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15 chapter Financial Accounting Better Business 3rd EditionSolomon (Contributing Editor) · Poatsy · Martin chapter © 2014 Pearson Education, Inc.
Accounting: What is it and who needs it?Accounting is a system for recognizing, organizing, analyzing, and reporting information about the financial transactions that affect an organization? What does accounting do? “Language” of business Record transactions Track income & expenses Prepare financial statements Helps answer and assist with important business decisions Managers Stockholders Employees Creditors Learning Objective 6: What are the functions of the different types of accounting? Accounting involves tracking a business’s income and expenses through a process of recording financial transactions. The transactions are then summarized into key financial reports that are further used to evaluate the business’s current and expected financial status. Accounting is not just for large organizations. Accounting defines the heart and soul of even the smallest business as it helps to “account for” what the business has done, what it is currently doing, and what it has the potential to do. While accounting involves a great deal of precision, there are also some degrees of interpretation in the process of accounting. This makes accounting both an art and a science. What other groups would be interested in accounting information? © 2014 Pearson Education, Inc.
Accounting: Who Does It?What Accountants Do: Public and Private Accountants Forensic Accountants Corporate Accountants Internal/External Auditors Government Accountants Accountants require expertise Certified Public Accountant (CPA) Certification 150-semester hours of college Rigorous Exam Direct Work Experience in accounting Certified Management Accountant (CMA) Certified Fraud Examiners Managerial accounting is responsible for tracking sales and the costs of producing the sales (production, marketing, and distribution). Geared towards INTERNAL users (hence name) Financial accounting produces financial documents to aid decision makers outside an organization in making decisions regarding investments and credibility. Geared towards OUTSIDE users (although internal users also rely heavily on financial accounting information) In addition to corporate accounting, there are several other types of accounting, including auditing, tax accounting, and government and not-for-profit accounting. Corporate accounting is the part of an organization’s finance department that is responsible for gathering and assembling data required for key financial statements. Corporate accounting has two separate functions: managerial accounting and financial accounting. Managerial accounting is responsible for tracking sales and the costs of producing the sales (production, marketing, and distribution). Managerial accountants help determine which business activities are most and least profitable. Based on their analysis, management is better equipped to make decisions about whether to continue with, expand, or eliminate certain business activities. Managerial accounting produces budgets so senior management can make informed decisions. By monitoring the activities involved in planned budgets, managerial accountants help determine and anticipate in what areas the company strays from its budgeted expectations. Financial accounting produces financial documents to aid decision makers outside an organization in making decisions regarding investments and credibility. Auditing is responsible for reviewing and evaluating the accuracy of financial reports. Large corporations may have private accountants on staff who work in house to determine whether the company’s financial information is recorded correctly using proper procedures. Generally, companies hire independent auditors from outside the company to ensure their financial reports have been prepared accurately and are not biased or manipulated in any way. Government and not-for-profit accounting refers to the accounting required for organizations that are not focused on generating a profit, such as legislative bodies and charities. Governmental and not-for-profit organizations need financial management expertise. Although their goal is not to make a profit, these organizations still must distribute and manage funds, maintain a budget, and plan for future projects. Government and not-for-profit organizations must also report their financial activities so taxpayers and donors can see how funds are spent and used. Tax accounting involves preparing taxes and giving advice on tax strategies. The process for filing taxes can be complicated and is ever-changing, so companies often have tax accountants on staff, or they hire an outside accounting firm to prepare their taxes. © 2014 Pearson Education, Inc.
Accounting Standards & ProcessesGenerally Accepted Accounting Principles (GAAP) – accounting standards that are used in the preparation of financial statements Through GAAP, the FASB aims to ensure that financial statements are: Relevant Reliable Consistent Comparable Financial Accounting Standards Board (FASB) – private self-regulated board that establishes and enforces GAAP For any financial information to be useful, it is critical that the information is accurate, fair and objective, and consistent over time. Accountants in the United States follow a set of generally acceptable accounting principles (or GAAP) that are standard accounting rules defined by the Financial Accounting Standard Board, an independent organization. . Although GAAP provides accountants with general rules, they are often subject to different interpretations, which can lead to problems. Companies such as WorldCom, Enron, and Tyco made headlines and fell into financial ruin in the early 2000s due to very aggressive and fraudulent accounting practices. In 2002, the United States Congress passed the Sarbanes-Oxley Act. It was created to protect investors from corporate accounting fraud. The act established the Public Company Accounting Oversight Board, which is responsible for overseeing financial audits of public companies. Other countries have their own agreed-upon accounting standards, which may differ from GAAP. Recently, there has been a movement toward international convergence of accounting standards. Most other countries are beginning to accept a common set of country-neutral accounting standards known as International Financial Reporting Standards (IFRS). By using IFRS, multinational companies such as Toyota, Nestlé, and Guinness may avoid the need to convert the financial reports prepared to meet their own country’s accounting standards into GAAP specifications. © 2014 Pearson Education, Inc.
The Accounting ProcessGAAP establishes two main financial accounting rules: The Accounting Equation Assets = Liabilities + Owner’s Equity Assets – The resources that a business own (ex. Cash, Accounts Receivable, Inventory, Equipment, and Real Estate/Land) Liabilities – The firm’s debts, what it owes others (ex. Accounts Payable and Notes Payable) Owner’s Equity – The difference between assets and liabilities (what would be left for the owners if the firm’s assets were sold and the money used to pay off its liabilities (ex. Retained Earnings, Stock) Double-Entry Bookkeeping System Each financial transaction is recorded as two separate accounting entries to maintain the balance of the accounting equation © 2014 Pearson Education, Inc.
The Accounting Process (cont.)Learning Objective 7: How is double-entry bookkeeping used to maintain the balance of the fundamental accounting equation? When people think of accounting, most think of the systematic recording of a company’s every financial transaction. This precise process is a small but important part of accounting called bookkeeping. The process of bookkeeping centers on a fundamental concept that what a company owns (its assets) must equal what it owes to its creditors (its liabilities) plus what it owes to its owners (owners’ equity). This balance is better described as the fundamental accounting equation: assets = liabilities + owners’ equity. To maintain the balance of assets and liabilities plus owners’ equity, accountants use a recording system called double-entry bookkeeping. Double-entry bookkeeping recognizes that for every transaction that affects an asset, an equal transaction must also affect either a liability or owners’ equity © 2014 Pearson Education, Inc.
The Accounting EquationAssets = Liabilities + Owner’s Equity Own = Owed Owner’s Claims Cash, Accounts Receivable, Inventory, Equipment, Real Estate Stock, Retained Earnings (cumulation of company’s profits and losses) Accounts Payable, Notes Payable $826, = $613, $213,000 Owner’s Equity (what’s left over to owner’s once liabilities are taken from assets), shown as: Assets – Liabilities = Owner’s Equity © 2014 Pearson Education, Inc.
Examples of the Accounting EquationIn the example on the left, we have a company without any debt. Without any liabilities, assets equal owners’ equity. On the right, we see a company that has borrowed $2,500 to purchase lawn mowers. Assets have increased by the same amount. Borrowing to buy assets increases assets and liabilities. © 2014 Pearson Education, Inc.
Financial Statements: Read All About UsFinancial accounting includes three basic financial statements: Balance Sheet Income Statement Statement of Cash Flows Corporations with publicly held stock must publish annual reports with all three statements. Financial statements are the formal reports of a business’s financial transactions that accountants prepare periodically. They represent what has happened in the past and provide management, as well as various outsiders such as creditors and investors, with a perspective of what is going to happen in the future. Publicly owned companies are required to publish three financial statements: A balance sheet shows what the company owns and what it has borrowed at a fixed point in time and shows the net worth of the business. An income statement shows how much money is coming into a company and how much money a company is spending over a period. It shows how well a company has done in terms of profit and loss. A statement of cash flows shows the exchange of money between a company and everyone else it deals with over a period of time. It shows where cash was used. © 2014 Pearson Education, Inc.
Assets = Liabilities + Owner’s EquityThe Balance Sheet Balance Sheet – summarizes a firm’s financial position at a specific point in time Assets – things of value that the firm owns Liabilities – indicates what the firm owes to non-owners Owner’s Equity – the claims owners have against their firm’s assets Assets = Liabilities + Owner’s Equity © 2014 Pearson Education, Inc.
© 2014 Pearson Education, Inc.Balance Sheet (cont.) Assets Liabilities Current assets Current liabilities + Fixed assets Long-term liabilities = Total Liabilities Owners’ Equity = Total Assets = Total Liabilities + Owners’ Equity Assets Listed in order of liquidity (ease with which an asset can be converted into cash) Current assets—can quickly be converted into cash or that will be used in one year or less Cash, accounts receivable, notes receivable, and merchandise inventory Fixed assets—will be held or used for a period longer than one year Real estate (Land and buildings), and equipment Depreciation—the process of apportioning the cost of a fixed asset over the period during which it will be used Liabilities Current liabilities—debts to be repaid in one year or less Accounts payable—short-term obligations that arise as a result of making credit purchases Notes payable—obligations that have been secured with promissory notes Long-term liabilities—debts that need not be repaid for at least one year Owners’ or stockholders’ equity Retained earnings—profits not distributed to stockholders Learning Objective 8: What is the function of balance sheets, income statements, and statement of cash flows? A balance sheet is a snapshot of a business’s financial condition at a specific moment in time. Balance sheets are based on the most fundamental equation in business accounting: assets = liabilities + owners’ equity. Assets are always presented on the left side of the balance sheet and must always equal claims on assets, which are liabilities plus stockholders’ equity (the items on the right side of the balance sheet). Assets are the things a company owns, which include cash, investments, buildings, furniture, and equipment. On a balance sheet, assets are organized into three categories: current, fixed, and intangible. Current assets are those assets that can be turned into cash within a year. Fixed assets are assets that have more long-term use, such as real estate, buildings, machinery, and equipment. Intangible assets are assets that do not have physical characteristics but still have value such as trademarks, patents, copyrights, brand recognition, and customer or employee relations. Liabilities are all debts and obligations and are listed on the balance sheet in the order in which they will come due. Short-term liabilities, also known as current liabilities, are obligations a company is responsible for paying within a year or less and are listed first on the balance sheet. Long-term liabilities include debts and obligations that are due in more than one year, such as mortgage loans, long-term leases, and bonds issued for large projects. For small businesses, owners’ equity is literally the amount the owners in the business can call their own. It is often referred to as the owners’ capital account. For larger publicly owned companies, owners’ equity becomes a bit more complicated. Shareholders are the owners of publicly owned companies. Owners’ equity, in this case, is the value of the stock issued as part of the owners’ (shareholders’) investment in the business and retained earnings, which are the accumulated profits a business has held onto for reinvestment into the company. © 2014 Pearson Education, Inc.
© 2014 Pearson Education, Inc.Balance Sheet Example At any point in time, the information in the balance sheet is used to answer questions such as, “Is the business in a good position to expand?” and “Does the business have enough cash to ride out an anticipated lull in sales?” In addition, by analyzing how a balance sheet changes over time, financial managers can identify trends and then suggest strategies to manage accounts receivable and payable in a way that is most beneficial to the company’s bottom line. © 2014 Pearson Education, Inc.
Analyzing a Balance Sheet with Some Financial RatiosWorking Capital = Current Assets – Current Liabilities Current Ratio = Current Assets ÷ Current Liabilities Debt-to-Equity Ratio = Total Liabilities ÷ Owners’ Equity A lot of information about a company can be determined by the balance sheet. For example, just looking at the amount of inventory a company keeps on hand can be an indicator of a company’s efficiency. Inventory is the merchandise a business owns but has not sold. Inventory on hand is necessary to satisfy customers’ needs quickly, which makes for good business. Ratio analysis is used to compare current data to data from previous years, competitors’ data, or industry averages. Ratios eliminate the effect of size, so you can reasonably compare a large company’s performance to a smaller company’s performance. There are three main calculations using information from a balance sheet to determine a company’s financial health and liquidity: Working capital tells you what is left over if the company pays off its short-term liabilities with its short-term assets. Working capital is a measure of a company’s short-term financial fitness, as well as its efficiency. Working capital ratio is calculated as: current assets – current liabilities = working capital. If a company has positive working capital (its current assets are greater than its current liabilities), that means it is able to pay off its short-term liabilities. If a company has negative working capital (its current assets are less than its current liabilities), that means it is currently unable to offset its short-term liabilities with its current assets. The current ratio (sometimes called liquidity ratio) is a measurement used to determine the extent to which a company can meet its current financial obligations. Current ratio is calculated as current ratio = current assets / current liabilities. Current ratio allows for better comparisons, especially when comparing a company to an industry on average. Having too high of a current ratio indicates the company may not be very efficient with its cash, but having too low of a current ratio may indicate the company will face potential problems paying back its creditors. The debt-to-equity ratio measures how much debt a company has relative to its assets by comparing a company’s total liabilities to its total shareholders’ equity. Debt-to-equity ratio is calculated as debt-to-equity ratio = total liabilities / shareholders’ equity. The debt-to-equity ratio can give a general idea of a company’s financial leverage. As you may remember from the beginning of this chapter, leverage is the amount of debt used to finance a firm’s assets. The debt-to-equity ratio will tell potential investors how much a company is willing to go into debt with creditors, lenders, and suppliers over debt with shareholders. A lower debt-to-equity ratio number means that a company is using less leverage and has more equity. Companies with too much long-term debt may end up financially overburdened with interest payments. © 2014 Pearson Education, Inc.
The Income Statement (aka P&L Statement)Income Statement – summarizes a firm’s operations over a given period of time in terms of profit and loss. Also called the Profit and Loss Statement Revenue– The $ amount a firm earns from selling its products Expenses – the cash the firm spends or other assets it uses to generate revenue Net Income (Profit) – the profit or loss the firm earns Revenue – Expenses = Net Income (Profit) Revenues > Expenses = Net Income (Profit) Expenses > Revenue = Loss © 2014 Pearson Education, Inc.
The Income Statement OutlineRevenue (Sales Price * Quantity Sold) Cost of Goods Sold (Beginning Inventory + Purchases - Ending Inventory) = Gross Profit Operating Expenses = Net Income Before Taxes Tax Expense = Net Income After Taxes What does the Income Statement Tell Us? Revenue is the amount of money generated by a business by either selling goods or performing services. It is calculated as Sales Price * Quantity Sold. Cost of Goods Sold are the variable expenses a company incurs to manufacture and sell a product, including the price of raw materials used in creating the good along with the labor costs used to produce and sell the items. To get COGS, you will take the Beginning Inventory balance, add in Purchases to inventory for that period, and Subtract the Ending Inventory balance (when you close out period). Gross profit tells you how much money a company makes just from its products and how efficiently management controls costs in the production process. Operating expenses include sales, general, and administrative expenses. These costs may consist of items such as rent, salaries, wages, utilities, depreciation, and insurance. Net Income Before Taxes tells us how much income (profit) is available to owners prior to paying taxes. Remember, in order to pay taxes, a business must show a profit. Otherwise they don’t owe any taxes. Taxes paid are subtracted to determine net income (or net income after taxes). Net Income After Taxes is the “bottom line” and is usually stated on the very last line of an income statement. An income statement reflects the profitability of a company by showing how much money the company takes in and how much money it spends. Income statements also work around an equation: revenues – expenses = profit (or loss). The income statement is grouped into four main categories: revenues, costs of goods sold, operating expenses, and net income, which are arranged in the following formula: Revenues – Cost of Goods Sold – Operating Expenses – Taxes = Net Income Revenue is the amount of money generated by a business by either selling goods or performing services. If a company has several different product lines or businesses, the income statement shows each product or division in categories to distinguish how much each generated in revenue. Cost of Goods Sold are the variable expenses a company incurs to manufacture and sell a product, including the price of raw materials used in creating the good along with the labor costs used to produce and sell the items. Gross profit tells you how much money a company makes just from its products and how efficiently management controls costs in the production process. Operating expenses include sales, general, and administrative expenses. These costs may consist of items such as rent, salaries, wages, utilities, depreciation, and insurance. Expenses associated with research and development of new products also are included in operating expenses. Taxes paid are subtracted to determine net income (or net income after taxes). Net income is the “bottom line” and is usually stated on the very last line of an income statement. © 2014 Pearson Education, Inc.
Income Statement ExampleNike’s income statement for 2011 shows us that they made a profit of over 2 billion dollars. © 2014 Pearson Education, Inc.
Analyzing Income Statements with Financial RatiosGross Profit Margin = (Revenue – COGS) / Revenue Operating profit margin = (Gross Profit – Operating Expenses) / Revenue Earnings Per Share = Net Income / Outstanding Shares Besides showing overall profitability, income statements also indicate how effectively management is controlling expenses by pinpointing abnormal or excessive expenditures, highlighting unexpected increases in costs of goods sold, or a showing a change in returns. The gross profit margin determines a company’s profitability of production. It indicates how efficient management is in using its labor and raw materials to produce goods. The operating profit margin determines a company’s profitability of operations. It indicates how efficiently management is in using business operations to generate a profit. The portion of a company’s profit allocated to the stockholders on a per-share basis is determined by calculating earnings per share. © 2014 Pearson Education, Inc.
© 2014 Pearson Education, Inc.
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