Understanding Accounting and Financial Statements

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Chapter 16 Understanding Accounting and Financial
Statements
Learning Goals
Explain the three principal financial
statements. Discuss how financial ratios are used
to analyze a firms financial strengths and
weaknesses. Describe the role of budgets in a
business. Explain uniform financial statements
and how exchange rates influence international
accounting practices.
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Explain the functions and importance of
accounting. Identify the three basic activities
involving accounting. Describe the roles played
by public, management, government and
not-for-profit accountants. Outline the steps in
the accounting process.
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Accounting Process of measuring, interpreting,
and communicating financial information to
support internal and external business decision
making. USERS OF ACCOUNTING INFORMATION
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 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 companys success.  Outsiders
use financial data to evaluate investment
opportunities.  Accountants serve public
good.  Example Volunteer programs that provide
free help for low- and middle-income senior
citizens file their taxes.
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BUSINESS ACTIVITIES INVOLVING ACCOUNTING
Accounting plays a key role in each of a
businesses three key areas  Financing
activities Provide necessary funds to start and
expand a business.  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.
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ACCOUNTING PROFESSIONALS Public
Accountants Public accountant Accountant who
works for an independent accounting
firm.  Provide three basic services to
clients  Auditing, or examining, financial
records.  Tax preparation, planning, and
related services.  Management consulting for an
independent accounting firm.  Four largest
firms dominate the industry Deloitte Touche,
Ernst Young, KPMG, and PricewaterhouseCoopers.
 Legislation limits the types of consulting
services auditors can provide. Certified public
accountant (CPA) Accountant who meets specified
educational and experiential requirements and
has passed a comprehensive examination on
accounting theory and practice.
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Management Accountants  Management accountant
Accountant employed by a business other than a
public accounting firm.  Collects and records
financial transactions and prepares financial
statements used by the firms managers in
decision making. Answers questions such
as  Where is the company going?  What
opportunities await it?  Do certain
situations expose the company to excessive
risk?  Does the firms information system
provide detailed and timely information to all
levels of management?  Often specialize (e.g.,
internal auditor, tax accountant). Government and
Not-for-Profit Accountants  Perform professional
services similar to those of management
accountants.
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THE ACCOUNTING PROCESS Accounting process Set of
activities involved in converting information
about transactions into financial statements.
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The Impact of Computers and the Internet on the
Accounting Process  Simplifies the accounting
process by automating data entry and
calculations. Available products are customized
for businesses of different sizes.
 Entrepreneurs and small businesses
QuickBooks, Peachtree, and BusinessWorks.
 Larger firms Computer Associates, Oracle,
and SAP. Software that handles accounting
information for international businesses is also
available.  Some systems are Web-based.
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The Foundation of the Accounting
System  Generally accepted accounting principles
(GAAP) Principles that encompass the conventions,
rules, and procedures for determining acceptable
accounting practices at a particular time.
Financial Accounting Standards Board (FASB)
Organization primarily responsible for
evaluating, setting, or modifying GAAP in the
U.S.  Monitors changing business
conditions.  Enacts new rules.  Modifies
existing rules when necessary.
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Sarbanes-Oxley Act A response 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. Added to the reporting
requirements for publicly traded companies.
Senior executives must personally certify that
the financial information reported by the
company is correct.  Resulted in increase in
demand for accountants.
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The Accounting Equation Assets Anything of value
owned or leased by a business.  Tangible
Equipment, buildings, inventory.  Intangible
Patents, trademarks Liability Claim against a
firms assets by a creditor. Owners 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.
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FINANCIAL STATEMENTS  Provide managers with
information for evaluating organizations ability
to meet current obligations and needs, its
profitability, and its overall financial
health. The Balance Sheet Balance sheet Statement
of a firms financial positionwhat it owns and
the claims against its assetsat a particular
point in time.
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The Income Statement Income statement Financial
record of a companys revenues, expenses, and
profits over a period of time.  Helps decision
makers focus on overall revenues and the costs
involved in generating these revenues.  Sometimes
called a profit-and-loss, or PL,
statement. This gentleman has clearly
encountered more loss than profit.
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The Statement of Cash Flows Statement of cash
flows Statement of a firms cash receipts and
cash payments that presents information on its
sources and uses of cash. Accrual accounting
Accounting method that records revenue and
expenses when they occur, not necessarily when
cash actually changes hands.  Inadequate cash
flow is a reason for many business failures.
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FINANCIAL RATIO ANALYSIS  Ratio analysis Tool
for measuring a firms liquidity, profitability,
and reliance on debt financing, as well as the
effectiveness of managements resource
utilization.
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Liquidity Ratios Liquidity ratios Firms
ability to meet short-term obligations when they
must be paid.  Current ratio compares current
assets to current liabilities. Example
Shasta  Ratio of 2 to 1 is generally
considered to indicate satisfactory liquidity.
Total current assets
Total current liabilities
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Acid-test (or quick) ratio measures the
ability of a firm to meet its debt payments on
short notice. Example Shasta
Cash and equivalents short-term investments
accounts receivable
Total current liabilities
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Activity Ratios Activity ratios Measure the
effectiveness of managements use of the firms
resources.  Inventory turnover ratio indicates
the number of times merchandise moves through a
business. Example Shasta
 Inventory turnover rates can vary
widely from industry to industry.
Net sales
Average of inventory 1/31/07 and 1/31/06
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 Total asset turnover ratio indicates how much
in sales each dollar invested in assets
generates. Example Shasta  Higher
ratios indicate greater efficiency.
Net sales
Average of total assets 1/31/07 and 1/31/06
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Profitability Ratios Profitability ratios
Measure the organizations overall financial
performance by evaluating its ability to generate
revenues in excess of operating costs and other
expenses.
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Leverage Ratios Leverage ratios Measure the the
extent to which a firm relies on debt
financing.  Total liabilities to total
assets ratio gt 50 percent indicates that a firm
is relying more on borrowed money than owners
equity.
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BUDGETS Budget Planning and control tool that
reflects a firms expected sales revenues,
operating expenses, and cash receipts and
outlays.  Preparation is generally
time-consuming, involving people throughout the
organization. Cash budget Tracks the firms
cash inflows and outflows.
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INTERNATIONAL ACCOUNTING  Global firms must
translate financial statements of the firms
international affiliates, branches, and
subsidiaries and convert data about foreign
currency transactions to dollars. Exchange
Rates Ratio at which a countrys 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.  Over a recent three-year period,
foreign currency adjustments effectively added
more than 1.5 billion to Procter Gambles
earnings.
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International Accounting Standards
International Accounting Standards Committee
(IASC) promotes worldwide consistency in
financial reporting practices.  Working to
create one worldwide set of accounting rules.