Using Accounting Information Chapter 15 Using Accounting Information

Learning Objectives Explain why accurate accounting information and audited financial statements are important. Identify the people who use accounting information and possible careers in the accounting industry. Discuss the accounting process. Read and interpret a balance sheet. Read and interpret an income statement. Describe business activities that affect a firm’s cash flow. Summarize how managers evaluate the financial health of a business.

Accounting …the process of systematically collecting, analyzing, and reporting financial information.

Accounting Provides Answers How much profit did a business earn last year? How much tax does a business owe the Internal Revenue Service? How much cash does a business have on hand?

Accounting As an Information System Source: Needles, Powers, Crosson, Principles of Accounting (Boston: Houghton Mifflin, 2005).

Recent Accounting Problems Pressure to “cook” the books Greed: compensation tied to stock value Inaccurate/misleading reporting Increased SEC and IRS scrutiny

Audited Financial Statements Audit: Examination of a company’s financial statements and accounting practices that produced them Generally Accepted Accounting Principles (GAAPs): Accepted set of guidelines and practices for companies reporting financial information and for the accounting profession

Organizations Influencing Accounting Profession Financial Accounting Standards Board (FASB) American Institute of Certified Public Accountants (AICPA) International Accounting Standards Board (IASB)

Sarbanes-Oxley Act (2002) SEC established oversight board CEO/CFO required to certify reports Accounting firms cannot provide non-auditing/consulting services Auditors keep documents/work papers for 5 years Prison sentences up to 20 years for document destruction Change auditing firm every 5 years Protection of whistle-blowers

Table 15.1: Users of Accounting Information Managers + outside individuals + other organizations

Types of Accounting Managerial: provides information to make decisions about financing, investing, and operations Financial: generates statements/reports Cost: determines cost of production Government: ensures tax revenues collected Not-for-Profit: accounts for donations and expenditures Tax: plans tax strategy and prepares returns

To Be Successful in Accounting Be responsible, honest, ethical Have strong background in financial management Know computer/software to process data Be able to communicate about accounting information

Income for Accountants and Auditors Spotlight Income for Accountants and Auditors Source: The Bureau of Labor Statistics web site at www.bls.gov, May 18, 2009.

Accountant Classifications Private: employed by specific organization Public: works on fee basis for clients and may be self-employed Certified Public Accountant (CPA): individual has met state requirements for accounting education and experience and has passed AICPA exam Certified Management Accountant (CMA): certified by Institute for Management Accountants

Requirements for Becoming a CPA Education = 150 undergraduate and/or graduate semester hours Most areas At least a bachelor’s degree Two+ years of public accounting (some areas accept non-public accounting) Certificate and license: pass exam and fulfill experience Age = 18+ Source: SmartPros, “Basic Information on the CPA Exam”, 2000, http://www.pro2net.com/x14341.xml

Assets = Liabilities + Owners’ Equity Accounting Equation Assets = Resources Business Owns Liabilities = Firm’s Debts Owners’ Equity = Total Assets - Total Liabilities

Double-Entry Bookkeeping …a system in which each financial transaction is recorded as two separate accounting entries to maintain the balance shown in the accounting equation.

Analyze Record Post Prepare Close Accounting Cycle Analyze Record Post Prepare Close

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.

Figure 15.1: Personal Balance Sheet Individuals determine their net worth, or owner’s equity, by subtracting the value of their debts from the value of their assets.

Balance Sheet Assets Listed Most Liquid Least Liquid

Figure 15.2: Business Balance Sheet Summarizes firm’s accounts at the end of an accounting period. Note that assets ($340,000) equal liabilities plus owners’ equity ($340,000).

Income Statement …a summary of a firm’s revenues and expenses during a specified accounting period.

Figure 15.3: Personal Income Statement By subtracting expenses from income, anyone can construct a personal income statement and determine if they have a surplus or deficit at the end of each month.

Income Statement Expense Accounts Cost of Goods Sold = Beginning Inventory Net Purchases Ending Inventory + -

Figure 15.4: Business Income Statement Summarizes firm’s revenues and expenses during a specified accounting period. For Northeast Art, net income after taxes is $30,175.

Statement of Cash Flows A statement that illustrates how the operating, investing, and financing activities of a company affect cash during an accounting period.

Figure 15.5: Statement of Cash Flows For Northeast Art, the amount of cash at the end of the year is $59,000—the same amount reported for the cash account on the firm’s balance sheet.

Cash Flows Activities Operating : cash flow from primary revenue source Investing: cash flow from investments such as purchase/sale of land, equipment, etc. Financing: cash flow from financing such as changes in debt obligation and owners’ equity Added to beginning cash balance to get ending cash balance

Using Annual Reports to Compare Data Determine profitability Read the letters Compare current statements with prior period statements Examine footnotes Learn to calculate financial ratios Compare with other firms’

Comparison of Financial Statements Since the beginning of the company 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

Financial Ratio …a number that shows the relationship between two elements of a firm’s financial statements.

Ratio Classification Profitability: effectiveness in use of resources Short-Term: ability to pay current liabilities Activity: how many times per year accounts receivable collected or inventory sold Debt to Owners’ Equity: degree operations financed through borrowing

Return on Owners’ Equity Profitability Ratios net income after tax net sales $30,175 $451,000 Return on Sales = = = 6.7% Return on Owners’ Equity net income after tax owners’ equity $30,175 $230,000 = = = 13.0% net income after tax common stock shares outstanding Earnings per Share $30,175 $25,000 = = = $1.21

Short-Term Financial Ratios current assets - current liabilities working capital $182,000 -$ 70,000 $112,000 Working Capital = = current assets current liabilities $182,000 $70,000 Current Ratio = = = 2.6 cash + marketable securities + receivables current liabilities $139,000 $70,000 Acid-Test Ratio = = = 1.99

Activity Ratios A/R Turnover = = = Inventory Turnover = = = net sales accounts receivable A/R Turnover = $451,000 $38,000 = = 11.9 times per year Inventory Turnover cost of goods sold average inventory = $334,000 $40,500 = = 8.2 times per year

Debt-to-Owners’ Equity Ratio total liabilities owners’ equity = $110,000 $230,000 = = 48 percent

Table 15.2: Financial Ratios Compared

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.

Chapter Quiz Current assets minus current liabilities equals return on owners’ equity. current ratio. acid-test ratio. working capital. current cash statement.