Understanding Principles of Accounting

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CHAPTER 18

• Understanding Principles of Accounting

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OUTLINE

• Users of Accounting Information
• Who Are Accountants And What Do They Do?
• Tools Of The Accounting Trade
• Financial Statements

3
Key Terms

• Accounting
• Comprehensive system for collecting, analyzing,
  and communicating financial information
• Bookkeeping
• Recording of accounting transactions
• Accounting System
• Organized means by which financial information is
  identified, measured, recorded, and retained for
  use in accounting statements and management
  reports

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Users of Accounting Information

• Business Managers
• Employees Unions
• Investors Creditors
• Tax Authorities
• Government Regulatory Agencies

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Who Are Accountants What Do They Do?

• Controller
• Person who manages all of a firms accounting
  activities (chief accounting officer)

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Financial versus Managerial Accounting

• Financial Accounting System
• Field of accounting concerned with external users
  of a companys financial information
• Managerial (or Management) Accounting System
• Field of accounting that serves internal users of
  a companys financial information

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Certified Public Accountant (CPA)

• Accountant licensed by the state and offering
  services to the public
• Professional Practice and the Big 5
• Arthur Andersen
• Deloitte  Touche
• Ernst  Young
• KPMG LLP
• PricewaterhouseCoopers

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CPA Services

• Audit  
• Systematic examination of a companys accounting
  system to determine whether its financial reports
  fairly represent its operations
• Generally Accepted Accounting Principles (GAAP) 
• Accepted rules and procedures governing the
  content and form of financial reports
• Tax Services
• Include assistance not only with tax return
  preparation but also with tax planning
• Management Advisory Services  
• Specialized accounting services to help managers
  resolve a variety of business problems

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Private Accountants

• Private Accountant
• Salaried accountant hired by a business to carry
  out its day-to-day financial activities
• Certified Management Accountant (CMA)
• Certified accountant specializing in management
  accounting

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Accounting Recordkeeping
Accounting is a comprehensive tool for
Collecting
Analyzing
Communicating
entered into
entered into
Forms basis for
Financial Information
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The Accounting Equation

• Assets  Liabilities  Owners equity
• Asset Any economic resource expected to benefit
  a firm or an individual who owns it
• Liability Debt owed by a firm to an outside
  organization or individual
• Owners Equity Amount of money that owners would
  receive if they sold all of a firms assets and
  paid all of its liabilities
• Assets  Liabilities  Owners equity

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Double-Entry Accounting System

• A bookkeeping system that balances the accounting
  equation by recording the dual effects of every
  financial transaction

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Financial Statements

• Any of several types of reports summarizing a
  companys financial status to aid in managerial
  decision making
• Balance Sheets
• Income Statements
• Statements of Cash Flows
• Budget

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Balance Sheets

• Financial statement detailing a firms assets,
  liabilities, and owners equity

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Perfect Posters Balance Sheet
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Three Types of Assets

• Current Asset
• Asset that can or will be converted into cash
  within the following year
• Liquidity ease with which an asset can be
  converted into cash
• Fixed Asset
• Asset with long-term use or value, such as land,
  buildings, and equipment
• Depreciation  process of distributing the cost
  of an asset over its life
• Intangible Assets
• Nonphysical asset, such as a patent or trademark,
  that has economic value in the form of expected
  benefit
• Goodwill  Amount paid for an existing business
  above the value of its other assets

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Three Important Nonliquid Assets

• Account Receivable  
• Amount due from a customer who has purchased
  goods on credit
• Merchandise Inventory  
• Cost of merchandise that has been acquired for
  sale to customers and is still on hand
• LIFO (last-in-first-out) method  Method of
  valuing inventories that assumes that those
  received most recently (last in) are sold first
• FIFO (first-in-first-out) method  Method of
  valuing inventories that assumes that older
  inventories (first in) are sold first
• Prepaid Expense
• Expense, such as prepaid rent, that is paid
  before the upcoming period in which it is due

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Liabilities

• Current Liability 
• Debt that must be paid within the year
• Accounts Payable  
• Current liabilities consisting of bills owed to
  suppliers, plus wages and taxes due within the
  upcoming year
• Long-term Liability  
• Debt that is not due for more than 1 year

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Owners Equity

• Paid-In Capital  
• Additional money, above proceeds from stock sale,
  paid directly to a firm by its owners
• Retained Earnings  
• Earnings retained by a firm for its use rather
  than paid as dividends

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Income Statement(Profit-and-loss Statement)  

• Financial statement listing a firms annual
  revenues and expenses so that a bottom line shows
  annual profit or loss
• Revenues  Expenses  Profit (or loss)
• You cannot buy a Hamburger with Profit you need
  cash

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Perfect Posters Income Statement
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Income Statements

• Revenues
• Funds that flow into a business from the sale of
  goods or services
• Cost of Goods Sold
• Total cost of obtaining materials for making the
  products sold by a firm during the year
• Gross Profit (or Gross Margin)  Revenues
  obtained from goods sold minus cost of goods sold
• Operating Expenses  
• Costs, other than the cost of goods sold,
  incurred in producing a good or service
• Operating Income  Gross profit minus operating
  expenses
• Net Income (or Net Profit or Net
  Earnings)  Gross profit minus operating expenses
  and income taxes

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Statement of Cash Flows 

• Financial statement describing a firms yearly
  cash receipts and cash payments
• Cash flows from operations
• Cash flows from investing
• Cash flows from financing
• You can increase without making a profit
• You can lose while making a profit

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Budget

• Detailed statement of estimated receipts and
  expenditures for a period of time in the future
• (EWAG)

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Perfect Posters Sales Budget
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Reporting Standards and Practices

• Revenue Recognition formal recording and
  reporting of revenues in the financial statements
  
• Matching  net income is calculated by
  subtracting expenses from revenues.

The matching principle states that expenses will
be matched with revenues to determine net income
for an accounting period.
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Reporting Standards Practices

• Full Disclosure financial statements should
  include not just numbers, but also
  interpretations and explanations by management so
  that external users can better understand
  information contained in the statements
• Managements Discussion Analysis (MDA)
  provides an interpretation as seen through the
  eyes of management.

Managers qualitative interpretations, together
with their detailed knowledge of a firms
activities, give them a valuable perspective on
past events and probable future events.
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Analyzing Financial Statements

• Solvency Ratio
• Financial ratio, either short- or long-term, for
  estimating the risk in investing in a firm
• Profitability Ratio
• Financial ratio for measuring a firms potential
  earnings
• Activity Ratio
• Financial ratio for evaluating managements use
  of a firms assets

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Short-Term Solvency Ratios

• Liquidity Ratio
• Solvency ratio measuring a firms ability to pay
  its immediate debts
• Current Ratio
• Solvency ratio that determines a firms credit
  worthiness by measuring its ability to pay
  current liabilities

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Short-Term Solvency Ratios

• Working Capital
• Difference between a firms current assets and
  current liabilities
• Quick (or Acid-Test) Ratio
• Solvency ratio for determining a firms ability
  to meet emergency demands for cash
• Quick Asset
• Cash plus assets one step removed from cash
  (marketable securities and accounts receivable)

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Long-Term Solvency Ratios

• Debt Ratio  
• Solvency ratio measuring a firms ability to meet
  its long-term debts
• Debt-to-Owners Equity Ratio (or Debt-to-Equity
  Ratio)  
• Solvency ratio describing the extent to which a
  firm is financed through borrowing
• Debt  
• A firms total liabilities

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Long-Term Solvency Ratios

• Leverage
• Ability to finance an investment through borrowed
  funds

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Profitability Ratios

• Net Profit Margin (or Return on Sales)
• Profitability ratio indicating the percentage of
  its income that is a firms profit

Return on Equity Profitability ratio measuring
income earned for each dollar invested
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Profitability Ratios

• Earnings Per Share
• Profitability ratio measuring the size of the
  dividend that a firm can pay shareholders

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Activity Ratios

• Inventory Turnover Ratio
• Activity ratio measuring the average number of
  times that inventory is sold and restocked during
  the year