Chapter 16 Understanding Accounting and Financial Statements nin r a e L s l a o gG 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 Explain the three principal financial statements 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 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 to 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 [...]... 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... 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... 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... 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 ... 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... 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. .. 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... 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...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