Understanding Accounting and Financial Statements

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Understanding Accounting and Financial Statements
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Chapter
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Learning Goals
Explain the functions and identify the three
basic activities involving accounting. Describe
the roles played by public, management,
government, and not-for-profit accountants. Identi
fy 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
owners equity, and the statement of cash
flows. Discuss how financial ratios are used to
analyze a companys 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

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

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Open Book Management

• 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 companys success.
• Outsiders use financial data to evaluate
  investment opportunities.

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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.

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Accounting Professionals

• 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

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Foundation of Accounting Systems

• 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.

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The Accounting Cycle

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

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The Accounting Equation

• Assets- anything of value owned or leased by a
  business.
• Liability- claim against a firms assets by a
  creditor.
• Owners 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.

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Impact of Technology on Accounting

• 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.

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Balance Sheet

• Balance sheet statement of a firms financial
  positionwhat it owns and the claims against its
  assetsat a particular point in time
• Photograph of firms assets together with its
  liabilities and owners equity
• Follows the accounting equation

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Sample Balance Sheet
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Income Statement

• Income Statement financial record of a companys
  revenues and expenses and profits over a period
  of time
• Firms 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

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Sample Income Statement
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Statement of Owners Equity

• 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

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Sample Statement of Owners Equity
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Statement of Cash Flows

• Statement of cash flows a firms 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

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Sample Statement of Cash Flows
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Financial Ratios Analysis

• Ratio analysis tool for measuring a firms
  liquidity, profitability, and reliance on debt
  financing as well as the effectiveness of
  managements resource utilization

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Liquidity Ratios
Total current assets

• Current ratio compares current assets to current
  liabilities.

Total current liabilities
Cash and equivalents short-term investments
accounts receivable

• Acid-test (or quick) ratio measures the ability
  of a firm to meet its debt payments on short
  notice.

Total current liabilities
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Activity Ratios
Net sales

• Inventory turnover ratio indicates the number of
  times merchandise moves through a business.

Average of inventory
Net sales

• Total asset turnover ratio indicates how much in
  sales each dollar invested in assets generates.

Average of total assets
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Profitability Ratios

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

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Leverage Ratios

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

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

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Budgets

• Budget- planning and control tool that reflects a
  firms 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 firms cash inflows and
  outflows.

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Sample Budget
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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 countrys
  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

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