Chapter 16
Understanding Accounting and Financial
Statements
5 Explain the three principal
financial statements.
1
Explain the functions and
importance of accounting.
6
2 Identify the three basic activities
involving accounting.
3
4
Describe the roles played by
public, management, government
and not-for-profit accountants.
Outline the steps in the accounting
process.
7
8
Discuss how financial ratios are
used to analyze a firm’s financial
strengths and weaknesses.
Describe the role of budgets in a
business.
Explain uniform financial
statements and how
exchange rates influence
international accounting
practices.
Accounting Process of measuring, interpreting, and communicating financial
information to support internal and external business decision making.
USERS OF ACCOUNTING
INFORMATION
• 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.
• Accountants serve public good.
• Example: Volunteer programs that provide free help for low- and middleincome senior citizens file their taxes.
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.
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.
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 firm’s 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 firm’s 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.
THE ACCOUNTING PROCESS
Accounting process Set of activities involved in converting
information about transactions into financial statements.
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.
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.
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.
The Accounting Equation
Assets Anything of value owned or leased by a business.
• Tangible: Equipment, buildings, inventory.
• Intangible: Patents, trademarks
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.
FINANCIAL STATEMENTS
• Provide managers with information for evaluating organization’s ability to meet
current obligations and needs, its profitability, and its overall financial health.
The 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.
The Income Statement
Income statement Financial record of a company’s 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 P&L, statement.
This gentleman has clearly encountered more loss than profit….
The Statement of Cash Flows
Statement of cash flows Statement of a firm’s 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.
FINANCIAL RATIO 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
• Liquidity ratios Firm’s ability to meet short-term obligations when they must be
paid.
• Current ratio compares current assets to current liabilities.
• Example: Shasta
Total current assets
Total current liabilities
• Ratio of 2 to 1 is generally considered to indicate
satisfactory liquidity.
• 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
Activity Ratios
• Activity ratios Measure the effectiveness of management’s use of the firm’s
resources.
• Inventory turnover ratio indicates the number of times merchandise moves
through a business.
Net sales
• Example: Shasta
Average of inventory 1/31/07 and 1/31/06
• Inventory turnover rates can vary widely from industry
to industry.
• Total asset turnover ratio indicates how much in sales each dollar invested in
assets generates.
• Example: Shasta
Net sales
Average of total assets 1/31/07 and 1/31/06
• Higher ratios indicate greater efficiency.
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 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.
• Preparation is generally time-consuming, involving people
throughout the organization.
• Cash budget Tracks the firm’s cash inflows and outflows.
INTERNATIONAL ACCOUNTING
• Global firms must translate financial statements of the firm’s international
affiliates, branches, and subsidiaries and convert data about foreign currency
transactions to dollars.
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.
• Over a recent three-year period, foreign currency adjustments effectively
added more than $1.5 billion to Procter & Gamble’s earnings.
International Accounting Standards
• International Accounting Standards Committee (IASC) promotes
worldwide consistency in financial reporting practices.
• Working to create one worldwide set of accounting rules.