Chapter Eighteen Using Accounting Information

Copyright © Houghton Mifflin Company. All rights reserved Learning Objectives 1.Explain how new regulations affect the accounting industry and the way businesses report financial information. 2.Understand why accounting information is important and what accountants do. 3.Discuss the accounting process. 4.Read and interpret a balance sheet. 5.Read and interpret an income statement. 6.Describe business activities that affect a firm’s cash flow. 7.Summarize how managers evaluate the financial health of a business.

Copyright © Houghton Mifflin Company. All rights reserved Improved Accountability in the Accounting Industry Recent accounting problems for corporations and their auditors –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

Copyright © Houghton Mifflin Company. All rights reserved Improved Accountability in the Accounting Industry (cont’d) What is an audit? –An examination of a company’s financial statements and accounting practices –Generally accepted accounting principles (GAAP)—an accepted set of guidelines and practices for companies reporting financial information and for the accounting profession –Organizations that influence the methods used by the accounting profession: FASB, AICPA, IASC –An audit does not guarantee that a company has not “cooked” the books

Copyright © Houghton Mifflin Company. All rights reserved Improved Accountability in the Accounting Industry (cont’d) Reform: The Sarbanes-Oxley Act of 2002 –The SEC must establish an oversight board to police the accounting industry –Top executives are required to certify periodic financial reports and are subject to criminal penalties for violations –Accounting firms cannot provide many types of consulting services to the companies they audit –Auditors must maintain financial documents and audit work papers for 5 years –Auditors and accountants can be imprisoned for up to 20 years for destroying documents and violating securities laws –A public corporation must change its auditing firm every 5 years –There is protection for whistle-blowers who report violations of the Sarbanes-Oxley Act

Copyright © Houghton Mifflin Company. All rights reserved Why Accounting Information Is Important Accounting –The process of systematically collecting, analyzing, and reporting financial information –Three key financial statements summarize the firm’s activities for a specific period Balance sheet Income statement Statement of cash flows

Copyright © Houghton Mifflin Company. All rights reserved Why Accounting Information Is Important (cont’d) The people who use accounting information –Managers are primary users –Lenders require financial information before lending –Stockholders want to know whether to invest or how well their investment is doing –Government agencies require a variety of information

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Copyright © Houghton Mifflin Company. All rights reserved Careers in Accounting Qualities to be successful in accounting –Be responsible, honest, ethical –Have a strong background in financial management –Know how to use a computer and accounting software –Be able to communicate with people who need accounting information

Copyright © Houghton Mifflin Company. All rights reserved Careers in Accounting (cont’d) Private Accountant –Employed by a specific organization –Services performed for the employer General accounting (recording transactions and preparing statements) Budgeting (for sales and operating expenses) Cost accounting (determining costs of producing products and services) Tax accounting (planning strategy and preparing returns) Internal auditing (reviewing finances and operations against goals)

Copyright © Houghton Mifflin Company. All rights reserved Careers in Accounting (cont’d) Public Accountant –Provides services to clients on a fee basis –Self-employed or employee of an accounting firm Certified Public Accountant (CPA) –Has met state requirements for accounting education and experience and has passed a rigorous two-day accounting examination prepared by the AICPA –Participates in continuing-education programs to maintain certification

Copyright © Houghton Mifflin Company. All rights reserved 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) The double-entry bookkeeping system –A system in which each financial transaction is recorded as two separate accounting entries to maintain the balance of the accounting equation

Copyright © Houghton Mifflin Company. All rights reserved The Accounting Process (cont’d) The accounting cycle –Done on a regular basis Analyzing source documents Recording transactions as they occur in the general journal Posting transactions to accounts in the general ledger –Done at the end of the period Preparing the trial balance of all general ledger accounts Preparing financial statements and closing the books

Copyright © Houghton Mifflin Company. All rights reserved 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 (also called statement of financial position) Assets –Listed in order of liquidity (ease with which an asset can be converted into cash) –Current assets—can quickly be converted to cash Cash, marketable securities, accounts receivable, notes receivable, merchandise inventory, and prepaid expenses

Copyright © Houghton Mifflin Company. All rights reserved The Balance Sheet (cont’d) Assets (cont’d) –Fixed assets—will be held or used for a period longer than one year Land, buildings, and equipment Depreciation—the process of apportioning the cost of a fixed asset over the period during which it will be used –Intangible assets—do not exist physically but have a value based on the rights or privileges they confer on the firm Patents, copyrights, trademarks, franchise rights, and goodwill

Copyright © Houghton Mifflin Company. All rights reserved The Balance Sheet (cont’d) Liabilities –Current liabilities—debts to be repaid in one year or less Accounts payable—short-term obligations that arise as a result of making credit purchases 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

Copyright © Houghton Mifflin Company. All rights reserved The Balance Sheet (cont’d) 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—stockholder’s equity –Retained earnings—profits not distributed to stockholders

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Copyright © Houghton Mifflin Company. All rights reserved 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

Copyright © Houghton Mifflin Company. All rights reserved The Income Statement (cont’d) 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

Copyright © Houghton Mifflin Company. All rights reserved The Income Statement (cont’d) 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

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Copyright © Houghton Mifflin Company. All rights reserved 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 long-term assets and investments) –Cash flows from financing activities (changes in debt obligation and owners’ equity accounts)

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Copyright © Houghton Mifflin Company. All rights reserved Evaluating Financial Statements Identify trends in sales, profits, borrowing, and other business variables Determine whether the firm is on track to meet long-term goals

Copyright © Houghton Mifflin Company. All rights reserved Comparing Data for Previous Accounting Periods Source: Adapted from the Microsoft Corporation 2002 Annual Report, February 24, 2003.

Copyright © Houghton Mifflin Company. All rights reserved Comparing Data with Other Firms’ Data Comparisons are possible because of GAAP Managers can get a general idea of a firm’s relative effectiveness and its standing within the industry Data are available from annual reports of public corporations Industry averages are available from Dun & Bradstreet, Standard & Poor’s, industry trade associations

Copyright © Houghton Mifflin Company. All rights reserved 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 and income statement

Copyright © Houghton Mifflin Company. All rights reserved Financial Ratios (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved Financial Ratios (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved Financial Ratios (cont’d)

Copyright © Houghton Mifflin Company. All rights reserved Financial Ratios (cont’d)