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Understanding Accounting and

Financial Statements

Chapter 16

Explain the functions and importance of accounting, 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.

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.

Learning Goals

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AccountingAccounting is the process of measuring, interpreting, and

communicating financial information to support internal and external business decision making.

• 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

Business Activities Involving

Accounting• 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.

Accounting Professionals

• Public Accountants– Provide accounting services to

individuals or business firms for a fee

• Management Accountants– Provide timely, relevant, accurate, and

concise information that executives can use to operate their firms

• Government and Not-for-Profit Accountants

• 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 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.

The Foundation of

Accounting Systems

The Accounting Cycle

Accounting process - set of activities involved in converting information about transactions

into financial statements.

• 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 that 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 Computers & The Internet 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

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.

Sample Income Statement

Statement of Owner’s Equity

Statement of Owner’s 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.

Sample Statement of

Owner’s Equity

The Statement of Cash Flows

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.

Sample Statement of Cash Flows

Financial Ratios Analysis

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.

• Standardize numbers; facilitate comparisons

• Used to highlight weaknesses and strengths

Why are ratios useful?

• Liquidity Ratios: Can we make required payments as they fall due?

• Activity Ratios (Asset management): Do we have the right amount of assets for the level of sales?

What are the five major categories of ratios, and what questions do they

answer?

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• Leverage Ratios (Debt management): Do we have the right mix of debt and equity?

• Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA?

• Market value: Do investors like what they see as reflected in P/E and M/B ratios?

Liquidity Ratios

Acid-test (or quick) ratio measures the

ability of a firm to meet its debt payments on

short notice.

Cash and equivalents + short-term investments + accounts receivable

Total current liabilities

Current ratio compares current assets to current liabilities.

Total current assets

Total current liabilities

Activity Ratios

Inventory turnover ratio indicates the number of times

merchandise moves through a business.

Net sales

Average of inventory

Total asset turnover ratio indicates how much in

sales each dollar invested in assets generates.

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 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.

Leverage Ratios

> > > > > > > > Market Ratios Return on Assets (ROA)

and Return on Equity (ROE)

ROA=

= = 7.2%.

Net income Total assets

$253.6 $3,517

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ROE =

= = 12.8%.

Net incomeCommon equity

$253.6 $1,977

2005E 2004 2003 Ind.ROA 7.2% -3.3% 6.0% 9.0%ROE 12.8% -17.1% 13.3% 18.0%

Both below average but improving.

• ROA is lowered by debt--interest expense lowers net income, which also lowers ROA.

• However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.

Effects of Debt on ROA and ROE

• 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.

Budgets

Sample Budget

International Accounting

• International Accounting Standards Committee (IASC) promotes worldwide consistency in financial reporting practices. In 2001, became the International Accounting Standards Board (IASB). International Financial Reporting Standards (IFRS) are the standards.

• 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.