Chapter Seventeen Understanding Accounting and Financial Information McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
SEAN PERICH Bakery Barn 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. Profile 17-2
WHAT S 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 firm s accounting information. 17-3
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 Managerial Accounting LG2 Users Government tax authority Government regulatory agencies People interested in the organization s income Managers of the firm 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 -- 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 Accounting LG2 17-8
HOW to READ an ANNUAL REPORT Key things to watch for and read: - Management s discussion and analysis of operations - Balance sheet - Income statement - Statement of cash flows - Auditor s opinion Financial Accounting LG2 17-9
PUBLIC vs. PRIVATE ACCOUNTANTS 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. Financial Accounting LG2 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 Auditing -- Reviewing and evaluating the information used to prepare a company s financial statements. LG2 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. 17-13
SPECIALIZED ACCOUNTANTS 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. Tax Accounting LG2 17-14
PROGRESS ASSESSMENT Progress Assessment What s the key difference between managerial and financial accounting? How s the job of a private accountant different from that of a public accountant? What s the job of an auditor? 17-15
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. 17-16
BOOKKEEPING S ROLE 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. The Accounting Cycle LG3 17-17
BOOKKEEPING S 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. 17-18
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 17-19
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 17-20
ASSETS Assets -- Economic resources owned by a firm. Items can be tangible or intangible. Classifying Assets LG4 Liquidity -- Ease with which assets can be converted into cash. 17-21
CLASSIFYING ASSETS Current Assets -- Items that can or will be converted to cash within one year. Classifying Assets LG4 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. 17-22
CLASSIFYING LIABILITIES 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. Liabilities and Owners Equity Accounts LG4 17-23
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 firm s profitable operations that are reinvested in the business. 17-24
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? What s included in the liabilities account on the balance sheet? What s owners equity and how do we determine it? Progress Assessment 17-25
The INCOME STATEMENT The Income Statement LG4 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. 17-26
The INCOME STATEMENT 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 Statement LG4 17-27
ACCOUNTS of the INCOME STATEMENT 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) The Income Statement LG4 17-28
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. 17-29
ACCOUNTING for WHAT S COMING and GOING in SMALL BUSINESS Spotlight on Small Business 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. 17-30
The STATEMENT of CASH FLOWS The Statement of Cash Flows 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 LG4 17-31
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. 17-32
ON the ACCOUNTING HOT SEAT Making Ethical Decisions You re 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 don t get the loan, you may lose your job. What do you do? 17-33
USING FINANCIAL RATIOS 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 Analyzing Financial Performance Using Ratios LG5 17-34
COMMONLY USED LIQUIDITY RATIOS Liquidity Ratios LG5 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. 17-35
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 Owner s Equity Ratio This information is found on the firm s balance sheet. 17-36
PROFITABILITY RATIOS 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 (Performance) Ratio LG5 17-37
ACTIVITY RATIOS Activity ratios measure how effectively management is turning over inventory. Activity Ratio LG5 Key ratios include: - Inventory turnover ratio This information is found on the firm s balance sheet and income statement. 17-38
The ACCOUNTING SHOT HEARD AROUND the WORLD Reaching Beyond Our Borders 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. 17-39
TIMELINE for the MOVE to IFRS Reaching Beyond Our Borders 2008: SEC offers proposed timeline 2009: 110 large companies have the option of using IFRS 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) LG5 17-40
PROGRESS ASSESSMENT Progress Assessment What s the primary purpose of performing ratio analysis using the firm s financial statements? What are the four main categories of financial ratios? 17-41