Using Accounting Information Chapter 15

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.

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

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.

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

Users of Accounting Information

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.

Using the Internet www.aicpa.org 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

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

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

The Accounting Cycle 1. Analyzing source documents (receipts etc) 2. Recording transactions (journal) 3. Posting transactions (general ledger) 4. Preparing the trial balance 5. Preparing the financial statements

The 3 Most Important Financial Statements Balance Sheet Income Statement Cash Flow Budget

Balance Sheet

The Balance Sheet must balance!! Total Assets Liabilities + Owners Equity

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

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

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

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

Balance Sheet Assets Listed Most Liquid Least Liquid

Most liquid to Least liquid Break into teams for this exercise

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

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 inventory Net purchases Ending inventory = + – Gross profit = a firm’s net sales less the cost of goods sold

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

Find Operating Expenses Brainstorming Exercise

Business Income Statement

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

Personal Income Statement

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)

Statement of Cash Flows

Comparison of Financial Statements Timeframe Main Accounts Income Up to 1 year Expense Profit Balance Sheet Since the beginning of the company Assets Liabilities Equity Cash Flow Operating Investment Financing

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.

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

Financial Ratios (cont.)

4 Kinds of Ratios Profitability Ratios Short-term Ratios Activity Ratios Debt-to-Owner’s Equity Ratio

Profitability Ratios Return on Sales Return on Owner’s Equity Earnings Per Share

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%.

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 = $30,175 = .13 = 13% $230000 Compare your answer to industry average of 12-15%.

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.

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.

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.

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.

Activity Ratios (“How many times a year do we do…….?”) Two Activity Ratios: Acounts Receivable Turnover Inventory Turnover

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.

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.

Debt-to-Owner’s Equity Ratio Answers: “How much of our operations are financed through borrowing?” Debt-to-Owner’s Equity = Total Liabilities 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.

Chapter Quiz The __________ is designed to improve accounting standards. Ethics in Accounting Act Graham-Rudman Reform Act Sarbanes-Oxley Act Securities and Exchange Accounting Act Accounting Standards Establishment Act

Chapter Quiz An accountant who is employed by a specific business or organization is referred to as a(n) public accountant. private accountant. proprietary accountant. AICPA accountant. asset accountant.

Chapter Quiz The first step in the accounting cycle is to analyze source documents. record individual transactions. post individual transactions. construct a beginning financial statement. prepare a list of employees.

Chapter Quiz Assets, liabilities, and owners’ equity would be listed on a firm’s balance sheet. income statement. statement of earnings. statement of retained earnings. statement of capital.