Understanding Accounting and Financial Information CHAPTER 17 Understanding Accounting and Financial Information McGraw-Hill/Irwin Copyright © 2015 by the McGraw-Hill Companies, Inc. All rights reserved.

LEARNING OBJECTIVES Demonstrate the role that accounting and financial information play for a business and its stakeholders. Identify the different disciplines within the accounting profession. List the steps in the accounting cycle, distinguish between accounting and bookkeeping, and explain how computers are used in accounting. 17-2

LEARNING OBJECTIVES Explain how the major financial statements differ. Demonstrate the application of ratio analysis in reporting financial information. 17-3

JOHN RAFTERY Patriot Contractors Served in the Marines and used his G.I. Bill to study accounting. Completed an entrepreneurship program for veterans and launched Patriot Contractors. He credits his knowledge of accounting with the growth of his business. 17-4

NAME that COMPANY Accounting software makes financial information available whenever the organization needs it. We specialize in software that addresses the accounting needs of small businesses that are often very different from major corporations. Name that company! Companies: Intuit’s QuickBooks 17-5

WHAT’S ACCOUNTING? LO 17-1 Accounting -- Recording, classifying, summarizing and interpreting of financial events and transactions in an organization to provide interested parties needed financial information. Outside parties - like employees, owners, creditors, unions, investors and the government - make use of a firm’s accounting information. See Learning Objective 1: Demonstrate the role financial information and accounting plays for a business and its stakeholders. 17-6

The ACCOUNTING SYSTEM LO 17-1 See Learning Objective 1: Demonstrate the role financial information and accounting plays for a business and its stakeholders. For students who are not taking an accounting class, this slide can help them understand an accounting system from a production perspective: *Inputs - Sales documents, purchasing documents, payroll records travel expenses, etc. *Processing – Entries are made to journals; then transferred into ledgers; and finally summarized and reviewed to compile a trial balance. *Outputs – Development of financial statements, such as the balance sheet, income statement, and statement of cash flows, prepared for management personnel within the company, as well as interested parties outside the company. It is very important for students to understand the importance of integrity when calculating numbers. Generally Accepted Accounting Principles (GAAP) outlines procedures that are generally accepted in the accounting field. Ask students: What role did questionable accounting procedures play with Enron, Fannie Mae, and World Com? 17-7

ACCOUNTANTS’ RESPONSIBILITIES LO 17-1 See Learning Objective 1: Demonstrate the role financial information and accounting plays for a business and its stakeholders. Accountants’ Responsibilities One of the biggest uses of accountants by business is taxes and auditing. Explain to the class that the theme of “integrity of numbers” is critical for business. In addition to the reasons listed on the slide, accountants can offer businesses the following value-added services: Getting complete visibility of processes Seeing the true cost of a process or part of a process Seeing the cost of process changes, volume changes, headcount, wastage, scrap, rejects, non-conformance, downtime Seeing costs by job and by department Seeing and comparing costs of outsourcing Mapping business processes, organization-wide or job specific Using scenario analysis to see how re-engineering will affect resources such as costs and headcounts 17-8

MANAGERIAL ACCOUNTING LO 17-2 Managerial Accounting -- Provides information and analysis to managers inside the organization to assist them in decision making. Managerial accounting is involved with: Costs of production Costs of marketing Preparation and control of budgets Minimizing tax liabilities See Learning Objective 2: Identify the different disciplines within the accounting profession. 17-9

USERS of ACCOUNTING INFORMATION LO 17-2 See Learning Objective 2: Identify the different disciplines within the accounting profession. 1. This slide (based on Figure 17.2) gives the student an overview of the importance of accounting information when managing a business. Accounting procedures are the foundation for controlling mechanisms that businesses put in place to measure performance and plan for the future. Accounting influences decisions for managers in the following ways: Understanding cost behavior and perform cost-volume profit analysis Using cost allocation in planning and control Using job-order-costing and process-costing to track the flow of costs to products Using relevant information to make marketing and production decisions Using capital budgeting techniques to make long-term capital investment decisions 2. Accounting information can improve a company’s ability to compete by: Using competitor information and sales analysis to bring new concepts to the financial planning process Learning to spot financial trends to predict strategic business decisions Learning how to integrate technology into decision-making 3. Explain to the students the most important point of using accounting information to influence decision-making is to make sure you have the RIGHT information, at the RIGHT time and in the RIGHT format. 17-10

FINANCIAL ACCOUNTING LO 17-2 Financial Accounting -- Financial information and analyses are generated for people primarily outside the organization. Outside users are interested in these questions: Is the organization profitable? Is it able to pay its bills? How much debt does it owe? Annual Report -- A yearly statement of the financial condition, progress, and expectations of the firm. See Learning Objective 2: Identify the different disciplines within the accounting profession. 17-11

HOW to READ an ANNUAL REPORT LO 17-2 Key things to watch for and read: Management’s discussion and analysis of operations Balance sheet Income statement Statement of cash flows Auditor’s opinion See Learning Objective 2: Identify the different disciplines within the accounting profession. This slide presents the key areas to read when analyzing a company’s annual report. It is important that students understand that the annual report is more than a balance sheet but contains different areas which are just as important. The auditor’s opinion is a critical area for students to understand. Basically there are four different types of opinion letters that can be submitted. They are: Unqualified opinion - An unqualified opinion letter involves a certification made by the independent CPA firm that the company's financial statements were prepared in conformity with Generally Accepted Accounting Principles [GAAP], and fairly represented the firm's financial condition on the statement date. Qualified opinion - A qualified auditor's opinion letter is one in which the CPA has included one or more specific qualifications to its assurance that the customer's financial statements follow GAAP. This means that one or more irregularities were found, and that the customer could not or would not correct these irregularities. Adverse opinion – This is the most serious of all the opinion letters that can accompany a customer's financial statements. When a CPA firm discovers information during the course of its audit that demonstrates material noncompliance with GAAP accounting rules, the CPA may choose to submit an adverse opinion letter to accompany the financial statements of the company under review. Disclaimer of opinion - Due to scope limitations, a CPA may be unwilling to express any opinion about the accuracy of a customer's financial statements. A disclaimer of opinion letter means the CPA does not assume responsibility for the accuracy of the company's financial statements. (Source: www.encyclopediaofcredit.com) 17-12

PUBLIC vs. PRIVATE ACCOUNTANTS LO 17-2 Private Accountants -- Work in a single firm, government agency, or nonprofit organization. Public Accountants -- Provide accounting services to individuals or businesses. Certified Public Accountants (CPAs) -- Accountants who have passed a series of examinations established by the American Institute of Certified Public Accountants (AICPA) and met a states requirements for education and experience. See Learning Objective 2: Identify the different disciplines within the accounting profession. This slide helps highlight the difference in public and private accounting. This may be a good time to discuss what accounting or finance careers will do for students: Develop them into a well rounded business executives Help them learn how to analyze and forecast financial goals through utilization of historical data, competitor information and financial data/information Make an impression at a multi-billion dollar corporation See the company increase its financial vitality by being a part of the financial planning and reporting process 17-13

WAYS to IMPROVE ACCOUNTING PRACTICES LO 17-2 See Learning Objective 2: Identify the different disciplines within the accounting profession. This slide charts ways to improve the accounting practice. If the events of the last ten years have taught us anything, it is that accurate financial data is critical for creditors, investors and managers to make informed decisions. The federal government has reacted with the passage of Sarbanes-Oxley. This law which went into effect in 2002 and has five major components: Section 302 - Periodic statutory financial reports are to include certifications that: The signing officers have reviewed the report; the report does not contain any material untrue statements or material omission or be considered misleading; the financial statements and related information fairly present the financial condition and the results in all material respects; the signing officers are responsible for internal controls and have evaluated these internal controls within the previous ninety days and have reported on their findings; a list of all deficiencies in the internal controls and information on any fraud that involves employees who are involved with internal activities; and any significant changes in internal controls or related factors that could have a negative impact on the internal controls Section 401 - Financial statements published by issuers are required to be accurate and presented in a manner that does not contain incorrect statements. Section 404 - Issuers are required to publish information in their annual reports concerning the scope and adequacy of the internal control structure and procedures for financial reporting. Section 409 - Issuers are required to disclose to the public, on an urgent basis, information on material changes in their financial condition or operations. Section 802 - Imposes penalties or fines and/or up to 20 years imprisonment for altering, destroying, mutilating, concealing, falsifying records, documents or tangible objects with the intent to obstruct, impede or influence a legal investigation. (Source: www.soxlaw.com) Source: www.soxlaw.com, accessed November 2014. 17-14

Photo Credit: Nancy Pelosi DODD-FRANK ACT LO 17-2 Dodd-Frank Wall Street Reform and Consumer Protection Act increased financial regulation by increasing the power of the Public Company Accounting Oversight Board. Act was brought on by the recent financial crisis. See Learning Objective 2: Identify the different disciplines within the accounting profession. Photo Credit: Nancy Pelosi 17-15

AUDITING CHECKS ACCURACY LO 17-2 Auditing -- Reviewing and evaluating the information used to prepare a company’s financial statements. Independent Audit -- An evaluation and unbiased opinion about the accuracy of a company’s financial statements. Certified Internal Auditors (CIAs) -- Accountants who have a bachelor’s degree and two years of experience in internal auditing and pass an exam administered by the Institute of Internal Auditors. See Learning Objective 2: Identify the different disciplines within the accounting profession. 17-16

ELEMENTARY, MR. AUDITOR, ELEMENTARY Fraud damages businesses, no matter the size. The SEC has committed itself to fighting fraud but not all auditors and CPAs are trained in finding fraud. Colleges are offering advanced degrees in forensic accounting to meet the upcoming demand for these accountants. See Learning Objective 2: Identify the different disciplines within the accounting profession. 17-17

SPECIALIZED ACCOUNTANTS LO 17-2 Tax Accountants -- Accountants trained in tax law and are responsible for preparing tax returns or developing tax strategies. Government and Not-for-Profit Accounting -- Support for organizations whose purpose is not generating a profit, but serving others according to a duly approved budget. See Learning Objective 2: Identify the different disciplines within the accounting profession. 17-18

TEST PREP What’s the key difference between managerial and financial accounting? How’s the job of a private accountant different from that of a public accountant? What’s the job of an auditor? What’s an independent audit? Managerial accounting provides information and analysis to the managers inside the organization and helps them make better informed decisions. Managerial accounting is concerned with measuring and reporting cost of production, marketing, and other functions such as preparing budgets; making sure business units stay within their budgets and designing strategies to minimize taxes. Financial accounting differs from managerial accounting in that financial accounting generates information for people primarily outside the organization. The private accountant works for a single firm, government agency, or nonprofit organization. While public accountants work for accounting firms that provide accounting services for a fee. Public accountants provide services to individuals or businesses that include designing an accounting system, selection of software to run the accounting system. and analyzing an organization’s financial performance. Auditors are responsible for examining the financial health of the organization as well as looking into the operational effectiveness and efficiencies of the organization. An independent audit is an audit conducted by public accounts who provide an evaluation and unbiased opinion about the accuracy of a company’s financial statements. 17-19

The ACCOUNTING CYCLE LO 17-3 Accounting Cycle -- A six-step procedure that results in the preparation and analysis of the major financial statements. See Learning Objective 3: List the steps in the accounting cycle, distinguish between accounting and bookkeeping, and explain how computers are used in accounting. With this slide (based on Figure 17.4) students are provided with the step-by-step progression of the accounting cycle. Place particular emphasis on the accounting cycle to give the student an overview of reporting requirements. To start a discussion with students ask the following questions before showing the next few slides: Can you explain the differences between accounting and bookkeeping? What’s the difference between an accounting journal and a ledger? Why does a bookkeeper prepare a trial balance? 17-20

BOOKKEEPER’S ROLE LO 17-3 Bookkeeping -- The recording of business transactions. Bookkeepers divide a firm’s transactions into meaningful categories and post them into a record book or computer program called a journal. Double-Entry Bookkeeping -- Bookkeepers record all transactions in two places so they can check one list of transactions against the other for accuracy. See Learning Objective 3: List the steps in the accounting cycle, distinguish between accounting and bookkeeping, and explain how computers are used in accounting. 17-21

BOOKKEEPER’S TOOLS LO 17-3 Ledger -- A specialized accounting book or program where all information is in one place. Trial Balance -- A summary of all the information in the account ledgers. See Learning Objective 3: List the steps in the accounting cycle, distinguish between accounting and bookkeeping, and explain how computers are used in accounting. 17-22

TECHNOLOGY and ACCOUNTING Computerized accounting programs post information instantly and from remote locations. Intuit’s QuickBooks address the specific needs of small businesses. See Learning Objective 3: List the steps in the accounting cycle, distinguish between accounting and bookkeeping, and explain how computers are used in accounting. 17-23

TEST PREP How is the job of the bookkeeper different from an accountant? What’s the purpose of accounting journals and a ledger? Why does a bookkeeper prepare a trial balance? How has computer software helped businesses in maintaining and compiling accounting information? A bookkeeper classifies and summarizes the firm’s financial data; while accountants interpret the data, prepare financial statements, and report the information to management. The purpose of accounting journal is to divide the firm’s transactions into meaningful categories to keep information organized and manageable. A ledger transfers information from an accounting journal so managers can find information about a single account in one place. A bookkeeper prepares a trial balance to ensure the figures in the account ledgers are correct and balanced. Computer software post information from journals instantaneously even from remote locations so financial information is readily available whenever the organization needs it. 17-24

FINANCIAL STATEMENTS LO 17-3 Financial Statement -- A summary of all the financial transactions that have occurred over a particular period. Key financial statements of business are: Balance sheet Income statement Statement of cash flows See Learning Objective 4: Explain how the major financial statements differ. Students often do not understand that financial statements are more than a balance sheet but incorporate the income statement and statement of cash flows. 17-25

The FUNDAMENTAL ACCOUNTING EQUATION LO 17-4 Fundamental Accounting Equation -- The basis for the balance sheet. The equation must always be balanced and includes the formula: Assets = Liabilities + Owners Equity See Learning Objective 4: Explain how the major financial statements differ. 17-26

The BALANCE SHEET LO 17-4 Balance Sheet -- The financial statement that reports a firm’s financial condition at a specific time. See Learning Objective 4: Explain how the major financial statements differ. See Figure 17.5 in the text for a sample Balance Sheet for Very Vegetarian. 17-27

ASSETS LO 17-4 Assets -- Economic resources owned by a firm. Items can be tangible or intangible. Liquidity -- Ease with which assets can be converted into cash. See Learning Objective 4: Explain how the major financial statements differ. 17-28

CLASSIFYING ASSETS LO 17-4 Current Assets -- Items that can or will be converted to cash within one year. Fixed Assets -- Long-term assets that are relatively permanent such as land, buildings, or equipment. Intangible Assets -- Long-term assets that have no physical form but do have value such as patents, trademarks, and goodwill. See Learning Objective 4: Explain how the major financial statements differ. Assets are divided into three categories according to how fast they can be converted into cash. 17-29

CLASSIFYING LIABILITIES LO 17-4 Liabilities -- What the business owes to others - its debts. Accounts Payable -- Current liabilities a firm owes for merchandise or services purchased on credit. Notes Payable -- Short or long-term liabilities a business promises to pay by a certain date. Bonds Payable -- Long-term liabilities that the firm must pay back. See Learning Objective 4: Explain how the major financial statements differ. 17-30

OWNERS’ EQUITY ACCOUNTS LO 17-4 Owners’ Equity -- The amount of the business that belongs to the owners minus any liabilities of the owners. Retained Earnings -- Accumulated earnings from the firm’s profitable operations that are reinvested in the business. See Learning Objective 4: Explain how the major financial statements differ. 17-31

TEST PREP What do we call the formula for the balance sheet? What three accounts does it include? What does it mean to list assets according to liquidity? What is the difference between long-term and short-term liabilities on the balance sheet? What is owners’ equity and how is it determined? The formula for the balance sheet is referred to as the fundamental accounting equation. This equation includes the following three accounts: assets, liabilities and owners equity. Assets on the balance sheet are listed according to how quickly they can be converted to cash. Therefore, as you move down the balance sheet it becomes more difficult to convert the assets into “liquid” cash. Liabilities are what the business owes to others. The liability account is divided into current and long-term liabilities. Common liability accounts include: accounts payable, notes payable and bonds payable. Owners’ equity is the amount of the business that belongs to the owners, minus any liabilities the business owes. The formula for owners’ equity is assets minus liabilities. 17-32

The INCOME STATEMENT LO 17-4 Income Statement -- The financial statement that shows a firm’s bottom line - that is, its profit after costs, expenses, and taxes. Net Income/Net Loss -- The revenue left over after costs and expenses. See Learning Objective 4: Explain how the major financial statements differ. 17-33

The INCOME STATEMENT The formula for the income statement: Revenue LO 17-4 The formula for the income statement: Revenue Cost of Goods Sold = Gross Profit Operating Expenses = Net Income before Taxes Taxes = Net Income or Net Loss See Learning Objective 4: Explain how the major financial statements differ. See Figure 17.7 in the text for a sample Income Statement for Very Vegetarian. 17-34

ACCOUNTS of the INCOME STATEMENT LO 17-4 Revenue is the monetary value a firm received for goods sold, services rendered or other payments. Cost of Goods Sold (or Manufactured) -- Measures the cost of merchandise the firm sells or the cost of raw materials and supplies it used in producing items for resale. Gross Profit (or Gross Margin) -- How much a firm earned by buying (or making) and selling merchandise. See Learning Objective 4: Explain how the major financial statements differ. 17-35

THE IN’S and OUT’S of VALUING INVENTORY Generally Accepted Accounting Principles (GAAP) sometimes permits accountants to use different method of accounting for inventory. FIFO: First-In, First-Out LIFO: Last-In, First-Out Each valuation can affect income and ending inventory valuation. See Learning Objective 4: Explain how the major financial statements differ. 17-36

ACCOUNTS of the INCOME STATEMENT LO 17-4 Operating Expenses – Cost involved in operating a business, such as rent, salaries and supplies. Depreciation -- The systematic write-off of the cost of a tangible asset over its estimated useful life. See Learning Objective 4: Explain how the major financial statements differ. While depreciation is an expense, it is a non-cash expense for the company. 17-37

The STATEMENT of CASH FLOWS Statement of Cash Flows -- Reports cash receipts and cash disbursements related to the three major activities of a firm: Operations Investments Financing See Learning Objective 4: Explain how the major financial statements differ. See Figure 17.8 in the text for a sample Statement of Cash Flows for Very Vegetarian. 17-38

UNDERSTANDING CASH FLOW Cash Flow -- The difference between cash coming in and cash going out of a business. Managing cash flow is a key consideration of a business and can be particularly challenging for small and seasonal businesses. See Learning Objective 4: Explain how the major financial statements differ. 17-39

WOULD YOU COOK the BOOKS? You are the only accountant employed by a small, struggling dog food company. The company requests a bank loan to keep operations going and your boss suggests you record some revenue early. This is against accounting principles, but you know if you don’t get the loan, you may lose your job. What do you do? See Learning Objective 4: Explain how the major financial statements differ. 17-40

TEST PREP What are the key steps in preparing an income statement? What’s the difference between revenue and income on the income statement? Why is the statement of cash flows important in evaluating a firm’s operations? The key steps in preparing an income statement are: Revenue Cost of Goods Sold = Gross Profit Operating Expenses = Net Income before Taxes Taxes = Net Income or Net Loss 2. Revenue is the monetary value of what a firm receives for goods sold, services rendered, and other payments such as rent. Income refers to the bottom line which is the net income (or perhaps net loss) the firm incurs from revenue minus sales returns, costs, expenses, and taxes over a period of time. 3. The statement of cash flows is important because it answers such questions as: How much cash came into the business from current operations? Did the firm use cash to buy stocks, bonds, or other investments? Did it sell some investments that brought in cash? 17-41

USING FINANCIAL RATIOS LO 17-5 Ratio Analysis -- The assessment of a firm’s financial condition using calculations and financial ratios developed from the firm’s financial statements. Key ratios include: Liquidity ratios Leverage ratios Performance ratios Activity ratios See Learning Objective 5: Demonstrate the application of ratio analysis in reporting financial information. Ratio analysis provides an assessment of the firm’s financial condition. It can be extremely useful when results of a ratio analysis are compared to industry peers. 17-42

COMMONLY USED LIQUIDITY RATIOS LO 17-5 Liquidity ratios measure a firm’s ability to turn assets into cash to pay its short-term debts. Two key ratios are: Current ratio Acid-test ratio This information is found on the firm’s balance sheet. See Learning Objective 5: Demonstrate the application of ratio analysis in reporting financial information. The acid-test ratio is sometimes referred to as the quick ratio. 17-43

LEVERAGE RATIOS LO 17-5 Leverage ratios measure the degree to which a firm relies on borrowed funds in its operations. Key ratios include: Debt to Owner’s Equity Ratio This information is found on the firm’s balance sheet. See Learning Objective 5: Demonstrate the application of ratio analysis in reporting financial information. 17-44

PROFITABILITY RATIOS LO 17-5 Profitability ratios measure how effectively a firm’s managers are using the firm’s various resources to achieve profits. Key ratios include: Basic earnings per share Return on sales Return on equity This information is found on the firm’s balance sheet and income statement. See Learning Objective 5: Demonstrate the application of ratio analysis in reporting financial information. 17-45

ACTIVITY RATIOS LO 17-5 Activity ratios measure how effectively management is turning over inventory. Key ratios include: Inventory turnover ratio This information is found on the firm’s balance sheet and income statement. See Learning Objective 5: Demonstrate the application of ratio analysis in reporting financial information. 17-46

SPEAKING a UNIVERSAL ACCOUNTING LANGUAGE Multinational companies must adapt their accounting reporting to the rules of multiple countries. Many countries have adopted International Financial Reporting Standards (IFRS) and are pushing to make them standard. The U.S. Securities & Exchange Commission believes there should be such a standard. See Learning Objective 5: Demonstrate the application of ratio analysis in reporting financial information. 17-47

TIMELINE for the MOVE to IFRS LO 17-5 2008: SEC offered proposed timeline 2009: 110 large companies had the option of using IFRS 2012: SEC assessed progress of IFRS 2013: Final decision on the move to IFRS 2015: Large public companies will be required to report in IFRS (pending SEC decision) 2016: All companies will be required to report in IFRS (pending SEC decision) See Learning Objective 5: Demonstrate the application of ratio analysis in reporting financial information. This slide profiles the timeline for the move to International Financial Reporting Standards International Financial Reporting Standards (IFRS) are a set of accounting standards developed by the International Accounting Standards Board (IASB) that is becoming the global standard for the preparation of public company financial statements. Ask students: What are some of the benefits of international accounting standards? If time permits have students explore the IFRS website (www.ifrs.com) and review some of the accounting case studies that the website presents. Source: IFRS.org, accessed November 2014. 17-48

TEST PREP What’s the primary purpose of performing ratio analysis using the firm’s financial statements? What are the four main categories of financial ratios? Ratio analysis is the assessment of a firm’s financial condition, using calculations and financial ratios. Financial ratios are especially useful in comparing the company’s performance to its financial objectives and to the performance of others in the industry. The four main categories of financial ratios are: liquidity, leverage, profitability and activity. 17-49