Chapter 14Chapter 14Using Financial Information and Using Financial Information and

AccountingAccounting

By By

Ryan KingRyan King

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Marijke VerwaijenMarijke Verwaijen

Accounting PrinciplesAccounting PrinciplesAccounting – the process of collecting, recording, Accounting – the process of collecting, recording, classifying, summarizing, reporting, and analyzing financial classifying, summarizing, reporting, and analyzing financial activitiesactivitiesManagerial Accounting- financial information for managers Managerial Accounting- financial information for managers inside the companyinside the company

Allows for decision makingAllows for decision making

Financial Accounting – financial information for people Financial Accounting – financial information for people outside the companyoutside the company

Allows others to see how well a company is workingAllows others to see how well a company is working Eases decisions for investmentsEases decisions for investments

Generally Accepted Accounting Principles (GAAP)Generally Accepted Accounting Principles (GAAP) Set-up by Financial Accounting Standards Board (FASB)Set-up by Financial Accounting Standards Board (FASB) Is the U.S. standard for accounting PrinciplesIs the U.S. standard for accounting Principles

No set international accounting principlesNo set international accounting principles Each country has its own standardsEach country has its own standards

Accounting ProfessionAccounting Profession

Public Accountants (CPA)Public Accountants (CPA) Does work for individuals or companies on a free-basisDoes work for individuals or companies on a free-basis Responsible for AuditsResponsible for Audits

Gives “Auditor’s Opinion” on whether all financial records were Gives “Auditor’s Opinion” on whether all financial records were done by the standardsdone by the standards

CPA’s must go through several levels CPA’s must go through several levels Obtain approved Bachelor’s DegreeObtain approved Bachelor’s Degree

Pass testPass test

Obtain experienceObtain experience Private AccountantsPrivate Accountants

Sever one company Sever one company

Certified Management Accountant (CMA)Certified Management Accountant (CMA) Must pass examinationMust pass examination

Recent Accounting Recent Accounting ProblemsProblems

AICPA report on bad accounting proceduresAICPA report on bad accounting procedures Commit fraudulent accounting reportingCommit fraudulent accounting reporting Unreasonable stretch accounting rules to enhance financial Unreasonable stretch accounting rules to enhance financial

recordsrecords Use loopholes to manage financial resultsUse loopholes to manage financial results

Why do companies bend rules?Why do companies bend rules? Larger profit margin Larger profit margin Show profit when lossShow profit when loss Look good in short termLook good in short term

Changing in Accounting Changing in Accounting StandardsStandards

Sarbanes-Oxley Act Sarbanes-Oxley Act Clarified rules for auditors and servicesClarified rules for auditors and services Set up the Public Company Accounting Oversight Board (PCAOB)Set up the Public Company Accounting Oversight Board (PCAOB)

Has authority to amend auditing, quality control, and ethics standardsHas authority to amend auditing, quality control, and ethics standards Changed audit standardsChanged audit standards

Must keep seven years of audit documentsMust keep seven years of audit documents Financial DisclosureFinancial Disclosure

Companies must disclose all transactionsCompanies must disclose all transactions

All significant changes must be made public on a current basisAll significant changes must be made public on a current basis Financial Statement CertificationFinancial Statement Certification

Company and Financial Officers must certify recordsCompany and Financial Officers must certify records

Severe penalties for false certification Severe penalties for false certification Internal ControlsInternal Controls

Must have internal control for financial proceduresMust have internal control for financial procedures Consulting WorkConsulting Work

Restrict non-auditing work done by auditors Restrict non-auditing work done by auditors

The Accounting EquationThe Accounting Equation

Assets = Liabilties + Owner’s EquityAssets = Liabilties + Owner’s EquityMust Always Balance !!!!Must Always Balance !!!!

The Accounting CycleThe Accounting Cycle

Six step processSix step process Analyze data recordedAnalyze data recorded Record each transaction in Journal Record each transaction in Journal Journal entries recorded in LedgerJournal entries recorded in Ledger Ledger accounts totaled in Trial BalanceLedger accounts totaled in Trial Balance These Values used to prepare Financial StatementsThese Values used to prepare Financial Statements Analyze reports and make decisionsAnalyze reports and make decisions

Computer in AccountingComputer in Accounting Accounting and Tax programs offers many toolsAccounting and Tax programs offers many tools Typically represents a large portion of the software budgetTypically represents a large portion of the software budget

The Balance SheetThe Balance SheetSummarizes financial position for specific point in timeSummarizes financial position for specific point in timeAssets Assets

Listed in order of LiquidityListed in order of Liquidity Current Assets Current Assets

Cash Cash Marketable SecuritiesMarketable SecuritiesAccounts ReceivableAccounts ReceivableNotes ReceivableNotes ReceivableInventoryInventory

Fixed AssetsFixed AssetsLong termLong termAccumulate depreciation over timeAccumulate depreciation over time

Intangible Assets Intangible Assets Long term with no physical existenceLong term with no physical existence

Copyrights, patents, etc.Copyrights, patents, etc.

The Balance Sheet Con’tThe Balance Sheet Con’t

LiabilitiesLiabilities Current LiabilitiesCurrent Liabilities

Accounts Payable Accounts Payable

Notes PayableNotes Payable

Accrued ExpensesAccrued Expenses

Income Tax PayableIncome Tax Payable

Current portion of long-term debtCurrent portion of long-term debt Long-term LiabilitiesLong-term Liabilities

Bank Loans, Mortgages, etc. Bank Loans, Mortgages, etc.

Owner’s EquityOwner’s Equity Owner’s total investment in the company Owner’s total investment in the company

Income StatementIncome Statement

Summarizes revenues and expensesSummarizes revenues and expenses

RevenuesRevenues Total income for the entityTotal income for the entity

ExpensesExpenses Total costs for running businessTotal costs for running business

Gross Profit – Operating Expenses = Net Profit/LossGross Profit – Operating Expenses = Net Profit/Loss

The Statement of Cash The Statement of Cash FlowsFlows

Statement of cash flows Statement of cash flows – A financial statement that – A financial statement that provides a summary of the money flowing into and out of a provides a summary of the money flowing into and out of a firm.firm.

the financial statement used to assess the sources and uses of the financial statement used to assess the sources and uses of cash during a periodcash during a period

It tracks the firm’s cash receipts and cash payments It tracks the firm’s cash receipts and cash payments It gives financial managers and analysts a way to identify cash It gives financial managers and analysts a way to identify cash

flow problems and assess the firm’s financial ability flow problems and assess the firm’s financial ability All publicly traded firms must include a statement of cash flows All publicly traded firms must include a statement of cash flows

in their financial reports to stockholders.in their financial reports to stockholders.

The Statement of Cash Flows The Statement of Cash Flows Con’tCon’t

The statement of cash flows divides the firm’s cash flows The statement of cash flows divides the firm’s cash flows into three groups;into three groups;

Cash flow from operating activities:Cash flow from operating activities:Those related to the production of the firm’s goods and/or Those related to the production of the firm’s goods and/or services. services.

Cash flows from investment activities:Cash flows from investment activities:Those related to the purchase and sake of fixed assets.Those related to the purchase and sake of fixed assets.

Cash flows from operating activities:Cash flows from operating activities:Those related to debt and equity financing.Those related to debt and equity financing.

Analyzing Financial StatementAnalyzing Financial Statementand Ratio Analysisand Ratio Analysis

Purpose of analyzing financial statements Purpose of analyzing financial statements By studying the relationship among the financial statements, By studying the relationship among the financial statements,

someone can gain more insight into a firm’s financial condition someone can gain more insight into a firm’s financial condition and performance. In order to do so, business people make use and performance. In order to do so, business people make use of ration analysis of ration analysis

Ratio analysis Ratio analysis The calculation and interpretation of financial ratios taken from The calculation and interpretation of financial ratios taken from

the firm's financial statements in order to assess its condition the firm's financial statements in order to assess its condition and performanceand performance

Ratio analysis simply highlights potential problems; it does not Ratio analysis simply highlights potential problems; it does not prove that they exist. However, ratios can help managers prove that they exist. However, ratios can help managers understand operations better and identify trouble spots.understand operations better and identify trouble spots.

Classification of RatiosClassification of RatiosRatios can be classified by what they measure; liquidity, Ratios can be classified by what they measure; liquidity, profitability, activity, and debt.profitability, activity, and debt.

Liquidity ratiosLiquidity ratios measure the firm’s ability to pay it’s short term measure the firm’s ability to pay it’s short term debts as they come duedebts as they come due

Current RatioCurrent RatioAcid-Test (quick) RatioAcid-Test (quick) RatioNet Working CapitalNet Working Capital

Profitability RatiosProfitability Ratios are ratios which measure how well a firm is are ratios which measure how well a firm is using its resources to generate profit, and how using its resources to generate profit, and how efficiently it is being managedefficiently it is being managed..

Net Profit MarginNet Profit MarginReturn On EquityReturn On EquityEarnings Per ShareEarnings Per Share

Activity RatiosActivity RatiosInventory Turnover RatioInventory Turnover Ratio

Debt RatioDebt RatioDebt-To-Equity RatioDebt-To-Equity Ratio

Ratio AnalysisRatio Analysis

1.1. Current Ratio - Current Ratio - Total Current AssetsTotal Current AssetsTotal Current Liabilities

2. Acid-Test Ratio - Total Current Assets – Inventory Total Current Liabilities

3. Net Working Capital - Total Current Assets – Total Current Liabilities

4. Net Profit Margin - Net ProfitNet Sales

5. Return On Equity - Net Profit Total Owner’s Equity

6. Earning Per Share - Net Profit Number of shares of common stock outstanding

Ratio Analysis Con’tRatio Analysis Con’t

7.7. Inventory Turnover - Inventory Turnover - Cost of Goods SoldCost of Goods Sold

Average Average InventoryInventory

Cost of Goods SoldCost of Goods Sold

(Beg. Inventory + Ending (Beg. Inventory + Ending Inventory)/2Inventory)/2

8.8. Debt Ratio - Debt Ratio - Total LiabilitiesTotal Liabilities

Owner’s EquityOwner’s Equity

Trends in BusinessTrends in BusinessAccountants Expand their RoleAccountants Expand their Role

Accountants now take an active role advising their clients on Accountants now take an active role advising their clients on systems and procedures, accounting software, and changes in systems and procedures, accounting software, and changes in accounting regulations.accounting regulations.

They also look into the risks and weaknesses of a company to They also look into the risks and weaknesses of a company to prevent future complications.prevent future complications.

Valuing Knowledge AssetsValuing Knowledge Assets The world’s economy is becoming more knowledge-based rather The world’s economy is becoming more knowledge-based rather

than industrial-basedthan industrial-based A company’s value may come from internally generated A company’s value may come from internally generated

intangible assets such as brands, trademarks, and employee intangible assets such as brands, trademarks, and employee talent.talent.

Tightening the GAAPTightening the GAAP Companies have been taking advantage of loopholes in GAAP to Companies have been taking advantage of loopholes in GAAP to

manipulate numbers.manipulate numbers.For example, Cendant was accused of fraudulently inflating income by For example, Cendant was accused of fraudulently inflating income by booking booking $500 million in factious revenues$500 million in factious revenuesMany companies are pushing the accounting edge to keep earning Many companies are pushing the accounting edge to keep earning rising to meet expectations of investment analysts and investorsrising to meet expectations of investment analysts and investors

Discussion/Study QuestionsDiscussion/Study Questions

Why are financial reports important?Why are financial reports important?Financial reports give managers, employees, investors, Financial reports give managers, employees, investors, customers, suppliers, creditors, and government agencies a customers, suppliers, creditors, and government agencies a way to analyze a company’s past, current, and future way to analyze a company’s past, current, and future performance.performance.

What are the differences between public and What are the differences between public and private accountants?private accountants?Public accountants work for independent firms that provide Public accountants work for independent firms that provide accounting services such as; financial report preparation and accounting services such as; financial report preparation and auditing, tax return preparation, and management consulting. auditing, tax return preparation, and management consulting. Private accountants are employed to serve one particular Private accountants are employed to serve one particular organization and may prepare financial statements, tax organization and may prepare financial statements, tax returns, and management reports.returns, and management reports.

Discussion/Study QuestionsDiscussion/Study Questions

What is the accounting equation?What is the accounting equation?Assets = Liability + Owner’s EquityAssets = Liability + Owner’s Equity

What are the six steps in the accounting cycle?What are the six steps in the accounting cycle?Analyze collected data, record transactions to the journal, Analyze collected data, record transactions to the journal, record journal entries in the ledger, total ledger in trial record journal entries in the ledger, total ledger in trial balance, prepare financial statements, analyze reports, and balance, prepare financial statements, analyze reports, and make decisions.make decisions.

Why was the Sarbanes-Oxley Act important?Why was the Sarbanes-Oxley Act important?It closed loopholes and clarified accounting procedures.It closed loopholes and clarified accounting procedures.

Discussion/Study QuestionsDiscussion/Study Questions

True or False;True or False; Things of value such as; cash, Things of value such as; cash, account receivable, and inventory, are called account receivable, and inventory, are called liabilities?liabilities?False, these are called assetsFalse, these are called assets

What does the balance sheet do?What does the balance sheet do?It summarizes the financial condition of the company for a It summarizes the financial condition of the company for a point in timepoint in time

Why is the cash flow statement an important Why is the cash flow statement an important source of information?source of information?It summarizes the firms sources and uses of cash during a It summarizes the firms sources and uses of cash during a financial-reporting period. financial-reporting period.

Discussion/Study QuestionsDiscussion/Study Questions

What is the purpose of an income statement?What is the purpose of an income statement?It summarizes revenues and expenses, showing the net It summarizes revenues and expenses, showing the net profit or lossprofit or loss

Why is ratio analysis used?Why is ratio analysis used?It allows someone to gain insight into a firm’s operations, It allows someone to gain insight into a firm’s operations, profitability, and overall financial condition.profitability, and overall financial condition.

What are the four types of ratios?What are the four types of ratios?Liquidity, profitability, activity, and debt ratiosLiquidity, profitability, activity, and debt ratios