Chapter 16: Understanding Accounting and Financial Statements.

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Accounting and
Financial Statements
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-forprofit 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
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
Outline accounting issues facing global
business and the move toward one set
of worldwide accounting rules.
Accounting is the process of measuring, interpreting, and
communicating financial information to support internal and
external business decision making.
• 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
• Financing activities provide necessary funds to
start a business and expand it after it begins
• 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
• 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
• 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.
Accounting process - set of activities involved in
converting information about transactions
into financial statements.
• 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.
• Simplifies the accounting process by automating data entry and
• 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
• Some systems offer web-based packages for small
medium businesses.
 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
 Income Statement - financial record of a company’s
revenues and expenses, and profits over a period of
 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
 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.
 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.
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.
Total current assets
Current ratio compares
current assets to current
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
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 measure the organization’s overall financial
performance by evaluating its ability to generate revenues in excess of
operating costs and other expenses.
• 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.
• 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
• 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.