FHF McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

part CHAPTER 15 Money and the Financial System 6 FHF 14-2 CHAPTER 14 Accounting and Financial Statements CHAPTER 16 Financial Management and Securities Markets

FHF AccountingAccounting  The recording, measurement and interpretation of financial information, often used in making business decisions  The Financial Accounting Standards Board sets principles of financial accounting and reporting Accounting can be a difficult and contentious science 14-3 …continued on next page

FHF AccountingAccounting  GAAP  Generally accepted accounting principles  SEC  Securities & Exchange Commission provides oversight  Has assumed a larger oversight role in recent years 14-4

FHF Types of Accounting Certified Public Accountant (CPA)  An independent professional who provides accounting services to the public (individuals or firms) for a fee Private Accountant  An accountant employed by a corporation, government agency, or other organization  Can be CPAs and CMAs (Certified Management Accountant) 14-5

FHF Forensic Accounting  Analyzing financial data in search of fraudulent entries or financial misconduct  Can help uncover money laundering, terrorist activity  Marital and family law  A growth area for public accountants 14-6

FHF Accounting or Bookkeeping? Bookkeeping  Often (mistakenly) used interchangeably with accounting  The routine day-to-day recording of business transactions  Bookkeepers obtain and record the financial information that accountants then analyze 14-7

FHF Uses of Accounting Information Internal  Managerial accounting is the internal use of accounting statements by managers in planning and directing organizational activities  Cash flow, the movement of money through an organization, is management’s greatest concern  Accounting helps management prepare a budget, an internal financial plan that forecasts expenses and income over a set period of time 14-8 …continued on next page

FHF Uses of Accounting Information External  Reporting to the IRS  The annual report, which is a summary of financial information, products and growth plans  Obtaining credit  As a gauge of performance 14-9

FHF Deceptive Accounting Practices Countries, states and companies have all engaged in deceptive accounting practices Hiding debt through off-balance sheet accounts Using derivatives to hide financial instability Overleveraging with too many loans Regulations try to minimize the practice Impossible to do away with all deceptive accounting 14-10

FHF The Accounting Equation  The relationship between assets, liabilities and owners’ equity Assets=Liabilities+Owners Equity Things of value that a firm owns = A firm’s debts and obligations + The difference between a firm’s assets and its liabilities

FHF Double-Entry Bookkeeping Assets=Liabilities+Owners Equity $ 325=$ -700+$ 1,025 Notice that both sides of the equation balance  A system of recording and classifying business transactions in separate accounts in order to maintain the balance of accounting equation

FHF The Accounting Cycle A four-step process through which financial data pass 1. Examine source documents 2. Record transactions in an accounting journal 3. Post transactions to a ledger.  If the trial balance does not balance, one must look for mistakes and try again 4. Prepare financial statements and have them certified by an accountant 14-13

FHF Financial Statements The end results of the accounting process are a series of financial statements  Income statement  Balance sheet  Statement of cash flows Financial statements are provided to: Stockholders and potential investors Creditors Government agencies Internal Revenue Service 14-14

FHF The Income Statement A financial report that shows an organization’s overall profitability or loss over a period of time  Month  Quarter  Year  Shows a firm’s bottom line: its expenses minus revenues 14-15

FHF Income Statement: Key Terms  Revenue : The total amount of money received or promised from the sale of goods/services and other activities Cost of Goods Sold : The amount of money the firm spent to buy and produce the products it sold Cost of goods sold= beginning inventory+ interim purchases – ending inventory  Gross Income/Profit : Revenues minus the cost of goods sold …continued on next page

FHF Income Statement: Key Terms Expenses : The costs incurred in day-to-day operations of an organization  Common expense accounts shown on income statements are: Selling, general & administrative R&D, engineering Interest …continued on next page

FHF Income Statement: Key Terms Depreciation : A special type of expense included in general and administrative category  Involves spreading the costs of long-lived assets over the total number of accounting periods in which they are to be used Net Income : The total profit or loss after all expenses are deducted from revenue  Accountants usually divide profits into subcategories (e.g. operating income) 14-18

FHF John’s Pizza Income Statement December 31,

FHF The Balance Sheet  A “snapshot” of an organization’s financial position at a given moment  Presents an accumulation of all the company’s transactions since it began  Shows what an organization owns and controls and sources of income used to pay for assets 14-20

FHF Balance Sheet: Key Terms Assets  Current Assets (Short-Term Assets): Used or converted to cash within a calendar year  Accounts Receivable : Money owed the company by clients or customers who have promised to pay at a later date Accountants usually include an allowance for bad debts, which the firm does not expect to collect  Long-Term Assets (Fixed Assets): Represent a commitment of funds for more than one year Includes tangible assets (plant, equipment) and intangibles (corporate goodwill, reputation) …continued on next page

FHF Balance Sheet: Key Terms Liabilities  Current Liabilities: Obligations to short-term creditors  Accounts Payable : Amounts owed to suppliers for goods and services purchased on credit  Accrued Expenses: All unpaid financial obligations incurred by the company …continued on next page

FHF Balance Sheet: Key Terms Owner’s Equity  All the owners’ contributions to the organization, along with income earned by the organization, retained for financing growth and development 14-23

FHF John’s Pizza Balance Sheet December 31,

FHF Statement of Cash Flows  Explains how the company’s cash changed from the beginning of the accounting period to the end  Takes the cash balance from two successive balance sheets and compares them  Change in cash explained in three categories: 1. Cash from (used for) operating activities 2. Cash from (used for) investing activities 3. Cash from (used for) financing activities 14-25

FHF Ratio Analysis Calculations that measure an organization’s financial health  Profitability ratios  Asset utilization ratios  Liquidity ratios  Debt utilization ratios  Per share data 14-26

FHF Profitability Ratios Profit Margin=Net Income / Sales Return on Assets=Net Income / Assets Return on Equity=Net Income / Equity

FHF Asset Utilization Ratios Receivables Turnover=Sales (Total Net Revenues) / Receivables Inventory Turnover=Sales / Inventory Total Asset Turnover=Sales / Total Assets

FHF Liquidity Ratios Current Ratio=Current Assets / Current Liabilities Quick Ratio=Current Assets – Inventory / Current Liabilities

FHF Debt Utilization Ratios Debt to Total Assets=Debts (Total liabilities) / Total Assets Times Interest Earned=Income Before Interest & Taxes (Operating Income) / Interest Expense

FHF Per Share Data Earnings per Share=Net Income / Number of Shares Outstanding Dividends per share=Dividends Paid / Number of Shares Outstanding

FHF Accounting and the Impact of the Financial Crisis Even after the passage of Sarbanes-Oxley, the financial crises and recession of are an example of failed accounting audits Many financial institutions manipulated their books to appear financially healthier and downplay risky decisions  Accountants and regulators need to be more thorough  Mark-to-market accounting blamed for many problems Problems valuing assets/liabilities under mark-to-market rules 14-32