Chapter 5 Private-Sector Accounting C H A P T E R 5

Accounting Standards Established by the Financial Accounting Standards Board (FASB): Reports must provide a clear and accurate picture of the financial condition of the entity. Reports must permit managers to take appropriate action when it is required.

The FASB Mission To establish and improve standards of financial accounting To do so for the purpose of guiding and educating the public, issuers, auditors, and users of reports To do so for the purpose of permitting investors that rely on financial reports to make sound investments

Goals of the FASB To be objective in decision making To weigh carefully the views of its constituents To create standards only when the benefits exceed the costs of doing so To minimize disruption to the continuity of the reporting practice To review the effects of past decisions

How the FASB Helps Investors By creating generally accepted accounting principles (GAAP) By setting the rules for asset valuation By setting the rules for valuation of loan contracts By standardizing the financial reporting system –Balance sheets –Income statements

Important GAAP Terms Regularity: Conformity to rules and laws Consistency: Entering similar data exactly the same Sincerity: Financial reports reflect the company’s financial position Prudence: Not making things prettier than they are Continuity: That the business will continue as a going concern

Important Accounting Terminology Accrual accounting: Business accounting where transactions are recorded as they occur Cash-basis accounting: Personal accounting where transactions are recorded as they are received Assets: Property, buildings, equipment, goodwill, or other measurable holdings of the company (continued)

Important Accounting Terminology (continued) Liabilities: Short- and long-term debt owed by the entity, other than to individuals or other organizations Balance sheets: Reports that provide a picture of the financial position of an entity at a given time Income statements: Reports that provide a picture of revenues and expenses over a given time (continued)

Important Accounting Terminology (continued) Journals: Books or electronic records that maintain transactions in chronological order Ledgers: The main accounting records of entities in which account transactions are recorded

What Is on a Balance Sheet? Current assets Fixed assets Total assets Short-term liabilities Long-term liabilities Equity

What Constitutes Assets? Current assets –Cash –Accounts receivable –Inventories Fixed assets –Property –Buildings –Equipment –Goodwill

What Constitutes Liabilities? Short-term liabilities –Accounts payable –Short-term loans Long-term liabilities –Long-term loans –Bonds issued by the entity

What Is on an Income Statement? Revenues Cost of goods sold Gross profit margin Overhead expenses Operating income Operating margin (continued)

What Is on an Income Statement? (continued) Nonoperating income and expenses Income before taxes Taxes Net income after taxes Net operating income margin

To Get Gross Profit Margin Add revenues. Subtract cost of goods sold. Divide the difference by total revenues.

To Get Operating Margin Subtract overhead expenses from gross profit margin. Add operating income. Divide the result by total revenues.

To Get Income Before Taxes Add nonoperating income to operating income. Subtract nonoperating expenses.

To Get the Net Operating Income Margin Subtract taxes from income before taxes. Divide the net income after taxes by total revenues.

Interpreting Income Statements Look at the net income margin (the bottom line). Depending on the bottom line, see whether costs of goods sold, overhead, or nonoperating expenses are too high. If the net income operating margin is high, buy stock in the company.

Summary FASB accounting –Sets the business accounting standards. –Defines reporting. GAAP –Generally accepted accounting principles –Accounting principles for full accrual accounting (continued)

Summary (continued) Reports –Balance sheets –Income statements Interpreting reports –Profits –Margins