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Chapter Seventeen

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Understanding Accounting and Financial Information

McGraw-Hill/Irwin

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

SEAN PERICH
Bakery Barn

*
Profile

A lifelong weightlifter who wanted a protein-packed cookie to take to the gym. Due to accounting troubles, his Bakery Barn business was in trouble. Became a supplier for another company and hired a comptroller and a new CEO.

17-2

WHATS ACCOUNTING?

* What is
Accounting? LG1

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 firms accounting information.

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The ACCOUNTING SYSTEM

* What is
Accounting? LG1

17-4

ACCOUNTANTS RESPONSIBILITIES

* What is
Accounting? LG1

17-5

MANAGERIAL ACCOUNTING

* Managerial
Accounting LG2

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
17-6

USERS of ACCOUNTING INFORMATION

Users
Government tax authority Government regulatory agencies People interested in the organizations income Managers of the firm

* Managerial
Accounting LG2

Type of Report
Tax reports Required reports

Financial statements found in annual reports Financial statements and internally distributed financial reports

17-7

FINANCIAL ACCOUNTING

* Financial
Accounting LG2

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.
17-8

HOW to READ an ANNUAL REPORT

Key things to watch for and read:
- Managements discussion and analysis of operations

* Financial
Accounting LG2

- Balance sheet
- Income statement - Statement of cash flows - Auditors opinion

17-9

PUBLIC vs. PRIVATE ACCOUNTANTS

* Financial
Accounting LG2

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.
17-10

*
BALANCE SHEETS SHERLOCKS
Legal Briefcase

When a company is suspected of fraud or other accounting wrongdoings a court will commission a forensic accountant to search for foul play. Forensic accountants look for proof a company is cooking the books. Problems within Enron, WorldCom, and our federal government were found by forensic accountants.
17-11

STEPS to CONTROL ACCOUNTING PRACTICES

* Financial
Accounting LG2

17-12

AUDITING CHECKS ACCURACY

Auditing -- Reviewing and evaluating the

* Auditing
LG2

information used to prepare a companys financial statements.

Independent Audit -- An evaluation and unbiased

opinion about the accuracy of a companys financial statements.

Certified Internal Auditors (CIAs) -- Accountants

who have a bachelors degree and two years of experience in internal auditing and pass an exam administered by the Institute of Internal Auditors.
17-13

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

* Tax
Accounting LG2

Government and Not-forProfit Accounting -- Support for

organizations whose purpose is not generating a profit, but serving others according to a duly approved budget.
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PROGRESS ASSESSMENT

* Progress
Assessment

*
Whats the key difference between managerial and financial accounting? Hows the job of a private accountant different from that of a public accountant? Whats the job of an auditor?

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The ACCOUNTING CYCLE

* The
Accounting Cycle LG3

Accounting Cycle -- A six-step procedure that

results in the preparation and analysis of the major financial statements.

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BOOKKEEPINGS ROLE
Bookkeeping -- The recording of business

* The
Accounting Cycle LG3

transactions. Bookkeepers divide a firms 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.
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BOOKKEEPINGS ROLE
Ledger -- A specialized
accounting book or program where all information is in one place.

* The
Accounting Cycle LG3

Trial Balance -- A
summary of all the information in the account ledgers.
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*
FINANCIAL STATEMENTS

Understanding Key Financial Statements

LG3

Financial Statement -- A summary of all the

financial transactions that have occurred over a particular period.

Key financial statements of business are:

- Balance sheet

- Income statement
- Statement of cash flows
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The FUNDAMENTAL ACCOUNTING EQUATION

The Fundamental Accounting Equation

LG4

Fundamental Accounting Equation -- The basis

for the balance sheet.

The equation must always be balanced and includes the formula:

o Assets = Liabilities + Owners Equity

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ASSETS

*Classifying
Assets LG4

Assets -- Economic resources owned by a firm.

Items can be tangible or intangible.

Liquidity -- Ease with which assets can be

converted into cash.

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CLASSIFYING ASSETS

*Classifying
Assets LG4

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.

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CLASSIFYING LIABILITIES

Liabilities and Owners Equity Accounts

LG4

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.
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OWNERS EQUITY ACCOUNTS

Liabilities and Owners Equity Accounts

LG4

Owners Equity -- The

amount of the business that belongs to the owners minus any liabilities of the owners.

Retained Earnings -Accumulated earnings from the firms profitable operations that are reinvested in the business.
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PROGRESS ASSESSMENT

* Progress
Assessment

*
What do we call the formula for the balance sheet? What three accounts does it include?
What does it mean to list assets according to liquidity? Whats included in the liabilities account on the balance sheet? Whats owners equity and how do we determine it?
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*
The INCOME STATEMENT

The Income Statement

LG4

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

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

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*
The INCOME STATEMENT
The formula for the income statement:
o Revenue o Minus Cost of Goods Sold

The Income Statement

LG4

o Equals Gross Profit

o Minus Operating Expenses o Equals Net Income before Taxes o Minus Taxes o Equals Net Income or Net Loss
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ACCOUNTS of the INCOME STATEMENT

The Income Statement

LG4

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.
(Continued)
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*
ACCOUNTS of the INCOME STATEMENT
(Continued)

The Income Statement

LG4

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.
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ACCOUNTING for WHATS COMING and GOING in SMALL BUSINESS

Spotlight on Small Business

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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.
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*
The STATEMENT of CASH FLOWS
Statement of Cash Flows -- Reports cash

The Statement of Cash Flows

LG4

receipts and cash disbursements related to the three major activities of a firm:
1. Operations 2. Investments 3. Financing

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UNDERSTANDING CASH FLOW

The Need for Cash Flow Analysis

LG4

Cash Flow -- The difference between cash coming

in and cash going out of a business.

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

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*
ON the ACCOUNTING HOT SEAT
Making Ethical Decisions

Youre the only accountant employed by a small, struggling firm.

The firm requests a bank loan to keep operations going and your boss suggests you record the revenue early. This is against accounting principles, but you know if you dont get the loan, you may lose your job. What do you do?
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USING FINANCIAL RATIOS

Analyzing Financial Performance Using Ratios

LG5

Ratio Analysis -- The assessment of a firms

financial condition using calculations and financial ratios developed from the firms financial statements.

Key ratios include:

- Liquidity ratios - Leverage ratios

- Performance ratios
- Activity ratios
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COMMONLY USED LIQUIDITY RATIOS

*Liquidity
Ratios LG5

Liquidity ratios measure a firms 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 firms balance sheet.

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LEVERAGE RATIOS

*Leverage
(Debt) Ratios LG5

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

Key ratios include:

- Debt to Owners Equity Ratio

This information is found on the firms balance sheet.

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PROFITABILITY RATIOS

*Profitability
(Performance) Ratio LG5

Profitability ratios measure how effectively a firms managers are using the firms various resources to achieve profits. Key ratios include:
- Basic earnings per share - Return on sales - Return on equity

This information is found on the firms balance sheet and income statement.
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ACTIVITY RATIOS
Activity ratios measure how effectively management is turning over inventory. Key ratios include:
- Inventory turnover ratio
Activity Ratio
LG5

This information is found on the firms balance sheet and income statement.
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The ACCOUNTING SHOT HEARD AROUND the WORLD

Reaching Beyond Our Borders

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Multinational companies must adapt their accounting reporting to the rules of multiple countries. Many countries have adopted International Financial Reporting Standards (IFRS) and are pushing to make them standard. The U.S. Securities & Exchange Commission believes there should be such a standard.
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* Reaching
TIMELINE for the MOVE to IFRS
2008: SEC offers proposed timeline 2009: 110 large companies have the option of using
IFRS
Beyond Our Borders LG5

2011: SEC assesses progress of IFRS 2013: Final decision on the move to IFRS 2014: Large public companies will be required to
report in IFRS (pending SEC decision)

2016: All companies will be required to report in

IFRS (pending SEC decision)
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PROGRESS ASSESSMENT

* Progress
Assessment

*
Whats the primary purpose of performing ratio analysis using the firms financial statements? What are the four main categories of financial ratios?

17-41