Chapter Eighteen

Using Accounting Information

Key Statements

Three key financial statements summarize the firm’s activities for a specific period

• Balance sheet (what you’re worth)• Income statement (your budget)• Statement of cash flows (your checkbook)

The Accounting Equation

Assets - Liabilities = Owners’ equity

Assets—the resources that a business owns (i.e.- cash, inventory, equipment, real estate)

Liabilities—the firm’s debts (loans, a/p)

Owners’ equity—difference between assets & liabilities

- what would be left for the owners, if the firm’s assets were sold and the money

used to pay off its liabilities

The Balance Sheet

• The dollar amounts of a firm’s assets, liabilities, and owners’ equity accounts at the end of a specific accounting period

– also called statement of financial position

– assets listed in order of liquidity

ease with which an asset can be converted into cash

Assets-Listed in order of liquidity

– Current assets—can quickly be converted to cash

• Cash, marketable securities, a/r, inventory

– Fixed assets—will be held or used for a period longer than one year

• Land, buildings, and equipment

– Intangible assets—do not exist physically -value is based on the rights they give the firm

• Patents, copyrights, trademarks, franchise rights, and goodwill

Liabilities

– Current liabilities—debts to be repaid in one year or less

• Accounts payable—short-term debts from credit purchases

• Notes payable—debts secured with promissory notes (IOU’s)

– Long-term liabilities—debts that need not be repaid for at least one year

• Mortgages, bonds, and long-term loans

Owners Equity

– For sole proprietorships—owners’ equity

– For partnerships—each partner’s share of ownership is reported separately in each owner’s name

– For corporations—stockholder’s equity

Personal Balance Sheet

The Income Statement

• A firm’s revenues minus its expenses– Profit (cash surplus)– Loss (cash deficit)

• Revenues– Money earned from selling goods or providing services

• Gross sales—the total dollar amount of all goods and services sold during the accounting period

• Net sales—dollar amounts received, adjusted for returns, allowances, discounts

COGS

Cost of goods sold

Beginning inventory

Net purchases

Ending inventory

= + –

• Gross profit– A firm’s net sales less the cost of goods

sold

The Income Statement

• Operating expenses– All business costs other than the cost of goods

sold• Selling expenses—costs related to marketing activities• General expenses—costs of managing the business

• Net income– Net sales less COGS & operating expenses,

when the difference is positive

• Net loss– Net sales less COGS & expenses, when the

difference is negative

Personal Income Statement

Long term liability Current liability

The Statement of Cash Flows

• How the company made & spent its money

– Cash flows from operating activities (providing goods and services)

– Cash flows from investing activities (asset

based) (purchase & sale of land, equipment, buildings)

– Cash flows from financing activities (liability based)

(pay off loans, sell stock, get a loan)

StatementofCash Flows

Financial Ratios

• Used to show relationship between two elements of a firm’s financial statements

• Can be compared with– The firm’s own past ratios– Ratios of competitors– Industry averages

Who Uses Accounting Information

– Managers, to plan business strategy

– Lenders, to reduce their risk when lending

– Stockholders, to know whether to invest or how well their investment is doing

– Government agencies to enforce the law

How do they know the information on the statements is accurate?

What is an audit?

– An examination of a company’s financial statements and accounting practices by someone not employed by the firm

– Generally accepted accounting principles (GAAP)

-an accepted set of guidelines and practices for companies reporting financial information

– An audit does not guarantee that a company has not “cooked” the books

The Sarbanes-Oxley Act of 2002

– Top executives are required to certify periodic financial reports and are subject to criminal penalties for violations

– Auditors must maintain financial documents and audit work papers for 5 years

– Auditors and accountants can be imprisoned for up to 20 years for destroying documents and violating securities laws

– Public Corps must change auditing firms every 5 years

– There is protection for whistle-blowers who report violations of the Sarbanes-Oxley Act