2 Why Accounting Information Is Important Recent accounting scandalsPressure on corporate executives to look good to analysts and investorsWhy audited financial statements are importantBankers, creditors, investors, and government agencies rely on an auditor’s opinion of the validity of a firm’s financial statements.
3 Why Accounting Information Is Important (cont.) What is an audit?An examination of a company’s financial statements and accounting practicesGenerally accepted accounting principles (GAAPs)— an accepted set of guidelines and practices for U.S. companies reporting financial information and the accounting professionThe FASB (Financial Accounting Standards Board) is developing a new set of standards combining those of GAAP and the International Financial Reporting StandardsAn audit does not guarantee that a company has not “cooked” the books
4 Why Accounting Information Is Important (cont.) Reform: The Sarbanes-Oxley Act of 2002Top executives must certify periodic financial reports and are liable for intentional violations of reporting requirements.Auditors must maintain financial documents and audit work papers for five years.Auditors and accountants can be imprisoned for up to twenty years and subject to fines for destroying documents and violating securities laws.A public corporation must change its lead auditing firm every five years.There is protection for whistle-blowers who report violations of the Sarbanes-Oxley Act.
5 Who Uses Accounting Information Managers are the primary usersProprietary: information that is not divulged to anyone outside the firmLenders, suppliers, stockholders, potential investors, and government agencies are other users
7 Different Types of Accounting Managerial accounting provides managers and employees within the organization with information needed to make decisions about a firm’s financing, investing, marketing, and operating activities.Financial accounting generates financial statements and reports for interested people outside an organization.
8 Using the Internet www.aicpa.org The American Institute of Certified Public Accountants (AICPA) is the preeminent governing body of the profession. Its website includes online articles and publications, guidelines, career resources, and links to other sites important to the field of accountancy.
9 The Accounting Process The accounting equation: assets = liabilities + owners’ equityAssets—the resources that a business owns (e.g., cash, inventory, equipment, and real estate)Liabilities—the firm’s debtsOwners’ 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)Double-entry bookkeeping system: each financial transaction is recorded as two separate accounting entries to maintain the balance of the accounting equation
10 The Accounting Process (cont.) The accounting cycleDone on a regular basis-gather receipts, record in journal, post in general ledgerDone at the end of the periodPrepare the trial balance of all general ledger accountsPrepare financial statementsClose the books
11 The Accounting Cycle 1. Analyzing source documents (receipts etc) 2. Recording transactions (journal)3. Posting transactions (general ledger)4. Preparing the trial balance5. Preparing the financial statements
12 The 3 Most Important Financial Statements Balance SheetIncome StatementCash Flow Budget
14 The Balance Sheet must balance!! Total AssetsLiabilities + Owners Equity
15 The Balance SheetA summary of the dollar amounts of a firm’s assets, liabilities, and owners’ equity accounts at the end of a specific accounting periodAssetsListed 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 lessCash, marketable securities, accounts receivable, notes receivable, merchandise inventory, and prepaid expenses
16 The Balance Sheet (cont.) Assets (cont.)Fixed assets—will be held or used for a period longer than one yearLand, buildings, and equipmentDepreciationIntangible assets—do not exist physically but have a value based on the rights or privileges they confer on the firmPatents, copyrights, trademarks, and goodwill
17 The Balance Sheet (cont.) LiabilitiesCurrent liabilities—debts to be repaid in one year or lessAccounts payable—short-term obligationsNotes payable—obligations that have been secured with promissory notesLong-term liabilities—debts that need not be repaid for at least one yearMortgages, bonds, and long-term loans
18 The Balance Sheet (cont.) Owners’ or stockholders’ equityFor sole proprietorships— Assets – liabilities = owners’ equityFor partnerships—each partner’s share of ownership is reported separately in each owner’s nameFor corporations—stockholders’ equityRetained earnings—profits not distributed to stockholders
19 Balance Sheet Assets Listed Most LiquidLeast Liquid
20 Most liquid to Least liquid Break into teams for this exercise
21 The Income StatementA summary of a firm’s revenues and expenses during a specified accounting periodProfit (cash surplus)Loss (cash deficit)RevenuesThe dollar amounts earned by a firm from selling goods, providing services, or performing business activitiesGross sales—the total dollar amount of all goods and services sold during the accounting periodNet sales—the actual dollar amounts received by a firm for the goods and services it has sold, after adjustment for returns, allowances, discounts
22 The Income Statement (cont.) Cost of goods soldThe dollar amount equal to beginning inventory plus net purchases less ending inventoryCost of goods soldBeginning inventoryNet purchasesEnding inventory=+–Gross profit = a firm’s net sales less the cost of goods sold
23 The Income Statement (cont.) Operating expensesAll business costs other than the cost of goods soldSelling expenses—costs related to marketing activitiesGeneral expenses—costs of managing the businessNet incomeRevenues less expenses, when the difference is positiveNet lossRevenues less expenses, when the difference is negative
26 Class ExerciseFor each of the following accounts, indicate whether it belongs on a balance sheet or an income statement.RentCashPatentMortgage paymentNet incomeSalaries payablePurchaseDelivery equipmentSalesCost of goods soldCommon stock
28 The Statement of Cash Flows Illustrates how the operating, investing, and financing activities of a company affect cash during an accounting periodCash flows from operating activities (providing goods and services)Cash flows from investing activities (purchase and sale of land, equipment, and other assets and investments)Cash flows from financing activities (changes in debt obligation and owners’ equity accounts)
30 Comparison of Financial Statements TimeframeMain AccountsIncomeUp to 1 yearExpenseProfitBalance SheetSince the beginning of the companyAssetsLiabilitiesEquityCash FlowOperatingInvestmentFinancing
31 Evaluating Financial Statements Using accounting information to evaluate a potential investment or to see if a firm is healthyUse common sense to interpret the numbers.Determine the firm’s ability to pay its debts and borrow money in the future.Understand the financial ratios. (compare them to the ratios for other businesses in that industry)Data are available from annual reports of public corporations.Industry averages are available from Dun & Bradstreet, Standard & Poor’s, and industry trade associations.
32 Financial RatiosNumbers that show the relationship between two elements of a firm’s financial statementsCan be compared with:The firm’s own past ratiosRatios of competitorsIndustry averagesInformation to calculate ratios is found on a firm’s balance sheet, income statement, and statement of cash flows
34 4 Kinds of RatiosProfitability RatiosShort-term RatiosActivity RatiosDebt-to-Owner’s Equity Ratio
35 Profitability RatiosReturn on SalesReturn on Owner’s EquityEarnings Per Share
36 Return on Sales Also called “Profit Margin” Answers the question: “How effectively is firm turning sales into profits?”Return on Sales = Net income after taxesNet SalesExample: Northeast Art SupplyReturn on Sales = $30,175 = .067 = 6.7%$451,000Compare your answer to industry average of 4-5%.
37 Return on Owner’s Equity Answers: “How much income is generated by each dollar of equity?”Return on Owner’s Equity = Net income after taxesOwner’s EquityExample: Northeast Art SupplyReturn on Owner’s Equity = $30,175 = .13 = 13%$230000Compare your answer to industry average of 12-15%.
38 Earnings Per ShareAnswers: “How much income is being contributed toward each share of stock?”Earnings Per Share = Net income after taxesCommon stock shares outstandingExample: Northeast Art SupplyEarnings Per Share = $30,175 = $1.21 per share25000Comparisons are not helpful if comparing to other businesses, but stockholders will compare to other stock they hold or are thinking about buying.
39 Short-term Ratios: Working Capital Answers: “If our creditors came calling today would we be able to pay our bills?”Working Capital = Current Assets-Current LiabilitiesExample: Northeast Art SupplyWorking Capital= $182,000-$70000 = $112,000If this isn’t enough to pay our bills, we may have to borrow. Not an ideal situation.
40 Short-term Ratios: Current Ratio Answers: “For every $1 of current assets that we have, how much current liabilities do we have?”Current Ratio = Current AssetsCurrent LiabilitiesExample: Northeast Art SupplyCurrent Ratio = $182,000 = 2.6$70,000We have $2.60 in assets for every $1 in liabilities.Compare that to the industry average of 2.0.
41 Short-term Ratios: Quick Ratio (the “Acid Test”) Answers: “If we had to liquidate quickly and pay all our debts, but we didn’t have time to sell off inventory, would we be able to pay all our debts?”Quick = Cash+Marketable Securities +All ReceivablesCurrent LiabilitiesExample: Northeast Art SupplyCurrent Ratio =$139,000 = 1.99$70,000If your answer is higher than 1 (the minimum desired quick ratio) then it shows that you are able to pay your current liabilities quickly.
42 Activity Ratios (“How many times a year do we do…….?”) Two Activity Ratios:Acounts Receivable TurnoverInventory Turnover
43 Activity Ratios (“How many times a year do we do…….?”) Answers: “How many times in one year do we collect our accounts receivable?”Accounts Receivable Turnover =Net SalesAccounts ReceivableExample: Northeast Art SupplyAR Turnover =$451,000 = times per year$38,000An AR Turnover of 11.9 times per year is about every 30 days.If your policy says that invoices are due every 25 days, then an AR Turnover of 30 days is within reason.Hard to compare one company’s AR Turnover to another’s.
44 Activity Ratios (“How many times a year do we do…….?”) Answers: “How many times in one year do we sell our inventory?”Inventory Turnover = COGSAverage InventoryAverage Inventory = Beginning + Ending Inventory2Example: Northeast Art SupplyInventory Turnover = $334,000 = 8.2 times per year$40,500Compare this to the industry average of 9.
45 Debt-to-Owner’s Equity Ratio Answers: “How much of our operations are financed through borrowing?”Debt-to-Owner’s Equity = Total LiabilitiesOwner’s EquityExample: Northeast Art SupplyDebt-to-Owner’s Equity = $110,000 = .48 = 48%$230,000The higher this ratio, the riskier it is for lenders so they may hesitate to lend you more money.
46 Chapter QuizThe __________ is designed to improve accounting standards.Ethics in Accounting ActGraham-Rudman Reform ActSarbanes-Oxley ActSecurities and Exchange Accounting ActAccounting Standards Establishment Act
47 Chapter QuizAn accountant who is employed by a specific business or organization is referred to as a(n)public accountant.private accountant.proprietary accountant.AICPA accountant.asset accountant.
48 Chapter Quiz The first step in the accounting cycle is to analyze source documents.record individual transactions.post individual transactions.construct a beginning financial statement.prepare a list of employees.
49 Chapter QuizAssets, liabilities, and owners’ equity would be listed on a firm’sbalance sheet.income statement.statement of earnings.statement of retained earnings.statement of capital.