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*Chapter Seventeen

Understanding Accounting

and Financial Information

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

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• 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.

WHAT’S ACCOUNTING?What is Accounting?

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*The ACCOUNTING SYSTEM

What is Accounting?

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*ACCOUNTANTS’

RESPONSIBILITIES

What is Accounting?

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• 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

MANAGERIAL ACCOUNTINGManagerial Accounting

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*USERS of ACCOUNTING

INFORMATION

Managerial Accounting

Users Type of Report

Government tax authority Tax reports

Government regulatory agencies

Required reports

People interested in the organization’s income

Financial statements found in annual reports

Managers of the firm Financial statements and internally distributed financial

reports

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• 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 ACCOUNTINGFinancial Accounting

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• Key things to watch for and read:

HOW to READ an ANNUAL REPORT

Financial Accounting

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- Management’s discussion and analysis of operations

- Balance sheet

- Income statement

- Statement of cash flows

- Auditor’s opinion

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• Accounting Cycle -- A six-step procedure that results in the preparation and analysis of the major financial statements.

The ACCOUNTING CYCLEThe Accounting Cycle

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• Financial Statement -- A summary of all the financial transactions that have occurred over a particular period.

FINANCIAL STATEMENTSUnderstanding Key Financial Statements

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• Key financial statements of business are:

- Balance sheet

- Income statement

- Statement of cash flows

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• Fundamental Accounting Equation -- The basis for the balance sheet.

• The equation must always be balanced and includes the formula:

o Assets = Liabilities + Owners Equity

The FUNDAMENTAL ACCOUNTING EQUATION

The Fundamental Accounting Equation

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• Assets -- Economic resources owned by a firm. Items can be tangible or intangible.

• Liquidity -- Ease with which assets can be converted into cash.

ASSETS Classifying Assets

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• 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.

CLASSIFYING ASSETS Classifying Assets

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• 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.

CLASSIFYING LIABILITIESLiabilities and Owners’ Equity Accounts

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• 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.

OWNERS’ EQUITY ACCOUNTSLiabilities and Owners’ Equity Accounts

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• 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.

The INCOME STATEMENTThe Income Statement

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• 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 STATEMENTThe Income Statement

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• 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.

ACCOUNTS of the INCOME STATEMENT

The Income Statement

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• 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.

ACCOUNTS of the INCOME STATEMENT

(Continued)

The Income Statement

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• 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

The STATEMENT of CASH FLOWSThe Statement of Cash Flows

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• Cash Flow -- The difference between cash coming in and cash going out of a business.

UNDERSTANDING CASH FLOWThe Need for Cash Flow Analysis

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

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• 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?

ON the ACCOUNTING HOT SEATMaking Ethical Decisions

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• 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

USING FINANCIAL RATIOSAnalyzing Financial Performance Using Ratios

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• 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.

COMMONLY USED LIQUIDITY RATIOS

Liquidity Ratios

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• 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.

LEVERAGE RATIOS Leverage (Debt) Ratios

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• 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 RATIOSProfitability (Performance) Ratio

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• Activity ratios measure how effectively management is turning over inventory.

• Key ratios include:- Inventory turnover ratio

ACTIVITY RATIOS Activity Ratio

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• This information is found on the firm’s balance sheet and income statement.

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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.

The ACCOUNTING SHOT HEARD AROUND the WORLD

Reaching Beyond Our Borders

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• 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)

TIMELINE for the MOVE to IFRSReaching Beyond Our Borders

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• What’s the primary purpose of performing ratio analysis using the firm’s financial statements?

• What are the four main categories of financial ratios?

PROGRESS ASSESSMENTProgress Assessment

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• 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.

SEAN PERICHBakery Barn

Profile

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• 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.

PUBLIC vs. PRIVATE ACCOUNTANTS

Financial Accounting

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*STEPS to CONTROL

ACCOUNTING PRACTICES

Financial Accounting

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• 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.

BALANCE SHEETS SHERLOCKSLegal Briefcase

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• 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.

BOOKKEEPING’S ROLEThe Accounting Cycle

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• Ledger -- A specialized accounting book or program where all information is in one place.

• Trial Balance -- A summary of all the information in the account ledgers.

BOOKKEEPING’S ROLEThe Accounting Cycle

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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.

ACCOUNTING for WHAT’S COMING and GOING in SMALL BUSINESS

Spotlight on Small Business

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• Auditing -- Reviewing and evaluating the information used to prepare a company’s financial statements.

• 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.

AUDITING CHECKS ACCURACYAuditing

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• 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.

SPECIALIZED ACCOUNTANTSTax Accounting

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• 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?

PROGRESS ASSESSMENTProgress Assessment

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• 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 ASSESSMENTProgress Assessment

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