McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Chapter 1717 Understanding Financial Information and Accounting 17-1

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved What is Accounting? Recording, classifying, summarizing, & interpreting financial events & transactions to provide management & other parties information to allow them to make good decisions.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Financial Transactions Include buying & selling goods & services, acquiring insurance, using supplies, & paying taxes.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved The Accounting Process DATA PROCESSINGINFORMATION

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved What Bookkeepers Do o Categorize and and o Record the Data in in o Books of Original Entry o Journals o Ledgers using using o Double Entry

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Bookkeeping's Role Bookkeeping -- The recording of business transactions. Bookkeepers divide a firm’s transactions into meaningful categories and post them into a record book or computer program called a journal. Double-Entry Bookkeeping -- Bookkeepers record all transactions in two places so they can check one list of transactions against the other for accuracy.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Bookkeeping's Role Ledger -- A specialized accounting book or program where all information is in one place. Trial Balance -- A summary of all the information in the account ledgers.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Accounting Guidelines Financial Accounting Standards Board (FASB) defines what are Generally Accepted Accounting Principles (GAAP) that accountants must follow

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Bookkeeping vs. Accounting Bookkeeping – –Start of Accounting Process – –Recording of Business Transactions – –Record/Journalize Accounting – –Classify – –Summarize – –Analyze – –Interpret – –Recommend

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved General Journal

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Cash No. 101 DateExplanationPRDebitCreditBalance Accounts Receivable No. 106 Date PRDebitCreditBalance Office Supplies No. 124 Date PRDebitCreditBalance Prepaid Insurance No. 128 Date PRDebitCreditBalance General Ledger

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved The Accounting Cycle

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Steps In The Accounting Cycle Analyze Source Documents Record Transactions in Journals Post Journal Entries to Ledger Take a Trial Balance Prepare Financial Statements Analyze Financial Statements

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Financial Statements

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Financial Statements o o Balance Shee t – Statement of Financial Position (on a specific date) o o Income State ment – Statement of Revenues, Expenses, & Profits (specific period of time) o o Statement of Cash Flows – Statement of Cash Receipts & Disbursements (cash coming in & cash going out)

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Balance Sheet Statement of Financial Position (on a specific date)

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Terms Assets –What the Company owns LiabilitiesLiabilities –What the Company owes EquityEquity –Owners’ Claims LiquidityLiquidity –How fast an asset can be converted into cash

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Accounting (Balance Sheet) Equation Assets Liabilities + Owner’s Equity Owns Owes + Owners’ Claims = =

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Classifying Assets o Current Assets -- Items that can or will be converted to cash within one year. o Fixed Assets -- Long-term assets that are relatively permanent such as land, buildings, or equipment. o Intangible Assets -- Long-term assets that have no physical form but do have value such as patents, trademarks, and goodwill.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Classifying Liabilities o Liabilities -- What the business owes to others - its debts. o Accounts Payable -- Current liabilities a firm owes for merchandise or services purchased on credit. o Notes Payable -- Short or long-term liabilities a business promises to pay by a certain date. o Bonds Payable -- Long-term liabilities that the firm must pay back.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Owners’ Equity Accounts Owners’ Equity -- The amount of the business that belongs to the owners minus any liabilities of the owners. Retained Earnings -- Accumulated earnings from the firm’s profitable operations that are reinvested in the business.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Balance Sheet Equation Assets Liabilities + Owner’s Equity = $826,000 = $613,000 + $213,000 $213,000 Very Vegetarian Company

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Very Vegetarian’s Balance Sheet (Assets) Period ending 12/31/14 Assets Current Assets Cash$ 15,000 Accounts Receivable 200,000 Notes Receivable 50,000 Inventory 335,000 Total Current Assets$600,000 Fixed Assets Land$ 40,000 Buildings (net) 110,000 Equipment & Vehicles (net) 40,000 Furniture & Fixtures (net) 16,000 Total Fixed Assets$206,000 Intangible Assets Goodwill$ 20,000 Total Intangible Assets$ 20,000 Total Assets$826,000

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Very Vegetarian’s Balance Sheet (Liabilities & Owner’s Equity) Period ending 12/31/14 Liabilities & Owners’ Equity Current Liabilities Accounts Payable$ 40,000 Notes Payable 8,000 Accrued Taxes & Salaries 240,000 Total Current Liabilities $288,000 Long-term Liabilities Notes Payable$ 35,000 Bonds Payable 290,000 Total Long-term Liabilities $325,000 Total Liabilities$613,000 Owners’ Equity Common Stock (1M shares) $100,000 Retained Earnings 113,000 Total Owners’ Equity$213,000 Total Liabilities & Owners’ Equity$826,000

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Income Statement Statement of Revenues, Expenses, & Profits (specific period of time)

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Income Statement Income Statement -- The financial statement that shows a firm’s bottom line - that is, its profit after costs, expenses, and taxes. Net Income/Net Loss -- The revenue left over or depleted.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Accounts of the Income Statement Revenues is the monetary value a firm received for goods sold, services rendered or other payments. Cost of Goods Sold (or Manufactured) -- Measures the cost of merchandise the firms sells or the cost of raw materials and supplies it used in producing items for resale. Gross Profit -- How much a firm earned by buying (or making) and selling merchandise.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Accounts of the Income Statement Operating Expenses -- Expenses a firm incurs in selling goods and services such as rent, salaries and supplies.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Income Statement Equation Profit = Revenues – Expenses

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Income Statement Formula Revenues Revenues –Cost of Goods Sold =Gross Profit (Gross Margin) –Operating Expenses =Net Income Before Taxes –Taxes =Net Income (or Loss)

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Very Vegetarian Income Statement Period Ending 12/31/14 Revenues Net Sales$ 700,000

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Very Vegetarian Income Statement Period Ending 12/31/14 Revenue Net Sales$ 700,000 Cost of Goods Sold Beginning Inventory $ 200,000 Purchases During the Year $ 440,000 Cost of Goods Available for Sale During the Year $ 640,000 Less: Ending Inventory $ 230,000 Less: Cost of Goods Sold $ 410,000 Gross Profit (Gross Margin)$ 290,000

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Income Statement Formula Revenues Revenues –Cost of Goods Sold =Gross Profit (Gross Margin) –Operating Expenses =Net Income Before Taxes –Taxes =Net Income (or Loss)

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Very Vegetarian’s Income Statement (cont’d) Gross Profit $290,000 Operating Expenses Selling Expenses Salaries$ 90,000 Advertising & Supplies$ 20,000 Total Selling Expenses$ 110,000 General Expenses Office Salaries$ 67,000 Depreciation$ 1,500 Insurance$ 1,500 Rent$ 28,000 Utilities$ 12,000 Miscellaneous$ 2,000 Total General Expenses$ 112,000 Less: Total Operating Expenses - $ 222,000 Net Income (Profit) Before Taxes$ 68,000 Less: Income Tax Expenses -$ 19,000 Net Income (Profit) After Taxes$ 49,000

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Statement of Cash Flows Statement of Cash Receipts & Disbursements (cash coming in & cash going out)

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Understanding Cash Flow Cash Flow -- The difference between cash coming in and cash going out of a business.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Statement of Cash Flows Reports cash receipts and disbursements related to the firm’s major activities: Operations – cash transactions associated with running the business Investments – cash used in or provided by firm’s investment activities Financing – cash raised from the issuance of new debt or equity capital or cash used to pay business expenses, past debts, or company dividends

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Depreciation o o Depreciation -- The systematic write- off of the cost of a tangible asset over its estimated useful life.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Ratio Analysis

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Ratio Analysis Assessment of firm’s financial condition and performance through calculations and interpretations of financial ratios developed from the firm’s financial statements

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Financial Ratios 1.Help in analyzing actual performance compared to financial objectives 2.Provide insights in to firm’s performance compared to other firms in the industry

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Using Financial Ratios o Ratio Analysis -- The assessment of a firm’s financial condition using calculations and financial ratios developed from the firm’s financial statements. o Key ratios include:  Liquidity ratios  Leverage ratios  Activity ratios

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Liquidity Ratios

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Commonly Used Liquidity Ratios o Liquidity ratios measure a firm’s ability to turn assets into cash to pay its short-term debts. o Two key ratios are: o Current ratio o Acid-test ratio o This information is found on the firm’s Balance Sheet.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Liquidity Ratios Current Assets Current Liabilities Quick (Acid-Test) Ratio Cash + Marketable Securities + Receivables Current Liabilities Current Ratio

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Liquidity Ratios Current Assets Current Liabilities Current Ratio

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Current Ratio- Very Vegetarian $600,000$288,000 =2.08 Current Assets Current Liabilities

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Quick (Acid-Test) Ratio $265,000 $288,000 =0.92 Cash + Marketable Securities + Receivables Current Liabilities

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Leverage (Debt) Ratios o Leverage ratios measure the degree to which a firm relies on borrowed funds in its operations. o Key ratios include: o Debt to Owner’s Equity Ratio o This information is found on the firm’s Balance Sheet.

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Debt to Equity Ratio $613,000 $213,000 = 287% Total Liabilities Owners’ Equity

McGraw-Hill/Irwin Understanding Business, 7/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved Activity Ratios Inventory Turnover = $410,000 = 1.9 $215,000 $215,000 Inventory Turnover Cost of Goods Sold Average Inventory