Using Accounting Information
Chapter
15
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 1
Why Accounting Information
Is Important

Recent accounting scandals
• Pressure on corporate executives to look good to
analysts and investors

Why audited financial statements
are important
• Bankers, creditors, investors, and government
agencies rely on an auditor’s opinion of the validity
of a firm’s financial statements.
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 2
Why Accounting Information
Is Important (cont.)

What is an audit?
• An examination of a company’s financial statements
and accounting practices
• Generally accepted accounting principles (GAAPs)—
an accepted set of guidelines and practices for U.S.
companies reporting financial information and the
accounting profession
• The FASB (Financial Accounting Standards Board) is
developing a new set of standards combining those
of GAAP and the International Financial Reporting
Standards
• An audit does not guarantee that a company has
not “cooked” the books
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 3
Why Accounting Information
Is Important (cont.)

Reform: The Sarbanes-Oxley Act of 2002
• Top executives must certify periodic financial reports
and are liable for intentional violations of reporting
requirements.
• Auditors must maintain financial documents and audit
work papers for five years.
• Auditors and accountants can be imprisoned for up to twenty
years and subject to fines for destroying documents and
violating securities laws.
• A public corporation must change its lead auditing firm every
five years.
• There is protection for whistle-blowers who report violations
of the Sarbanes-Oxley Act.
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 4
Who Uses Accounting Information

Managers are the primary users
• Proprietary: information that is not divulged to
anyone outside the firm

Lenders, suppliers, stockholders, potential
investors, and government agencies are
other users
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 5
Users of Accounting Information
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Chapter 15 | Slide 6
Different Types of Accounting

Managerial accounting provides managers and
employees within the organization with information
needed to make decisions about a firm’s financing,
investing, marketing, and operating activities.

Financial accounting generates financial
statements and reports for interested people
outside an organization.
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 7
Using the Internet

The American Institute of Certified Public Accountants
(AICPA) is the preeminent governing body of the
profession. Its website includes online articles and
publications, guidelines, career resources, and links to
other sites important to the field of accountancy.
www.aicpa.org
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 8
The Accounting Process

The accounting equation:
assets = liabilities + owners’ equity
• Assets—the resources that a business owns
(e.g., cash, inventory, equipment, and real estate)
• Liabilities—the firm’s debts
• Owners’ equity—the difference between assets and
liabilities (what would be left for the owners if the firm’s
assets were sold and the money used to pay off its
liabilities)
Double-entry bookkeeping system: each financial transaction is
recorded as two separate accounting entries to maintain the balance
of the accounting equation
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 9
The Accounting Process (cont.)

The accounting cycle
• Done on a regular basis-gather receipts, record in
journal, post in general ledger

Done at the end of the period
• Prepare the trial balance of all general ledger
accounts
• Prepare financial statements
• Close the books
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 10
The Accounting Cycle
1. Analyzing
source
documents
(receipts etc)
5.
Preparing
the
financial
statements
4. Preparing
the trial
balance
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
2. Recording
transactions
(journal)
3. Posting
transactions
(general
ledger)
Chapter 15 | Slide 11
The 3 Most Important Financial Statements

Balance Sheet

Income Statement

Cash Flow Budget
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 12
Balance Sheet
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Chapter 15 | Slide 13
Balance Sheet

The Balance Sheet must balance!!
Total Assets
Liabilities + Owners Equity
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Chapter 15 | Slide 14
The Balance Sheet

A summary of the dollar amounts of a firm’s
assets, liabilities, and owners’ equity accounts
at the end of a specific accounting period

Assets
• Listed in order of liquidity (ease with which an
asset can be converted into cash)
• Current assets—can quickly be converted into
cash or that will be used in one year or less
–
Cash, marketable securities, accounts receivable,
notes receivable, merchandise inventory, and
prepaid expenses
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 15
The Balance Sheet (cont.)

Assets (cont.)
• Fixed assets—will be held or used for a period
longer than one year
–
–
Land, buildings, and equipment
Depreciation
• Intangible assets—do not exist physically but have a
value based on the rights or privileges they confer
on the firm
–
Patents, copyrights, trademarks, and goodwill
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 16
The Balance Sheet (cont.)

Liabilities
• Current liabilities—debts to be repaid in one year
or less
–
–
Accounts payable—short-term obligations
Notes payable—obligations that have been secured with
promissory notes
• Long-term liabilities—debts that need not be repaid
for at least one year
–
Mortgages, bonds, and long-term loans
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 17
The Balance Sheet (cont.)

Owners’ or stockholders’ equity
• For sole proprietorships—
Assets – liabilities = owners’ equity
• For partnerships—each partner’s share of ownership
is reported separately in each owner’s name
• For corporations—stockholders’ equity
• Retained earnings—profits not distributed to
stockholders
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Chapter 15 | Slide 18
Balance Sheet Assets Listed
Most Liquid
Least Liquid
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Chapter 15 | Slide 19
Most liquid to Least liquid

Break into teams for this exercise
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Chapter 15 | Slide 20
The Income Statement

A summary of a firm’s revenues and expenses
during a specified accounting period
• Profit (cash surplus)
• Loss (cash deficit)

Revenues
• The dollar amounts earned by a firm from selling goods,
providing services, or performing business activities
• Gross sales—the total dollar amount of all goods and
services sold during the accounting period
• Net sales—the actual dollar amounts received by a firm
for the goods and services it has sold, after adjustment
for returns, allowances, discounts
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 21
The Income Statement (cont.)

Cost of goods sold
• The dollar amount equal to beginning inventory
plus net purchases less ending inventory
Cost of
goods sold
=
Beginning +
Net
Ending
–
inventory
purchases
inventory
Gross profit = a firm’s net sales less the cost of goods sold
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 22
The Income Statement (cont.)

Operating expenses
• All business costs other than the cost of goods sold
– Selling expenses—costs related to marketing activities
– General expenses—costs of managing the business

Net income
• Revenues less expenses, when the difference
is positive

Net loss
• Revenues less expenses, when the difference
is negative
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 23
Find Operating Expenses

Brainstorming Exercise
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Chapter 15 | Slide 24

Business Income
Statement
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Chapter 15 | Slide 25
Class Exercise

For each of the following accounts, indicate whether it
belongs on a balance sheet or an income statement.
•
•
•
•
•
•
•
•
•
•
•
Rent
Cash
Patent
Mortgage payment
Net income
Salaries payable
Purchase
Delivery equipment
Sales
Cost of goods sold
Common stock
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 26
Personal Income Statement
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Chapter 15 | Slide 27
The Statement of Cash Flows

Illustrates how the operating, investing, and
financing activities of a company affect cash
during an accounting period
• Cash flows from operating activities
(providing goods and services)
• Cash flows from investing activities
(purchase and sale of land, equipment, and other assets
and investments)
• Cash flows from financing activities
(changes in debt obligation and owners’ equity accounts)
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 28
Statement of Cash Flows
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Chapter 15 | Slide 29
Comparison of Financial Statements
Statement
Timeframe
Income
Up to 1 year
Balance
Sheet
Since the
beginning of the
company
Assets
Liabilities
Equity
Up to 1 year
Operating
Investment
Financing
Cash Flow
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Main Accounts
Income
Expense
Profit
Chapter 15 | Slide 30
Evaluating Financial Statements

Using accounting information to evaluate
a potential investment or to see if a firm is
healthy
• Use common sense to interpret the numbers.
• Determine the firm’s ability to pay its debts and borrow
money in the future.
• Understand the financial ratios. (compare them to the
ratios for other businesses in that industry)
• Data are available from annual reports of public
corporations.
• Industry averages are available from Dun &
Bradstreet, Standard & Poor’s, and industry trade
associations.
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 31
Financial Ratios

Numbers that show the relationship between two
elements of a firm’s financial statements

Can be compared with:
• The firm’s own past ratios
• Ratios of competitors
• Industry averages

Information to calculate ratios is found on a
firm’s balance sheet, income statement, and
statement of cash flows
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 32
Financial Ratios (cont.)
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Chapter 15 | Slide 33
4 Kinds of Ratios

Profitability Ratios

Short-term Ratios

Activity Ratios

Debt-to-Owner’s Equity Ratio
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 34
Profitability Ratios

Return on Sales

Return on Owner’s Equity

Earnings Per Share
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Chapter 15 | Slide 35
Return on Sales
Also called “Profit Margin”
 Answers the question: “How effectively is firm turning
sales into profits?”


Return on Sales = Net income after taxes
Net Sales

Example: Northeast Art Supply
Return on Sales = $30,175 = .067 = 6.7%
$451,000

Compare your answer to industry average of 4-5%.
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 36
Return on Owner’s Equity
Answers: “How much income is generated by each dollar
of equity?”

Return on Owner’s Equity = Net income after taxes
Owner’s Equity

Example: Northeast Art Supply
Return on Owner’s Equity =
13%

$30,175 = .13 =
$230000
Compare your answer to industry average of 12-15%.
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 37
Earnings Per Share
Answers: “How much income is being contributed toward
each share of stock?”

Earnings Per Share = Net income after taxes
Common stock shares outstanding

Example: Northeast Art Supply
Earnings Per Share = $30,175 = $1.21 per share
25000
Comparisons are not helpful if comparing to other
businesses, but stockholders will compare to other
stock they hold or are thinking about buying.

© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 38
Short-term Ratios: Working Capital
Answers: “If our creditors came calling today would we be
able to pay our bills?”

Working Capital = Current Assets-Current Liabilities

Example: Northeast Art Supply
Working Capital= $182,000-$70000 = $112,000

If this isn’t enough to pay our bills, we may have to
borrow. Not an ideal situation.
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 39
Short-term Ratios: Current Ratio
Answers: “For every $1 of current assets that we have,
how much current liabilities do we have?”

Current Ratio = Current Assets
Current Liabilities

Example: Northeast Art Supply
Current Ratio = $182,000 = 2.6
$70,000
We have $2.60 in assets for every $1 in liabilities.
Compare that to the industry average of 2.0.


© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 40
Short-term Ratios: Quick Ratio (the “Acid Test”)
Answers: “If we had to liquidate quickly and pay all our
debts, but we didn’t have time to sell off inventory, would
we be able to pay all our debts?”

Quick = Cash+Marketable Securities +All Receivables
Current Liabilities

Example: Northeast Art Supply
Current Ratio =$139,000 = 1.99
$70,000
If your answer is higher than 1 (the minimum desired
quick ratio) then it shows that you are able to pay your
current liabilities quickly.

© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 41
Activity Ratios (“How many times a year do we
do…….?”)
Two Activity Ratios:
1.
Acounts Receivable Turnover
2.
Inventory Turnover
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Chapter 15 | Slide 42
Activity Ratios (“How many times a year do we
do…….?”)
Answers: “How many times in one year do we collect our
accounts receivable?”
 Accounts Receivable Turnover =
Net Sales
Accounts Receivable
 Example: Northeast Art Supply
AR Turnover =$451,000 = 11.9 times per year
$38,000
 An AR Turnover of 11.9 times per year is about every 30
days.
 If your policy says that invoices are due every 25 days,
then an AR Turnover of 30 days is within reason.
 Hard to compare one company’s AR Turnover to
another’s.
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Chapter 15 | Slide 43
Activity Ratios (“How many times a year do we
do…….?”)
Answers: “How many times in one year do we sell our
inventory?”
 Inventory Turnover =
COGS
Average Inventory

Average Inventory = Beginning + Ending Inventory
2
Example: Northeast Art Supply
Inventory Turnover = $334,000 = 8.2 times per year
$40,500

Compare this to the industry average of 9.
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 44
Debt-to-Owner’s Equity Ratio
Answers: “How much of our operations are financed through
borrowing?”

Debt-to-Owner’s Equity =

Example: Northeast Art Supply
Debt-to-Owner’s Equity = $110,000 = .48 = 48%
$230,000

The higher this ratio, the riskier it is for lenders so they
may hesitate to lend you more money.
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Total Liabilities
Owner’s Equity
Chapter 15 | Slide 45
Chapter Quiz
1. The __________ is designed to improve
accounting standards.
A.
B.
C.
D.
E.
Ethics in Accounting Act
Graham-Rudman Reform Act
Sarbanes-Oxley Act
Securities and Exchange Accounting Act
Accounting Standards Establishment Act
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 46
Chapter Quiz
2. An accountant who is employed by a specific
business or organization is referred to as a(n)
A.
B.
C.
D.
E.
public accountant.
private accountant.
proprietary accountant.
AICPA accountant.
asset accountant.
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 47
Chapter Quiz
3. The first step in the accounting cycle is to
A.
B.
C.
D.
E.
analyze source documents.
record individual transactions.
post individual transactions.
construct a beginning financial statement.
prepare a list of employees.
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 48
Chapter Quiz
4. Assets, liabilities, and owners’ equity would
be listed on a firm’s
A.
B.
C.
D.
E.
balance sheet.
income statement.
statement of earnings.
statement of retained earnings.
statement of capital.
© 2013 South-Western, a part of Cengage Learning. All rights reserved.
Chapter 15 | Slide 49