Chapter 17: Understanding Accounting and Financial Information

Learning goal 1: Demonstrate the role that accounting and financial information
play for a business and for its stakeholders.

Financial management is the heartbeat of competitive businesses, and accounting

information helps keep the heartbeat stable.

Accounting  recording, classifying, summarizing, and interpreting of financial

events and transactions to provide management and other interested parties the
information they need to make good decisions. Method to record and summarize
accounting data into reports → accounting system.

Learning goal 2: Identify the different disciplines within the accounting profession.

1. Managerial accounting  accounting used to provide information and analyses

to managers inside the organization to assist them in decision making.

Certified management accountant (CMA)  a professional accountant who has

met certain educational and experience requirements, passed a qualifying exam,
and been certified by the Institute of Certified Management Accountants.

2. Financial accounting  accounting information and analyses prepared for

people outside the organization.

Annual report  a yearly statement of the financial condition, progress, and

expectations of an organization.

Private accountant  an accountant who works for a single firm, government

agency, or nonprofit organization. (internal basis)

Public accountant  an accountant who provides accounting services to

individuals or businesses on a fee basis. (external basis)

Certified public accountant (CPA)  an accountant who passes a series of

examinations established by the American Institute of Certified Accountants
(AICPA). The independent Financial Accounting Standards Board (FASB) defines the
generally accepted accounting principles (GAAP) that accountants must follow.

3. Auditing  the job of reviewing and evaluating the information used to prepare a
company’s financial statements.

Independent audit  evaluation and unbiased opinion about the accuracy of a

company’s financial statements.

Certified internal auditor (CIA)  an accountant who has a bachelor’s degree and
two years of experience in internal auditing, and who has passed an exam
administered by the Institute of Internal Auditors.

4. Tax accountant  an accountant trained in tax law and responsible for

preparing tax returns or developing tax strategies.

5. Government and not-for-profit accounting  accounting system for

organizations whose purpose is not generating a profit but serving ratepayers,
taxpayers, and others according to a duly approved budget.

Learning goal 3: List the steps in the accounting cycle, distinguish between
accounting and bookkeeping, and explain how computres are used in accounting.

Accounting cycle  a six-step procedure that results in the preparation and

analysis of the major financial statements, see page 462.

Bookkeeping  the recording of business transactions. Accountants classify and

summarize financial data provided by bookkeepers, and then interpret the data
and report the information to management.

Journal  record book or computer program where accounting data are first

entered. Double-entry bookkeeping  practice of writing every business

transaction in two places.

Ledger  a specialized accounting book or computer program in which information

from accounting journals is accumulated into specific categories and posted so that
managers can find all the information about one account in the same place.

Trial balance  a summary of all the financial data in the account ledgers that
ensures the figures are correct and balanced.

Learning goal 4: Explain how the major financial statements differ.

Financial statement  a summary of all the transactions that have occurred over a
particular period. They indicate a firm’s financial health and stability, and are the
key factors in management decision making. The key financial statements of a
business are:

1. The balance sheet, which reports the firm’s financial condition on a specific date.
2. The income statement, which summarizes revenues, cost of goods, and expenses
(including taxes), for a specific period and highlights the total profit or loss the firm
experienced during that period.
3. The statement of cash flows, which provides a summary of money coming into
and going out of the firm that tracks a company’s cash receipts and cash
payments.

Fundamental accounting equation  Assets = Liabilities + Owner’s equity  basis

balance sheet.

Balance sheet  financial statement that reports a firm’s financial condition at a

specific time and is composed of three major accounts: assets liabilities, and
owner’s equity.
Assets  economic resources (things of value) owned by a firm.

Liquidity  the ease with which an asset can be converted into cash. For example
an account receivable is an amount of money owed to the firm that it expects to
receive within one year.

Assets are divided into three categories, according to how quickly they can be
turned into cash:

1. Current assets  items that can or will be converted into cash within one year.
They include cash, accounts receivable, and inventory.
2. Fixed assets  long-term assets that are relatively permanent such as land,
buildings, and equipment.
3. Intangible assets  are long-term assets that have no physical form but do have
value. Patents, trademarks, copyrights, and goodwill are intangible assets. Goodwill
represents the value attached to factors such as a firm’s reputation, location, and
superior products.

Liabilities  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 more.
Common on a balance sheet:

1. Accounts payable  current liabilities or bills the company owes others for
merchandise or services it purchased on credit but has not yet paid for.
2. Notes payable  short-term or long-term liabilities (like loans from banks) that a
business promises to repay by a certain date.
3. Bonds payable  long-term liabilities: money lent to the firm that it must pay

back. Equity  value of things you own (assets) minus the amount of money you

owe others (liabilities).

Owners’ equity  amount of the business that belongs to the owners minus any
liabilities owed by the business.

Retained earnings  accumulated earnings from a firm’s profitable operations that

were reinvested in the business and not paid out to stockholders in dividends.

Income statement  financial statement that shows a firm’s profit after costs,
expenses, and taxes, it summarizes all of the resources that have come into the firm
(revenue), all the resources that have left the firm, and the resulting net income.

Net income or net loss  revenue left over after all costs and expenses, including
taxes, are paid.

Revenue
- Cost of goods sold
= Gross Profit (gross margin)
- Operating expenses
= Net income before taxes
- Taxes
= Net income or loss

Be sure not to confuse the terms revenue and sales. Most revenue comes from sales,
but companies can also have other sources of revenue.

Gross sales  the total of all sales the firm completed.

Net sales  gross sales minus returns, discounts, and allowances.

Cost of goods sold (or cost of goods manufactured)  measure of the cost of
merchandise sold or cost of raw materials and supplies used for producing items for
resale.
Gross profit (or gross margin)  how much a firm earned by buying (or making)
and selling merchandise.

Operating expenses  costs involved in operating a business, such as rent, utilities,

and salaries. Depreciation  the systematic write-off of the cost of a tangible

asset over its estimated useful life.

Selling expenses are related to the marketing and distribution of the firm’s goods or
services, such as advertising, salespeople’s salaries, and supplies.
General expenses are administrative expenses of the firm such as office salaries,
depreciation, insurance, and rent.

Statement of cash flows  financial statement that reports cash receipts and
disbursements related to a firm’s three major activities:

 Operations  cash transactions associated with running the business.

 Investments cash used in or provided by the firm’s investment activities. 
Financing  cash raised by taking on new debt, or equity capital or cash used to
pay business expenses, past debts or company dividends.

Cash flow  difference between cash coming in and cash going out of a business.

Learning goal 5: Demonstrate the application of ratio analysis in reporting financial

information.

The firm’s financial statements – its balance sheet, income statement, and
statement of cash flows – form the basis for financial analyses performed by
accountants inside and outside the firm.

Ratio analysis  the assessment of a firm’s financial condition using calculations

and interpretations of financial ratios developed from the firm’s financial
statements. Four key types business use:

 Liquidity Ratios
Liquidity refers to how fast an asset can be converted to cash. Liquidity ratios
measure a company’s ability to turn assets into cash to pay its short-term debts
(liabilities that must be repaid within one year). Two key liquidity ratios are the
current ratio and the acid-test ratio.

The current ratio is the ratio of a firm’s current assets to its current liabilities.

Current ratio = Current assets / Current liabilities

Usually a company with a current ratio of 2 or better is considered a safe risk for
lenders granting short-term credit, since it appears to be performing in line with
market expectations.

The acid-test or quick ratio measures the cash, marketable securities (such as stocks
and bonds), and receivables of a firm, compared to its current liabilities:

Acid-test ratio = (Cash + Accounts receivable + Marketable securities) / Current

liabilities

An acid-test ratio between 0.5 and 1.0 is usually considered satisfactory, but
bordering on cash-flow problems.

 Leverage (Debt) Ratios

Leverage (debt) ratios measure the degree to which a firm relies on borrowed funds
in its operations. The debts to owners’ equity ratio measures the degree to which
the company is financed by borrowed funds that it must repay.

Debts to owners’ equity ratio = Total liabilities / Owners’ equity

Anything above 100 percent shows that a firm has more debt than equity, which
implies that lenders and investors may perceive the firm to be quite risky. However,
again it’s important to compare a firm’s debt ratios to those of other firms in its
industry, because debt financing is more acceptable in some industries than in
others.

 Profitability (Performance) Ratios

Profitability (performance) ratios measure how effectively a firm’s managers are

using its various resources to achieve profits. Three of the more important ratios
are earnings per share (EPS), return on sales, and return on equity.

Financial Accounting Standards Board requires companies to report their quarterly

EPS in two ways:

a. Basic earnings per share (basic EPS) ratio helps determine the amount of profit a
company earned for each share of outstanding common stock.
b. Diluted earnings per share (diluted EPS) ratio measures the amount of profit
earned for each share of outstanding common stock, but also considers stock
options, warrants, preferred stock, and convertible debt securities the firm can
convert into common stock.

Basic earnings per share = Net income after taxes / Number of common stock
shares outstanding

Another reliable indicator of performance is return on sales, which tells us whether

the firm is doing as well as its competitors in generating income from sales.

Return on sales = Net income / Net sales

Return on equity indirectly measures risk by telling us how much a firm earned for
each dollar invested by its owners.

Return on equity = Net income after tax / Total owners’ equity

 Activity Ratios

Converting the firm’s inventory to profits is a key function of management. Activity

ratios tell us how effectively management is turning over inventory. Inventory
turnover ratio measures the speed with which inventory moves through the firm and
gets converted into sales.

Inventory turnover = Costs of goods sold / Average inventory

A lower-than-average inventory turnover ratio often indicates obsolete merchandise

on hand or poor buying practices. A higher-than-average ratio may signal that the
firm has lost sales because of inadequate stock.