Understanding Accounting and Financial Statements Chapter 16 Understanding Accounting and Financial Statements

Learning Goals 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. 5 1 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. 2 6 3 7 4 8

Accounting Accounting is the process of measuring, interpreting, and communicating financial information to support internal and external business decision making.

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 company’s success. Outsiders use financial data to evaluate investment opportunities.

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

The 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 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.

into financial statements. The Accounting Cycle Accounting process - set of activities involved in converting information about transactions into financial statements.

The Accounting Equation 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.

Impact of Computers & The Internet 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.

Balance Sheet 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

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.

Liquidity Ratios Total current assets Current ratio compares current assets to current liabilities. Total current liabilities 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

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

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 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.

Budgets 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.

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.