CHAPTER 14 ROLE OF ACCOUNTANTSAND ACCOUNTING INFORMATION © 2007 Prentice Hall, Inc. All rights reserved.14–1 B U S 1 0 0

© 2007 Prentice Hall, Inc. All rights reserved.14–2 L E A R N I N G O B J E C T I V E S After reading this chapter, you should be able to: 1. Explain the role of accountants and distinguish between the kinds of work done by public accountants, private accountants, management accountants, and forensic accountants. 2. Explain how the accounting equation is used. 3. Describe the three basic financial statements and show how they reflect the activity and financial condition of a business. 4. Explain the key standards and principles for reporting financial statements.

© 2007 Prentice Hall, Inc. All rights reserved.14–3 L E A R N I N G O B J E C T I V E S (cont’d) After reading this chapter, you should be able to: 5. Describe how computing financial ratios can help users get more information from financial statements to determine the financial strengths of a business. 6. Discuss the role of ethics in accounting.

© 2007 Prentice Hall, Inc. All rights reserved.14–4 What’s in It for Me? By understanding this chapter’s discussion of accountants, their methods, and their responsibilities, you’ll benefit in three ways: 1. if you’re thinking about starting your own business, you’ll discover your obligations for reporting your firm’s financial status 2. As an employee or union member, you’ll see how to evaluate your company’s financial condition and its prospects for the future 3. As an interested citizen, you’ll learn about accounting ethics and regulatory requirements for maintaining public trust in the business system

© 2007 Prentice Hall, Inc. All rights reserved.14–5 What Is Accounting? Accounting Defined:  A comprehensive system for collecting, analyzing and communicating financial information  Bookkeeping: the recording of transactions Users of Accounting Information:  Business managers  Employees and unions  Investors and creditors  Tax authorities  Government regulatory agencies

© 2007 Prentice Hall, Inc. All rights reserved.14–6 Who Are Accountants and What Do They Do? Controller  Manages all of a firm’s accounting activities Types of Accounting Systems  Financial Accounting  Concerned with external information users—the firm’s external stakeholders  Prepares income statements, balance sheets, and other financial reports published for shareholders and the public  Managerial (Management) Accounting  Serves internal users (managers) by providing information to make departmental decisions, monitor projects, and plan future activities

© 2007 Prentice Hall, Inc. All rights reserved.14–7 Who Are Accountants and What Do They Do? (cont’d) Certified Public Accountants (CPAs)  Licensed, offering services to the public  Auditing (GAAP)  Tax services  Management advisory services Noncertified Public Accountants Private Accountants  Work exclusively for a firm as accountants Management Accountants  Certified management accountant (CMA)

© 2007 Prentice Hall, Inc. All rights reserved.14–8 Who Are Accountants and What Do They Do? (cont’d) Forensic Accountants  Assist in the investigation of business and financial issues that may have application to a court of law  Investigative Accounting  Identifying financial evidence that may be pertinent  Analyzing financial evidence  Presenting accounting conclusions and their legal implications  Litigation Support  Certified Fraud Examiner: A specialty area within forensic accounting

© 2007 Prentice Hall, Inc. All rights reserved.14–9 The CPA Vision Project Identifying issues for the future Global forces as drivers of change Recommendations A new direction  Core services  Core competencies

© 2007 Prentice Hall, Inc. All rights reserved.14–10 TABLE 14.1Core Competencies for Accounting Strategic and Critical Thinking Skills The accountant can provide competent advice for strategic action by combining data, knowledge, and insight. Communications and Leadership Skills The accountant can exchange information meaningfully in a variety of business situations with effective delivery and interpersonal skills. Focus on the Customer, Client, and Market The accountant can meet the changing needs of clients, customers, and employers better than the competition and can anticipate those needs better than competitors. Skills in Interpreting Converging Information The accountant can interpret new meaning by combining financial and nonfinancial information into a broader understanding that adds more business value. Technology Skills The accountant can use technology to add value to activities performed for employers, customers, and clients

© 2007 Prentice Hall, Inc. All rights reserved.14–11 Federal Restrictions on CPA Services and Financial Reporting: Sarbox Sarbanes-Oxley Act of 2002 (Sarbox)  Enacted to restore public trust in corporate accounting practices as a direct response to corporate financial abuses  Restricts non-audit services that CPAs can provide Sarbox Compliance Requirements  CFOs and CEOs must pledge that the company’s finances are correct and face severe penalties noncompliance  Whistleblowers must be protected

© 2007 Prentice Hall, Inc. All rights reserved.14–12 TABLE 14.2Selected Provisions of the Sarbanes-Oxley Act Creates a national Accounting Oversight Board that, among other activities, must establish the ethics standards used by CPA firms in preparing audits. Requires that auditors retain audit working papers for specified periods of time (they cannot destroy audit records). Requires auditor rotation by prohibiting the same person from being the lead auditor for more than five consecutive years. Requires that the CEO and CFO certify that the company’s financial statements are true, fair, and accurate. Prohibits corporations from extending personal loans to executives and directors. Requires that the audited company disclose whether it has adopted a code of ethics for its senior financial officers. Requires that the SEC regularly review each corporation’s financial statements. Prevents employers from retaliating against research analysts that write negative reports. Imposes criminal penalties on auditors and clients for falsifying, destroying, altering, or concealing records (10 years in prison). Imposes fine or imprisonment (up to 25 years) on any person that defrauds shareholders. Increases penalties for mail and wire fraud from 5 to 20 years in prison. Establishes criminal liability for failure of corporate officers to certify financial reports.

© 2007 Prentice Hall, Inc. All rights reserved.14–13 The Accounting Equation  Assets = Liabilities + Owners’ Equity  Assets – Liabilities = Owners’ Equity (or Net Worth) Asset  Any economic resource that is expected to benefit a firm or an individual who owns it Liability  A debt that the firm owes to an outside party Owners’ Equity   Money that owners would receive if they sold all of a company’s assets and paid all of its liabilities

© 2007 Prentice Hall, Inc. All rights reserved.14–14 Financial Statements Balance Sheets  Supply detailed information about:  Assets –Current assets: Cash/assets that can be converted into cash within a year –Fixed assets: Capital that has long-term use or value –Intangible assets: Patents, trademarks, copyrights, etc.  Liabilities –Current liabilities: debts that must be paid within one year, including accounts payable –Long-term liabilities: debts not due for at least a year  Owners’ Equity –Paid-in (invested) capital –Retained earnings (net profits)

© 2007 Prentice Hall, Inc. All rights reserved.14–15 FIGURE 14.1Google’s Balance Sheet

© 2007 Prentice Hall, Inc. All rights reserved.14–16 Financial Statements (cont’d) Income Statement (Profit and Loss Statement)  Its description of revenues and expenses results in a figure showing the firm’s annual profit or loss  Revenues: the funds that flow into a business from the sale of goods or services  Cost of revenues: shows the costs of obtaining the revenues from other companies during the year  Cost of goods sold: costs of obtaining materials to make products sold during the year  Gross profit: considers revenues and cost of revenues from the income statement  Operating expenses: resources that must flow out of a company if it is to earn revenues

© 2007 Prentice Hall, Inc. All rights reserved.14–17 FIGURE 14.2Google’s Income Statement

© 2007 Prentice Hall, Inc. All rights reserved.14–18 Financial Statements (cont’d) Statements of Cash Flows  Describes yearly cash receipts and cash payments  Cash Flows from Operations: Concerns main operating activities: cash transactions involved in buying and selling goods and services  Cash Flows from Investing: Net cash used in or provided by investing  Cash Flows from Financing: Net cash from all financing activities The Budget  A detailed report on estimated receipts and expenditures for a future period of time

© 2007 Prentice Hall, Inc. All rights reserved.14–19 FIGURE 14.3Google’s Statement of Cash Flows

© 2007 Prentice Hall, Inc. All rights reserved.14–20 FIGURE 14.4Perfect Posters’ Sales Budget

© 2007 Prentice Hall, Inc. All rights reserved.14–21 Financial Statements Review Balance Sheet Assets – Liabilities = Owners’ Equity Income Statement Revenues – Expenses = Profit (or Loss) Statement of Cash Flows Cash In and Cash Out Budget Estimate – Actual = Variance

© 2007 Prentice Hall, Inc. All rights reserved.14–22 Reporting Standards and Practices Generally Accepted Accounting Principles (GAAP)  Revenue recognition: Formal recording and reporting of revenues at the appropriate time  Full disclosure  Financial statements should not include just numbers but should also furnish management’s interpretations and explanations of those numbers so that users can better understand information in the statements

© 2007 Prentice Hall, Inc. All rights reserved.14–23 Solvency Ratios Profitability Ratios Activity Ratios Analyzing Financial Statements

© 2007 Prentice Hall, Inc. All rights reserved.14–24 Current Assets Current Liabilities Solvency Ratios Current Ratio: Short-Term Leverage:The ability to finance an investment through borrowed funds

© 2007 Prentice Hall, Inc. All rights reserved.14–25 Solvency Ratios Debt to Owners’ Equity Ratio: Debt Owners’ Equity Long-Term

© 2007 Prentice Hall, Inc. All rights reserved.14–26 Profitability and Activity Ratios Return on Equity: Earnings Per Share: Net Income Total Owners' Equity Inventory Turnover Ratio: Cost of Goods Sold Average Inventory Net Income # of Shares Outstanding

© 2007 Prentice Hall, Inc. All rights reserved.14–27 Bringing Ethics into the Accounting Equation Why Accounting Ethics?  To maintain public confidence in business institutions, financial markets, and the products and services of the accounting profession AICPA’s Code of Professional Conduct  Maintained and enforced by the AICPA  The AICPA identifies six ethics-related areas with which accountants must comply to maintain certification

© 2007 Prentice Hall, Inc. All rights reserved.14–28 TABLE 14.3 Overview of Code of Ethics for CPAs Membership in the American Institute of Certified Public Accountants is voluntary. By accepting membership, a certified public accountant assumes an obligation of self-discipline above and beyond the requirements of laws and regulations. ResponsibilitiesIn carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities. The Public Interest Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism. IntegrityTo maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity. Objectivity and Independence A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services. Due CareA member should observe the profession’s technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member’s ability. Scope and Nature of Services A member in public practice should observe the Principles of the Code of Professional Conduct in determining the scope and nature of services to be provided.

© 2007 Prentice Hall, Inc. All rights reserved.14–29 TABLE 14.4Examples of Unethical and Illegal Accounting Actions Corporation Accounting Violation AOL Time Warner America Online (AOL) inflated ad revenues to keep stock prices high before and after merging with Time Warner. Cendant Inflated income in financial statements by $500 million through fraud and errors. HCA, Columbia/ HCA Defrauded Medicare, Medicaid, and TRICARE through false cost claims and unlawful billings (must pay $1.7 billion in civil penalties, damages, criminal fines, and penalties). Tyco Dennis Kozlowski illegally used company funds to buy expensive art for personal possession (he received an 8- to 25-year prison sentence). Waste Management Overstated income in financial statements (false and misleading reports) by improperly calculating depreciation and salvage value for equipment. WorldCom Hid $3.8 billion in expenses to show an inflated (false) profit instead of loss in annual income statement.

© 2007 Prentice Hall, Inc. All rights reserved.14–30 K E Y T E R M S accounting accounting equation accounting information system (AIS) accounts payable (payables) activity ratio assetaudit balance sheet bookkeepingbudget Certified Fraud Examiner (CFE) certified management accountant (CMA) certified public accountant (CPA) code of professional conduct controller core competencies for accounting cost of goods sold cost of revenues current asset current liability current ratio debtdepreciation earnings per share financial accounting

© 2007 Prentice Hall, Inc. All rights reserved.14–31 K E Y T E R M S (cont’d) financial statement fixed asset forensic accounting full disclosure generally accepted accounting principles (GAAP) goodwill gross profit income statement (profit-and-loss statement) intangible asset leverageliabilityliquidity long-term liability management accountant management advisory services managerial (management) accounting net income (net profit, net earnings) operating expenses operating income owners’ equity paid-in capital private accountant profitability ratio retained earnings

© 2007 Prentice Hall, Inc. All rights reserved.14–32 K E Y T E R M S (cont’d) revenue recognition revenues Sarbanes-Oxley Act of 2002 (Sarbox) short-term solvency ratio solvency ratio statement of cash flows tax services