Understanding Accounting and Financial Statements

Chapter

15

Explain the functions and identify the three basic activities involving accounting.

Describe the roles played by public, management, government, and not-for-profit accountants.

Identify the foundations of the accounting system, including GAAP and the role of the Financial Accounting Standards Board (FASB).

Outline the steps in the accounting cycle, and define double-entry bookkeeping and the accounting equation.

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Learning Goals

Explain the functions and major components of the four principal financial statements: the balance sheet, the income statement, the statement of owner’s equity, and the statement of cash flows.

Discuss how financial ratios are used to analyze a company’s financial strengths and weaknesses.

Describe the role of budgets in a business.

Outline accounting issues facing global business and the move toward one set of worldwide accounting rules.

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Accounting is the process of measuring, interpreting, and communicating financial information to enable people inside and outside the firm to make informed decisions.

Accounting

Open book management- sharing sensitive financial information with employees and teaching them how to understand and use financial statements.

Viewing financial information may help them better understand how their work contributes to the company’s success.

Outsiders use financial data to evaluate investment opportunities.

Open Book Management

Financing activities provide necessary funds to start a business and expand it after it begins operating.

Investing activities provide valuable assets required to run a business.

Operating activities focus on selling goods and services, but they also consider expenses as important elements of sound financial management.

Business Activities Involving Accounting

Public Accountants Provide accounting services

(auditing, tax preparation, consulting) to individuals or business firms for a fee

CPA Management Accountants

Provide timely, relevant, accurate, and concise information that executives can use to operate their firms

CMA Government and Not-for-Profit Accountants

Accounting Professionals

Generally accepted accounting principles (GAAP) encompass the conventions, rules, and procedures for determining acceptable accounting practices at a particular time.

Financial Accounting Standards Board (FASB) is primarily responsible for evaluating, setting, or modifying GAAP in the U.S.

Sarbanes-Oxley Act (SOX) responded to cases of accounting fraud.

Created the Public Accounting Oversight Board, which sets audit standards and investigates and sanctions accounting firms that certify the books of publicly traded firms.

Senior executives must personally certify that the financial information reported by the company is correct.

Resulted in increase in demand for accountants.

Foundation of Accounting Systems

Accounting cycle- set of activities involved in converting information about transactions into financial statements.

The Accounting Cycle

Assets- anything of value owned or leased by a business.

Liability- claim against a firm’s assets by a creditor.

Owner’s equity- all claims of the proprietor, partners, or stockholders against the assets of a firm, equal to the excess of assets over liabilities.

Basic accounting equation- relationship that states assets equal liabilities plus owners’ equity.

Double-entry bookkeeping- process by which accounting transactions are entered; each individual transaction always has an offsetting transaction.

The Accounting Equation

Simplifies the accounting process by automating data entry and calculations.

Available products are customized for businesses of different sizes. Entrepreneurs and small businesses use:

QuickBooks, Peachtree, and BusinessWorks. Larger firms use larger scale software packages

like: Computer Associates, Oracle, and SAP. Software that handles accounting information for international businesses is another option. Offers different country information/language.

Some systems offer web-based packages for small and medium businesses.

Impact of Technology on Accounting

Balance sheet— statement of a firm’s financial position—what it owns and the claims against its assets—at a particular point in time

Photograph of firm’s assets together with its liabilities and owner’s equity

Follows the accounting equation

Balance Sheet

Sample Balance Sheet

Income Statement— financial record of a company’s revenues and expenses and profits over a period of time

Firm’s financial performance in terms of revenues, expenses, and profits over a given time period

Reports profit or loss Focus on revenues and costs associated with revenues

Income Statement

Sample Income Statement

Statement of Owners’ Equity— is designed to show the components of the change in equity from the end of one fiscal year to the end of the next

Begins with the amount of equity shown on the balance sheet

Net income is added, and cash dividends paid to owners are subtracted

Statement of Owners’ Equity

Sample Statement of Owners’ Equity

Statement of cash flows— a firm’s cash receipts and cash payments that presents information on its sources and uses of cash

Accrual accounting— method that records revenue and expenses when they occur, not necessarily when cash actually changes hands

Statement of Cash Flows

Sample Statement of Cash Flows

Ratio analysis— tool for measuring a firm’s liquidity, profitability, and reliance on debt financing as well as the effectiveness of management’s resource utilization

Financial Ratios Analysis

Liquidity Ratios

Cash and equivalents

+ short-term investments

+ accounts receivable

Total current liabilities

Total current assets

Total current liabilities

Current ratio compares

current assets to

current liabilities.

Acid-test (or quick)

ratio measures the

ability of a firm to

meet its debt payments

on short notice.

Activity Ratios

Inventory turnover

ratio indicates the

number of times

merchandise moves

through a business.Total asset turnover

ratio indicates how

much in sales each

dollar invested in

assets generates.

Net sales

Average of inventory

Net sales

Average of total assets

Profitability Ratios

Profitability ratios measure the organization’s overall financial performance by evaluating its ability to generate revenues in excess of operating costs and other expenses.

Leverage Ratios

Leverage ratios measure the extent to which a firm relies on debt financing.

Total liabilities to total assets ratio > 50 percent indicates that a firm is relying more on borrowed money than owners’ equity.

Budgets

Budget- planning and control tool that reflects a firm’s expected sales revenues, operating expenses, and cash receipts and outlays

Management estimates of expected sales, cash inflows and outflows, and costs

Budgets are a financial blueprint that serves as a financial plan

Cash budget- tracks the firm’s cash inflows and outflows.

Sample Budget

International Accounting

Accounting procedures and practices must be adapted to accommodate an international business environment.

The International Accounting Standards Committee (IASC) was established in 1973 to promote worldwide consistency in financial reporting practices. The IASC soon developed its first set of accounting standards and interpretations and, in 2001, became the International Accounting Standards Board (IASB). International Financial Reporting Standards (IFRS) are the standards and interpretations adopted by the IASB.

Exchange rates- ratio at which a country’s currency can be exchanged for other currencies

Consolidated financial statements must reflect gains and losses due to changes in exchange rates

Can have significant impact on financial statement