Chapter 14 Accounting and Financial Statements




Chapter Outline:

  1. Define accounting and describe the different uses of accounting information.
    1. Accounting – recording, measurement, and interpretation of financial information
    2. Accounting functions carried out by:
      1. Public accountants
        1. Certified Public accountant (CPA) – one who has been certified officially in the state in which he/she practices after meeting certain educational and professional requirements established by the law.
      2. Private accountants
        1. Prepare financial statements, interpret them, take part in the decision making process of the firm.
        2. CMA's (Certified Management Accountants) are private accountants with some degree of managerial responsibility.
    3. Internal uses of accounting information
      1. Managerial accounting – internal use of accounting statement by managers in planning and directing the organization’s activities
        1. Greatest single managerial concern = Cash Flow
        2. Managerial accounting is backbone of an organization’s budget.
    4. External uses of accounting information
      1. Report financial performance to outsiders
        1. IRS, stockholders, customers, employees, and others
        2. Information used for filing income taxes, obtaining credit from lenders, reporting results to stockholders, establishing reasonable expectations for employee salary and benefits.

  2. Demonstrate the accounting process
    1. Accountants concerned with organizations:
      1. Assets
      2. Liabilities
      3. Owner’s equity
    2. Accounting Equation:
      1. Assets = Liabilities + Owner’s equity
    3. Double-entry bookkeeping – system of recording and classifying business transactions in separate accounts in order to maintain the balance of the accounting equation.
    4. Accounting System:
      1. Financial data pass through a four-step procedure –also known as Accounting Cycle:
        1. Examining source documents
        2. Recording transactions in a journal
        3. Posting transactions into a general ledger
        4. Preparing financial statements.

  3. Decipher the various components of an income statement in order to evaluate a firm’s bottom line.
    1. Income statement – financial report that shows an organization’s profitability or income (the bottom line) over a period of time (month, quarter or year).
      1. Income statement – can be referred to as profit and loss statement or an operating statement
    2. Revenue – total amount of dollars generated from sales and related business activities
    3. Cost of goods sold (CGS) – amount of money a firm spent to buy or product the products it sold during the period to which the income statement applies.
      1. CGS = Beginning inventory + Interim purchases – Ending inventory
    4. Expenses – costs incurred in the day-to-day operations of the organization.
      1. 3 common expense accounts on income statements
        1. Selling, general and administrative expenses (including depreciation
        2. Research, development, and engineering expenses
        3. Interest expenses
    5. Net income – total profit (or loss) after all expenses including taxes have been deducted from revenue.

  4. Interpret a company’s balance sheet to determine its current financial position
    1. Balance Sheet – a snapshot of a company’s financial position at a given moment
      1. Accumulation of all the company’s transactions since it began
      2. Balanced accounting equation:
        1. Assets must equal liabilities plus owners’ equity
    2. Assets – listed in descending order of liquidity (how quickly each can be converted to cash)
      1. Cash
      2. Temporary investments
      3. Accounts receivable
        1. Money owned the company by its customers)
      4. Inventory
    3. Assets must be financed either through borrowing (liabilities) or through owner investments (owner’s equity).
      1. Current liabilities must be repaid within one year
      2. Liabilities include:
        1. Accounts payable
          1. Amounts owed to a company’s suppliers
        2. Wages earned but not yet paid
        3. Taxes owed
    4. Owner’s equity—owners’ contributions to their business along with income retained to finance continued growth and product development.

  5. Analyse financial statements, using ratio analysis, to evaluate a company’s performance.
    1. Ratio Analysis – calculations that measure a firm’s financial health, brining the information form the balance sheet and income statement into sharper focus.
      1. Allows managers, lenders, owners and other interested parties to measure and compare the organization’s productivity, profitability and financing mix with other similar entities.
    2. Profitability Ratios – how much operating income or net income a firm is able to generate relative to its assets, owners’ equity, and sales.
      1. Profit margin = Net income/Sales
        1. Shows overall percentage profits earned by the company
      2. Return on assets = Net income/Assets
        1. Shows how much income the firm produces for every dollar invested in assets.
      3. Return on equity = Net income/Owners’ equity
        1. Shows how much income is generated by each $1 the owners have invested in the firm.
    3. Asset utilization ratios – measure how efficiently a firm uses its assets to generate one dollar in sales
      1. Receivables turnover = Sales/Accounts receivable
        1. How many times a firm collects its accounts receivable in one year.
      2. Inventory turnover = Sales/Total inventory
        1. How many times a firm sells and replaces its inventory over a year
      3. Total asset turnover = Sales/Total assets
        1. Measures how well an organization uses all of its assets in creating sales and indicates whether a company is using its assets productively.
    4. Liquidity ratios – measure the speed with which a company can turn its assets into cash to pay off short-term debt.
      1. Current ration = Current assets/ Current liabilities
      2. Quick ratio (acid test) = Current assets – Inventory/Current liabilities
    5. Debt utilization ratios – indicate how much debt the company is using relative to other sources of capital
      1. Debt to total assets ratio = Total debt/Total assets
        1. How much of the firm’s debt is financed by debt and how much by owner’s equity
      2. Times interest earned ratio = Income before interest and taxes/Interest expense
        1. Measure of the safety margin a company has with respect to interest payments it must make to its creditors.
    6. Per share data – used by investors to compare performance of one company with another on an equal basis.
      1. Earnings per share = Net income/Number of shares outstanding
        1. Important because yearly changes, in combination with other factors, determine a company’s overall stock price.
      2. Dividends per share = Dividends paid/Number of shares outstanding
    7. Comparing a firm’s current performance to previous years is an excellent gauge of whether operations are improving.