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Part 6 Financing the

Enterprise

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

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CHAPTER 14 Accounting and Financial Statements

CHAPTER 15 Money and the Financial System

CHAPTER 16 Financial Management and Securities Markets

APPENDIX D Personal Financial Planning

© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

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Learning Objectives

LO 14-1 Define accounting and describe the different uses of accounting information. LO 14-2 Demonstrate the accounting process. LO 14-3 Examine the various components of an income

statement to evaluate a firm’s bottom line. LO 14-4 Interpret a company’s balance sheet to determine its

current financial position. LO 14-5 Analyze the statement of cash flows to evaluate the

increase and decrease in a company’s cash balance. LO 14-6 Assess a company’s financial position using its

accounting statements and ratio analysis. © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned,

duplicated, forwarded, distributed, or posted on a website, in whole or part.

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The Nature of Accounting

Accounting • The recording, measurement and interpretation of

financial information

Certified Public Accountant (CPA)

• An individual who has been state certified to provide accounting services ranging from the preparation of financial records and the filing of tax returns to complex audits of corporate financial records


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Prestige Rankings of Accounting Firms

Most public accounts are either self-employed or members of large public accounting firms such as Ernst & Young, KPMG,

Deloitte, and PricewaterhouseCoopers, together referred to as “the Big Four”


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Accountants

After the accounting scandals of Enron and Worldcom in the early 2000’s, Congress passed the: • Sarbanes-Oxley Act – required firms to be more

rigorous in their accounting and reporting practices During the latest financial crisis, banks developed questionable lending practices, leading to: • Dodd Frank Act – strengthens the oversight of financial

institutions

DID YOU KNOW? Corporate fraud costs are estimated as $3.7 trillion annually


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Accounting Standards Different entities have different standards for their accounting

methods

Public and private businesses follow the Generally Accepted Accounting Principles (GAAP) method GAAP is generally used in the United States as the standard for

accounting methods (established by the Financial Accounting Standards Board (FASB))

Local government entities have a different set of accounting standards which are set by the Governmental Accounting Standards Board (GASB)

Federal government follows yet another set of standards determined by the Federal Accounting Standards Advisory Board (FASAB)

Another set of standards for international companies which follow the International Financial Reporting Standards (IFRS)


http://en.wikipedia.org/wiki/Generally_accepted_accounting_principles

http://en.wikipedia.org/wiki/Generally_accepted_accounting_principles

http://www.fasb.org/home

http://www.fasb.org/home

http://www.gasb.org/

http://www.gasb.org/

http://www.fasab.gov/

http://www.ifrs.com/

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Forensic Accounting A growing area for public accounts:

Forensic Accounting • Accounting that is fit for legal review

o Involves analyzing financial documents in search of fraudulent entries or financial misconduct

o Function as much as detectives as accountants o Used since the 1930’s o Booming since the accounting scandals of the

early 2000s o Rot out evidence of “cooked books” for federal

agencies © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned,


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Private Accountants

Private Accountants

• Employed by large corporations, government agencies, and other organizations to prepare and analyze their financial statements • Deeply involved in most of the most important

financial decisions of the organization

Certified Management Accountants (CMAs) • Private accountants who, after rigorous examination,

are certified by the National Association of Accountants and who have some managerial responsibility


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Accounting or Bookkeeping?

The terms accounting and bookkeeping are often mistakenly used interchangeably

Bookkeeping is typically limited to the routine, day-to-day recording of business transactions Much narrower and far more mechanical than

accounting Require less training than accountants Responsible for obtaining and recording the

information accounts require to analyze a firm’s financial position

Accountants usually complete course work beyond their basic 4 or 5 year college degree


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The Users of Accounting Information

Managers and owners use financial statements: 1. Aid in internal planning and control 2. External purposes such as reporting to the Internal Revenue

Service, stockholders, creditors, customers, employees, and other interested parties


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Internal Uses of Accounting Information Managerial Accounting

• The internal use of accounting statements by managers in planning and directing the organization’s activities

• The movement of money through an organization over a daily, weekly, monthly or yearly basis

Cash Flow

• An internal financial plan that forecasts expenses and income over a set period of time

Budget


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External Uses of Accounting Information Managers use accounting statements to report to

outsiders Used for filing income taxes,

obtaining credit and reporting results to stockholders

Annual Report • A summary of a firm’s financial

information, products, and growth plans for owners and potential investors

Audited financial statements are those signed off on by a certified public accountant

Many investors look at a firm’s annual report to determine how well the company is doing

financially © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned,


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Greece and Deceptive Accounting Practices During the global financial crisis, Greece had been engaging in

deceptive accounting practices with the help of U.S. investment banks

♦ Used financial techniques to hide massive amounts of debt from its public balance sheet

♦ Eventually markets discovered the country might not be able to pay off its creditors

♦ European Union and International Monetary Fund gave some credit relief

Get your financial house in order

Referred to as PIGS (Portugal, Italy, Ireland, Greece, and Spain) all had debt problems

Germany demanded austerity, but others wanted more growth-oriented strategies


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Banks and Financial Statements One of the biggest

banks in the U.S. Wells Fargo specializes in banking, mortgage, and financial services

Data it provides can be used in financial statements

Short-term lender examines a firm’s cash flow to assess its ability to repay a loan quickly with cash generated from sales

Long-term lender more interested in the company’s profitability and indebtedness to other lenders


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The Accounting Equation

Assets = Liabilities + Owner’s Equity

• A firm’s economic resources, or items of value that it owns, such as cash, inventory, land, equipment, buildings, and other tangible and intangible things

Assets

• Debts that a firm owes to others

Liabilities

• Equals assets minus liabilities and reflects historical values

Owners’ Equity


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Owner’s Equity

The owner’s equity portion of a company’s balance sheet: ► Such as that of Rendezvous Barbecue in Memphis, TN

► Includes the money the company’s owners have put into the firm


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Double-Entry Bookkeeping

Double-Entry Bookkeeping • A system of recording and classifying business transactions

that maintains the balance of the accounting equation

Balance • To keep the

accounting equation in balance, each transaction must be recorded in two separate accounts

Classification • All business

transactions are classified as either assets, liabilities, or owner’s equity

Break Down • Assets broken down

into cash, inventory and equipment

• Liabilities broken down into bank loans, supplier credit, and other debts


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The Accounting Cycle Accounting Cycle

• The four-step procedure of an accounting system: • Examining source documents • Recording transactions in an

accounting journal • Posting recorded transactions • Preparing financial statements

• A time-ordered list of account transactions

Journal • A book or computer

file with separate sections for each account

Ledger


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Income Statement Income Statement

• A financial report that shows an organization’s profitability over a period of time – month, quarter, or year

Revenue • The total amount of money received from

the sale of goods or services, as well as from related business activities

Cost of Goods Sold • The amount of money a firm spent to buy

or produce the products it sold during the period to which the income statement applies


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Equivalent Terms in Accounting

o As is the case in many other disciplines, certain concepts have more than one name

o For example, sales and revenues are often interchanged, as are profits, income, and earnings.


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Gross Income and Expenses

Gross Income (or Profit) • Revenues minus the cost of goods sold required to

generate the revenues

The income available after paying all expenses of production

Expenses • The costs incurred in the day-to-day operations of an

organization Common expense accounts: 1. Selling, general, and administrative expenses (including

depreciation) 2. Research, development and engineering expenses 3. Interest expenses


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Depreciation Depreciation

• The process of spreading the costs of long-lived assets such as building and equipment over the total number of accounting periods in which they are expected to be used

1. A manufacturer that purchases a $100,000 machine expected to last about 10 years

2. Rather than showing an expense of $100,000 in the first year and no expense for the item over the next 9 years, manufacturer allowed to depreciation expenses of $10,000/year in each of the next 10 years

3. Better matches the cost of the equipment to the years the item is used

4. Depreciation is “written off” as an expense and book value of the machine is also reduced by $10,000


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Net Income Net Income

• The total profit (or loss) after all expenses, including taxes, have been deducted from revenue; also called net earnings

Most companies present the current year’s results along with the previous two years’ income statements Gross profit, earnings before interest and taxes,

and net income are the results of calculations made from the revenues and expenses accounts; they are not actual accounts When corporation elects to pay dividends, it

decreases the cash account as well as a capital account


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Balance Sheet Balance Sheet

• A “snapshot” of an organization’s financial position at a given moment

• Shows assets and the funding used to pay for these assets, such as bank debt or owners’ equity

• Takes its name from its reliance on the accounting equation: assets must equal liabilities plus owners’ equity

• The balance sheet is an accumulation of all financial transactions since the company’s founding

• Traditional balance sheet places assets on the left side and its liabilities and owners’ equity on the right

• Vertical format has assets on the top followed by liabilities and owners’ equity


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Balance Sheet - Assets Listed in descending order of liquidity – how fast they can be

turned into cash

Current Assets • Assets used or converted into cash within the course of a

calendar year • Cash, temporary investments, accounts receivable and inventory

Accounts Receivable • Money owed a company by its clients or customers who have

promised to pay for the products at a later date

Long-term, or fixed assets represent a commitment of funds of at least one year

Items include: long-term investments, plant and equipment, and intangible assets such as reputation, patents and trademarks


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Balance Sheet – Liabilities

Current Liabilities • A firm’s financial obligation to short-term creditors,

which must be repaid within one year

Accounts Payable • The amount a company owes to suppliers for goods

and services purchased with credit

Accrued Expenses • An account representing all unpaid financial

obligations incurred by the organization


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Balance Sheet – Owners’ Equity

Owners’ equity includes: ♦ The owners’ contributions to the organization ♦ Along with income earned by the organization retained to

finance continued growth and development

Accounts listed as owners’ equity on a balance sheet may differ dramatically from company to company ♦ Corporations sell stock to investors, who then become

owners of the firm ♦ Many corporations issue several different classes of

common and preferred stock Each with different dividend payments and/or voting

rights © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned,


14-29

Pro Forma Financial Statements

Pro forma financial statements are used to make decisions about future operations changes within a company Include balance sheets, income statements, and cash flow

statements. When a company is considering a change, composing pro forma

financial statements will show

o Whether profits will increase or decrease

o The magnitude of expenses involved

o Whether the company needs financing to facilitate the proposed change


http://aaupwiki.princeton.edu/index.php/Proforma_Financial_Statements

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Statement of Cash Flows

Statement of Cash Flows • Explains how the company’s cash changed from

the beginning of the accounting period to the end

Balance sheet shows the cash account in one point of time; most investors want a better picture of how cash flows into and out of the company

Statement of cash flows takes the cash balance from one year’s balance sheet and compares it with the next while providing detail about how the firm used the cash


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Statement of Cash Flows (cont.)

The change in cash is detailed in these three categories

• Calculated by combining the changes in the revenue, expense, current assets and current liability accounts

Cash From Operating Activities

• Calculated from changes in the long-term or fixed asset accounts

Cash From Investing Activities

• Calculated from changes in the long-term liability accounts and the contributed capital accounts in owners’ equity

Cash From Financing Activities


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Ratio Analysis

Ratio Analysis • Calculations that measure an organization’s financial

health

Brings complex information from the income statement and balance sheet into sharper focus

To measure and compare the organization’s productivity, profitability, and financing mix with other similar entities

Profitability Ratios • Ratios measuring the amount of operating income or

net income an organization is able to generate relative to its assets, owners’ equity, and sales


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Financial Ratios A ratio is simply one number divided by another, with the result showing the relationship between the two numbers Financial ratios are used to weigh and evaluate a firm’s

performance

Earnings of $70,000 or accounts receivable of $200,000 rarely provides as much useful information as a well-constructed ratio

Whether numbers are good or bad depends on their relation to other numbers If a company earned $70,000 on $700,000 in sales (10%

return) such an earnings level might be satisfactory

The president of the company earning this same $70,000 on sales of $7 million (1% return) should probably start looking for another job


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Profit Margin

Net Income (Net Earnings) $21,863Sales (Total Net Revenues) $77,849Profit Margin = i=i = 28.08%

So, for every $1 in sales, Microsoft generated profits after taxes of nearly 28 cents


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Return on Assets

Net Income (Net Earnings) $21,863Total Assets $142,431Return on Assets = i=i = 15.35%

For every $1 in assets, Microsoft generated a return of 15.35%, or profits of 15.35 cents


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Return on Equity

Net Income $21,863Stockholders' Equity $78,944Return on Equity = i=i = 27.69%

For every $1 invested by Microsoft stockholders, the company earns 27.69% return, or 27.69 cents


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Asset Utilization Ratios

Asset Utilization Ratios • Ratios that measure how well a firm uses its

assets to generate each $1 of sales

Managers use asset utilization ratios to pinpoint areas of inefficiency in their operations

These ratios – receivables turnover, inventory turnover, and total asset turnover – relate balance sheet assets to sales, which are found on the income statement


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Receivables Turnover

Sales (Total Net Revenues) $77,849Receivables $17,486Receivables Turnover = i=i = 4.45 X

Microsoft collected its receivables 4.45 times per year; which translates to about 80 days that

receivables are outstanding


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Inventory Turnover

Sales (Total Net Revenues) $77,849Inventory $1,938Inventory Turnover = i=i = 40.17 X

Microsoft’s inventory turnover indicates they replaced its inventory 40.17 times last year, or about every 9

days © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned,


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Total Asset Turnover

Sales (Total Net Revenues) $77,849.00Total Assets $142,431.00Total Asset Turnover = = = 0.55X

Microsoft generated $0.55 in sales for every $1 in total corporate assets


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Liquidity Ratios

Liquidity Ratios • Ratios that measure the speed with which a company

can turn its assets into cash to meet short-term debt

High liquidity ratios may satisfy a creditor’s need for safety, but may indicate the company is not using its current assets efficiently

Liquidity ratios are best examined in conjunction with asset utilization ratios because high turnover ratios imply cash is flowing through very quickly


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Current Ratio

Current Assets $101,466Current Liabilities $37,417Current Ratio = i=i = 2.71X

Microsoft’s current ratio indicates that for every $1 of current liabilities, the firm had $2.71 of current assets

on hand


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Quick Ratio (Acid Test)

Current Assets - Inventory $99,528Current Liabilities $37,417Quick Ratio = i=i = 2.66X

In 2011, Microsoft had $2.66 invested in current assets (after subtracting inventory) for every $1 of

current liabilities


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Debt Utilization Ratios

Debt Utilization Ratios • Ratios that measure how much debt an organization is

using relative to other sources of capital, such as owners’ equity

Debt financing is riskier than equity as it demands a monthly payment regardless of profitability

Recessions affect heavily indebted firms far more than those financed through equity

Most companies tend to keep debt-to-asset levels below 50 percent


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Debt to Total Assets Ratio

Debt (Total Liabilities) $63,487Total Assets $142,431Debt to Total Assets = i=i = 45%

For every $1 of Microsoft’s total assets, 45% is financed with debt and 55% with owners’ equity


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Times Interest Earned Ratio

EBIT (Operating Income) $26,863Interest (from note 3) $429Times Interest Earned = i=i = 62.39X

Microsoft paid $429 million in interest expense, but that amount was covered 62.39 times by income

before interest and taxes


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Diluted Earnings Per Share

Net Income $21,863# Of Shares Outstanding (Diluted) 8,470Diluted Earnings Per Share = i=i = $2.58

Microsoft’s basic earnings per share declined from $2.69 per share to $2.58, and this decline also shows

up in diluted earnings per share


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Dividends Per Share

Dividends Paid $7,456# Of Shares Outstanding 8,103Dividends Per Share = i=i = $0.92

Since 2004, Microsoft has raised its dividend every year, from $0.16 per share to $0.92 per share


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Importance of Integrity in Accounting The recent financial crisis and recession showed

another example of a failure in accounting reporting Many firms attempted to exploit loopholes and

manipulate accounting reporting Banks and other financial institutions often held assets

off their books by manipulating accounts Transparency and

accuracy in reporting revenue, income and assets develops trust from investors and other stakeholders


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Compliance to Accounting Principles Strong compliance to accounting principles creates trust

among stakeholders ►Accounting and financial planning is important for all

organizational entities even cities ◄ City of Maricopa in Arizona received the Government Finance

Officers Association of the United States and Canada Distinguished Budget Presentation Award for its government budgeting

◄ City scored proficient in its policy, financial plan, operations guide, and communications device

► Integrity in accounting is crucial to: ◄ Create trust ◄ Understanding the financial position of an organization or entity ◄ Making financial decisions that will benefit the organization


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Solve the Dilemma Exploring the Secrets of Accounting

You have been promoted from vice president of marketing of BrainDrain Co. to president and CEO

► You know marketing like the back of your hand, but know next to nothing about finance

► BrainDrain is in danger of failure if steps to correct large and continuing financial losses are not taken at once ♦ You have asked vice president of finance and accounting

for a complete set of accounting statements ♦ Detailing the financial operations of the company over the

past several years ♦ You decide to attack the problem systematically and learn

“hidden secrets” of the company statement by statement © 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned,


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Solve the Dilemma Exploring the Secrets of Accounting (cont.)

Searching for answers:

• With the firm’s trusted senior financial analyst by you side, you delve into the accounting statements

• Resolved to “get to the bottom” of the firm’s financial problems

• Set new course that will take the firm from insolvency and failure to financial recovery and perpetual prosperity

Discussion Questions • Describe the 3 basic

accounting statements. What types of information does each provide that can help you evaluate the situation?

• Which of the financial ratios are likely to prove to be of greatest value in identifying problem areas in the company? Why? Which of your company’s financial ratios might you expect to be especially poor?

• Discuss the limitations of ratio analysis.


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Discussion

? Why are accountants so important to a corporation? What function do they perform?

? Describe the accounting process and cycle.

? The income statements of all corporations are in the same format. True or false? Discuss.

? Why are debt ratios important in assessing the risk of the firm?


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Financing the Enterprise - WordPress.com · Financing the Enterprise ... managers in planning and directing the organization’s ... to determine how well the company is doing