liquidity -- Ease with which assets can be converted into cash.

ASSETS Classifying Assets

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• Current Assets -- Items that can or will be converted to cash within one year.

• Fixed Assets -- Long-term assets that are relatively permanent such as land, buildings, or equipment.

• Intangible Assets -- Long-term assets that have no physical form but do have value such as patents, trademarks, and goodwill.

CLASSIFYING ASSETS Classifying Assets

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17-19

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• Liabilities -- What the business owes to others - its debts.

• Accounts Payable -- Current liabilities a firm owes for merchandise or services purchased on credit.

• Notes Payable -- Short or long-term liabilities a business promises to pay by a certain date.

• Bonds Payable -- Long-term liabilities that the firm must pay back.

CLASSIFYING LIABILITIESLiabilities and Owners’ Equity Accounts

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17-20

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• Owners’ Equity -- The amount of the business that belongs to the owners minus any liabilities of the owners.

• Retained Earnings -- Accumulated earnings from the firm’s profitable operations that are reinvested in the business.

OWNERS’ EQUITY ACCOUNTSLiabilities and Owners’ Equity Accounts

LG4

17-21

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• Income Statement -- The financial statement that shows a firm’s bottom line - that is, its profit after costs, expenses, and taxes.

• Net Income/Net Loss -- The revenue left over or depleted.

The INCOME STATEMENTThe Income Statement

LG4

17-22

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• The formula for the income statement:

o Revenue

o Minus Cost of Goods Sold

o Equals Gross Profit

o Minus Operating Expenses

o Equals Net Income before Taxes

o Minus Taxes

o Equals Net Income or Net Loss

The INCOME STATEMENTThe Income Statement

LG4

17-23

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• Revenues is the monetary value a firm received for goods sold, services rendered or other payments.

• Cost of Goods Sold (or Manufactured) -- Measures the cost of merchandise the firms sells or the cost of raw materials and supplies it used in producing items for resale.

• Gross Profit -- How much a firm earned by buying (or making) and selling merchandise.

ACCOUNTS of the INCOME STATEMENT

The Income Statement

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(Continued)17-24

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• Operating Expenses -- Expenses a firm incurs in selling goods and services such as rent, salaries and supplies.

• Depreciation -- The systematic write-off of the cost of a tangible asset over its estimated useful life.

ACCOUNTS of the INCOME STATEMENT

(Continued)

The Income Statement

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17-25

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• Generally Accepted Accounting Principles (GAAP) sometimes permits accountants to use different method of accounting for inventory.

• FIFO: First-In, First-Out

• LIFO: Last-In, Last-Out

• Each valuation can affect income and ending inventory valuation.

ACCOUNTING for WHAT’S COMING and GOING in SMALL BUSINESS

Spotlight on Small Business

17-26

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• Statement of Cash Flows -- Reports cash receipts and cash disbursements related to the three major activities of a firm:

1. Operations

2. Investments

3. Financing

The STATEMENT of CASH FLOWSThe Statement of Cash Flows

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• Cash Flow -- The difference between cash coming in and cash going out of a business.

UNDERSTANDING CASH FLOWThe Need for Cash Flow Analysis

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• Managing cash flow is a key consideration of a business and can be particularly challenging for small and seasonal businesses.

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• Ratio Analysis -- The assessment of a firm’s financial condition using calculations and financial ratios developed from the firm’s financial statements.

• Key ratios include:

- Liquidity ratios

- Leverage ratios

- Performance ratios

- Activity ratios

USING FINANCIAL RATIOSAnalyzing Financial Performance Using Ratios

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• Liquidity ratios measure a firm’s ability to turn assets into cash to pay its short-term debts.

• Two key ratios are:

- Current ratio

- Acid-test ratio

• This information is found on the firm’s balance sheet.

COMMONLY USED LIQUIDITY RATIOS

Liquidity Ratios

LG5

17-30

Liquidity ratios

• Current ratio = current assets/ current liabilities

• Acid test ratio = cash +AR+marketable securites/ current liab**(the acid test uses easily convertible items but

excludes inventory)

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• Leverage ratios measure the degree to which a firm relies on borrowed funds in its operations.

• Key ratios include:

- Debt to Owner’s Equity Ratio

• This information is found on the firm’s balance sheet.

LEVERAGE RATIOS Leverage (Debt) Ratios

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Leverage ratio

• = Total liab/owners equity

• *this could show that a firm with too much debt would have difficulty paying creditors and stockholders a return

• * a number greater than 100 could imply riskier venture

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• Profitability ratios measure how effectively a firm’s managers are using the firm’s various resources to achieve profits.

• Key ratios include:- Basic earnings per share

- Return on sales

- Return on equity

• This information is found on the firm’s balance sheet and income statement.

PROFITABILITY RATIOSProfitability (Performance) Ratio

LG5

17-34

Profitability ratios

• EPS

• Return on sales = net income / net sales

• Return on equity = net income after tax/ owner equity

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• Activity ratios measure how effectively management is turning over inventory.

• Key ratios include:- Inventory turnover ratio

ACTIVITY RATIOS Activity Ratio

LG5

• This information is found on the firm’s balance sheet and income statement.

17-36

Inventory turn over

• How many times are you turning inventory over to make the sales (helps est. purchasing, helps est. profitability on inv dollars)

• Inventory turnover = cogs /avg inventory

• **this number could indicate obsolescence, poor purchasing, poor stocking