Ch.12
Understanding Financial Information and Accounting
Introduction to Accounting:
* You don’t have to be an accountant to know about accounting.
* Accounting is helpful in many aspects of our life. You will be dealing
with numbers constantly when you go to work. If you want to buy a
business or start a business you need to know accounting to enable
you to better control your business.
The Importance of Financial Information:
* All individuals can benefit personally and professionally by having
a basic working knowledge of accounting.
* This chapter will expose you to some basics of accounting; it will
make accounting terms much easier to comprehend.
What Is Accounting?
* Financial information is primarily based on information generated
from accounting.
Accounting: is the
Recording
Classifying
summarizing and
interpreting
of financial events and transactions in order to provide management
and other stakeholders with the information they need to make
good decisions.
Financial transactions:
Can include such things as buying and selling goods and services or
acquiring Insurance, paying employees, using supplies and so on.
* When the transactions are recorded, they are classified into groups
that have common characteristics.
E.g. all purchases are grouped together, all sales grouped together.
Accounting system:
is the method used to record and summarize accounting data into
reports, to illustrate the operating performance of the firm from
which management can make informed decisions.
* Another major purpose of accounting is to report financial
information to people outside the firm, such as owners, creditors,
suppliers, investors and the government. So, in summary, accounting
gives financial information to various users (inside and outside the
organization) regarding the economic activities of the firm.
Areas of Accounting:
* There are mainly 5 accounting areas in which you could have an
accounting career.
1. Managerial and Financial Accounting.
2. Auditing.
3. Tax accounting.
4. Government and not for profit accounting.
1) Managerial and Financial Accounting:
Managerial Accounting: is used to provide information and
analysis to managers within the organization, to assist them in
decision making.
* It is concerned with such things as:
- Measuring and reporting: costs of production cost of
marketing, and cost of other functions.
- Preparing budgets (planning).
- Checking whether or not units are staying within their
budgets (controlling).
- Designing strategies to minimize taxes.
Financial Accounting: is used to generate information for
use outside the organization.
* The information generate by the FA not only goes to
company owners, managers and employees, but also to
creditors and lenders, employee unions, customers,
suppliers, government agencies and the general public.
Because these people are interested in getting answers for
such important questions as:
- Is the organization profitable?
- Is it able to pay its bills?
- How much debt does the organization hold?
* The Financial Accountants prepares annual reports.
Annual Reports: are yearly statements of the financial
conditions, progress, and expectations of an organization.
* If anyone is interested in becoming either a Managerial
accountant or Financial accountant, they should take
courses in both M & F accounting and specialize in one of
them as a certified management accountant or a certified
public accountant.
Certified management accountant (CMA): is a professional
accountant who has met certain educational and experience
requirements, passed a qualifying exam in the field, and
been certified by the Institute of Certified Management
Accountants.
Certified public accountants (CPA): is an accountant who
passes a series of examinations established by the American
Institute of Certified Public Accountants (AICPA), and have
certain years of experience.
The CPA: find careers as private accountants or public
accountants and can fill other financial positions within
organizations.
Private Accountants: is a person who works for a single firm,
or government agency, or non profit organization and are on
the payroll of the company or organization.
* But not all firms or non profit organization want or need a
full – time accountant, so we have public accountants.
Public accountants: is a person who does not work for a
specific company. He can be hired to help businesses with
payroll, taxes and other projects. Public accountants could
have his/ her business and be hired by other companies.
* Accountants ensure that the financial information provide
to others is accurate.
* The independent Financial Accounting Standards Board
(FASB) defines the set of Generally Accepted Accounting
Principles (GAAP) that accountants must follow.
So if financial reports are prepared in accordance with
GAAP, the users can expect that the information is reported
according to standards agreed on by accounting
professionals.
*All financial accounts in Bahrain are prepared according to
International accounting standards.
2) Auditing:
Auditing: is the job of reviewing and evaluating the records
used to prepare a company’s financial statements.
* Accountants within the organization do the internal audits
to ensure that proper accounting procedures and financial
reporting are being followed.
* Internal auditors get certain education and get or receive
accreditation called a Certified Internal auditor (CIA).
* External auditing is done by the public accountants, who
conduct Independent audit.
Independent audit: is an evaluation, an unbiased opinion,
regarding the accuracy of a company’s financial statement.
3) Tax Accounting:
* Taxes are the price people pay for roads, parks, schools,
police protection, the military and other functions provided
by the government.
* Taxes are filed normally once a year, but the Businesses
have to file and pay taxes on a quarterly basis.
Tax accountant: Is trained in tax law and is responsible for
preparing tax returns or developing tax strategies to save the
company money.
4) Government and not- for profit Accounting:
*Government accounting and not-for-profit accounting meet
the needs of organizations whose purpose is not generating a
profit.
* The government requires an accounting system that satisfies
the needs of their information users.
- Government information users are citizens, special interest
groups, legislative bodies, and creditors.
- These users want to ensure that government is fulfilling its
obligations and making the proper use of taxpayers’ money
(Public money).
- The government accounting standards are set by the
Government Accounting standards Board (GASB).
* The not-for-profit organization requires accountants because
contributors want to see exactly how and where the funds they
contribute are being spent.
e.g. not-for-profit could be the Red Cross- university – hospitals
* Accounting is different from Book Keeping.
Book Keeping: is simply the recording of business transactions.
Accounting: is not just recording transactions, its summarizing
and classifying data according to formal standards and
principles.
Accounting Tools:
* Accountants have tools to make their job easier.
* These tools include:
1- The journal:
- It’s a record book.
- Could be in electronic format.
- Transactions are recorded for each day, week, or month.
- e.g. in a retail store, the journal would include the data
regarding all the sales, inventory received.
- The main purpose of a journal is to have a chronological
listing of the business transactions that take place.
* To ensure the accuracy of the information being recorded,
the accountants record the financial transactions in two places,
which is called Double- entry bookkeeping.
* In double- entry bookkeeping is two separate entries, one
each in the journal and the ledger, are required for each
company transaction.
2- Ledger:
is also one of the accounting tools.
- It’s a specialized accounting book or computer program in
which information from accounting journals is recorded into
specific categories.
* The journal
does not provide information about the
different accounts, but is a log of transactions as they happen.
* The ledger
information is listed in categories, so this type
of system allows managers to easily find the data they need to
make decisions.
* Today, accounting is done through computerized programs that
post information from journals into ledgers daily, or instantaneously,
which makes the manager’s job easier.
Sarbanes –Oxley Act:
* This act was mentioned before in the ethics chapter.
* This act was signed into law in 2002 after many accounting
scandals.
* The act requires higher standards of accounting practices and
auditing firms.
* This act has its supporters and people who are against it.
The Six – Steps accounting cycle:
* The accounting cycle is made up of six – steps, which at the end will
result in the preparation and analysis of the major financial
statements.
* The accounting cycle involves the work of both the:
- Book keeper.
- The accountant. (Managerial accountants)
* The six steps include:
1) Analyzing and categorizing documents. e.g. invoices Receipts.
2) Putting the information into journals.
3) Posting the information into ledgers.
4) Preparing a Trial Balance.
- Trial Balance: is a summary of all the financial data in the account
ledgers.
- It is needed to check whether the figures are correct and balanced.
* If the information in the account ledgers is not accurate, it must be
corrected before the firm’s financial statements are prepared and
analyzed.
5) Preparing the financial statements:
* The financial statements include: a balance sheet, income
statements, and statement of cash flows.
6) Analyzing the financial statements and evaluating the overall
financial condition of the firm.
* The financial statements are a result of the ongoing work of
bookkeepers and managerial accountants and their recording of daily
transactions.
* See figure 12.1 - P.394 *
Financial Statements:
A financial Statement: is a summary of all the transactions (e.g. all
expenses and revenues) that have occurred over a particular period.
They indicate a firm’s financial health and stability (That is why
stockholders are interested in them).
* The key financial statements are:
1- Balance sheet: This reports the firm’s financial conditions on a
specific date. “It shows the financial health of the company that
exact day.”
2- The income statement: (also called a profit and loss statement or
P&L for short) which summarizes revenues, cost of goods and
expenses for a specific period of time and highlights the total profit
or loss the firm experienced during that period. It shows the
performance of the company over a specified period ( e.g. From 1,
july to 31,Dec)
3- The statement of cash flows: which provides a summary of money
coming into and going out of the firm and tracks a company’s cash
receipts and cash payments. Also over a specified period of time.
* So the difference between them is:
# the balance sheet details what the company owns “assets” and
owes “liabilities” on a certain day.
# the income statement shows what a firm sells its products for
“sales” and its selling cost “cost of goods sold” are over a specific
period.
# the statement of cash flows highlights the difference between
cash coming into, and cash going out of a business.
The Accounting Equation:
* Assets: what the company owns such as cars, buildings, and cash.
* Liabilities: what the company owes to others, such as loans.
*owner’s equity: is the capital the owners put into the business.
So the equation is =
Assets = liabilities + owner’s equity
So owner’s equity is a way of stating the difference between what is
owned versus what is owed. e.g. let’s say you own a car and a house
for BD 80,000, so your assets are 80,000, you own the bank BD
65,000 so your liability is 65,000. Your net worth is 80,000 – 65,000=
BD 15,000.
But what if you own only a simple car for BD 8,000, so your assets
are BD 8000 and you own a bank 1,000, so your liabilities are 1,000.
Your net worth is 8000 – 1000= BD 7000
So you are richer than the first one whose assets are 80,000.
* This is called the fundamental accounting equation, which is crucial
part of the Balance Sheet.
I- The Balance sheet:
* A Balance Sheet: is the financial statement that reports a firm’s
financial condition at a specific time.
* It includes three major accounts:
1) Assets
2) Liabilities
3) Owner’s equity
* It called a balance sheet, because it shows a balance between two
figures:
The company’s assets on hand and its liabilities + owner’s.
* Whenever you want to calculate your available resources, you
could do it by preparing your balance sheet.
1- Assets:
* Are economic resources (things of value) owned by a firm.
Assets could be: productive, tangible items (e.g. equipment,
buildings, land, furniture, motor vehicles, etc.), or intangibles with
value (e.g. patents, trademarks, copyrights, good will, brand name
“could be among the firm’s most valuable assets”)
Liquidity:
* Refers to how fast an asset can be converted into cash.
* e.g. Account receivable (which is the amount of money owed to
the firm) that is expected to be received within one year, so it is
considered liquid assets.
But land on the other hand takes time to sell and turn into cash
(because needs a lot of legal procedures and paper work) so it is
considered fixed assets.
* Assets therefore are divided into 3 categories according to how
quickly they can be turned into cash:
1- Current assets: things that can be turned into cash within one year
(e.g. cash, account receivable, inventory).
2- Fixed assets: long-term assets that are relatively. Permanent (e.g.
land, buildings, equipments).
Both current & fixed assets are tangible assets
3- Intangible assets: long-term assets that have no real physical
form, but have value (e.g. patents, trademarks, copyrights, good
will).
2- Liabilities:
* Are what the business owes to others (debts.)
* - Current liabilities: are debts due in one year or less.
- Long – term liabilities: are debts not due for one year or longer.
* Examples of liabilities are:
1) Account payable: are current liabilities involving money owned to
others, for merchandise or services purchased on credit.
2) Notes payable: are also short-term liabilities (e.g. loans from
banks) that a business promises to repay by a certain date.
3) Bond payable: are long-term liabilities that represent money lent
to the firm that must be paid back.
Assets – Liabilities = Equity
3-Equity:
* also called (stockholder’s equity or shareholders equity), and as
the shareholders are the owners of the company it could be called
owner’s equity.
* If you consider buying an existing business, then the balance sheet
is very useful because it tells the potential buyer all of the assets the
company has, and also what it owes.
II- The Income Statement:
Income statement: is a financial statement that shows a firm’s
bottom line income – i.e. its profit after costs, expenses and taxes.
* The income statement summarizes:
1- (Sales):
All of the resources (Revenue) that have come into the firm from
operating activities.
2- (Cost of goods sold):
The money resources that were used up.
3- (Expenses):
The money expenses include in doing business.
4- (Profit):
What resources were left after all costs and expenses (including
taxes) were paid out.
The left over resources are referred to as net income or net loss.
* The income statement reports the firm’s financial operations over
a particular period of time (e.g. a year – a quarter or a month).
* This Financial statement is the one that reveals whether the
business is actually earning a profit or losing money.
* The formulas used to prepare the income statement are:
Revenue – cost of goods sold = gross profit or gross margin.
Gross profit – operating expenses = Net income before Taxes
Net income before taxes – Taxes = Net income or net loss.
Revenue:
* It is the value of what is received from goods sold, services
rendered, and other financial sources. (There is a difference between
revenue and sales most revenue comes from sales, but there
could be other sources of revenue e.g. renting a portion of the
building to a tenant).
Gross sales: the total of all sales the firm completed.
Net sales: gross sales – Returns (merchandise customer send back)
Discounts (price reduction given to customer)
Allowances (reduction on specific sale).
Cost of goods sold (cost of goods manufactured): equals to
Cost of opening inventory + cost of purchased inventory = Total
cost of available inventory
Total cost of inventory available for sale – cost of remaining
inventory = cost of goods sold.
Cost of goods sold: is a measure of the cost of merchandise sold, or
the cost of the raw materials and supplies used for producing items
for sale.
* Cost of goods sold for retailers:
They don’t worry about the cost of raw material, because its
included in the price of the goods they buy from the wholesaler.
* So their main concern is purchase price and the storage cost.
Gross profit or (gross margin) = Net Revenue or Net sale – cost of
goods sold.
So gross profit is how much a firm earned by buying (or making) and
selling merchandise.
So this will tell us how much we earned on the goods not including
the expenses.
Operating Expenses and Net Profit and Loss:
Operating Expenses: are the costs involved in operating a business,
such as rent, salaries, supplies, utilities, insurance, depreciation...etc.
Expenses are classified into two categories:
1) Selling expenses: are expenses related to the marketing and
distribution of the goods or services, such as salaries of sales
persons, advertising, supplies ... etc.
2) General expenses: are the administrative expenses of the firm,
such as office salaries, depreciation, insurance, rent, etc.
* There are also non operating expenses such as interest. e.g.
where the company takes a loan to buy a land, the interest they
pay on this loan is considered non operating expenses.
* So after deducting all the expenses, we can determine the
company’s Net income before tax.
* A net income statement reveals if the company is spending too
much on a certain expenses
so the owners may want to
consider changing spending habits.
- Sometimes lack of sales (i.e. revenue) or too many expenses can
result in cash flow problems.
Cash flow: Is the amount of money coming and going out.
So cash flow statements help companies prevent going out of
cash or money.
III- The statement of cash flows:
* It reports cash receipts and disbursements related to three
major activities of a firm:
1) Operations: cash transactions associated with running the
business. (Cash from customers – cash paid to suppliers – interest
paid... etc)
2) Investments: Cash used in, or provided by the firm’s
investment activities. (Proceeds from sale of plant assets – cash
paid for purchase of equipments).
3) Financing: Cash raised from the issuance of debt, such as taking
out a loan. (Payment of long-term debts – payment of dividends).
* Cash flow statement helps to determine the firm’s net cash
position.
So it gives the firm some insight into how to handle cash better, so
no cash flow problems occur.
* Cash flow statement shows how much money is on hand at any
given time.
* Companies do not want to have too much money on hand, yet
they need to have enough to pay their expenses.
* Cash flow statements can be prepared yearly, or monthly or
even weekly.
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