Copyright © 2015 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Understanding Accounting and Financial Information CHAPTER 17

WHAT’S ACCOUNTING? 17-2 LO 17-1 What does accounting do? “Language” of business Record transactions Track income & expenses Prepare financial statements Helps answer and assist with important business decisions ManagersOwners EmployeesCreditors What other groups would be interested in accounting information? Accounting is a system for recognizing, organizing, analyzing, and reporting information about the financial transactions that affect an organization?

The ACCOUNTING SYSTEM 17-3 LO 17-1

ACCOUNTANTS’ RESPONSIBILITIES 17-4 LO 17-1

ACCOUNTING: WHO DOES IT? 17-5 LO 17-2 Managerial accounting is responsible for tracking sales and the costs of producing the sales (production, marketing, and distribution). Geared towards INTERNAL users (hence name) Financial accounting produces financial documents to aid decision makers outside an organization in making decisions regarding investments and credibility. Geared towards OUTSIDE users (although internal users also rely heavily on financial accounting information) What Accountants Do: Public and Private Accountants Forensic Accountants Corporate Accountants Internal/External Auditors Government Accountants Accountants require expertise Certified Public Accountant (CPA) Certification 150-semester hours of college Rigorous Exam Direct Work Experience in accounting Certified Management Accountant (CMA) Certified Fraud Examiners

MANAGERIAL ACCOUNTING 17-6 LO 17-2 Managerial Accounting -- Provides information and analysis to managers inside the organization to assist them in decision making. Managerial accounting is involved with:  Costs of production  Costs of marketing  Preparation and control of budgets  Minimizing tax liabilities

USERS of ACCOUNTING INFORMATION 17-7 LO 17-2

FINANCIAL ACCOUNTING 17-8 LO 17-2 Financial Accounting -- Financial information and analyses are generated for people primarily outside the organization. Outside users are interested in these questions:  Is the organization profitable?  Is it able to pay its bills?  How much debt does it owe? Annual Report -- A yearly statement of the financial condition, progress, and expectations of the firm.

Key things to watch for and read: HOW to READ an ANNUAL REPORT 17-9 LO 17-2  Management’s discussion and analysis of operations  Balance sheet  Income statement  Statement of cash flows  Auditor’s opinion

PUBLIC vs. PRIVATE ACCOUNTANTS LO 17-2 Private Accountants -- Work in a single firm, government agency, or nonprofit organization. Public Accountants -- Provide accounting services to individuals or businesses. Certified Public Accountants (CPAs) -- Accountants who have passed a series of examinations established by the American Institute of Certified Public Accountants (AICPA) and met a states requirements for education and experience.American Institute of Certified Public Accountants (AICPA)

WAYS to IMPROVE ACCOUNTING PRACTICES Source: accessed November LO 17-2

DODD-FRANK ACT Photo Credit: Nancy Pelosi LO 17-2 Dodd-Frank Wall Street Reform and Consumer Protection Act increased financial regulation by increasing the power of the Public Company Accounting Oversight Board. Act was brought on by the recent financial crisis.

AUDITING CHECKS ACCURACY LO 17-2 Auditing -- Reviewing and evaluating the information used to prepare a company’s financial statements. Independent Audit -- An evaluation and unbiased opinion about the accuracy of a company’s financial statements. Certified Internal Auditors (CIAs) -- Accountants who have a bachelor’s degree and two years of experience in internal auditing and pass an exam administered by the Institute of Internal Auditors.Institute of Internal Auditors

ELEMENTARY, MR. AUDITOR, ELEMENTARY Fraud damages businesses, no matter the size. The SEC has committed itself to fighting fraud but not all auditors and CPAs are trained in finding fraud. Colleges are offering advanced degrees in forensic accounting to meet the upcoming demand for these accountants.

Tax Accountants -- Accountants trained in tax law and are responsible for preparing tax returns or developing tax strategies. SPECIALIZED ACCOUNTANTS LO 17-2 Government and Not-for- Profit Accounting -- Support for organizations whose purpose is not generating a profit, but serving others according to a duly approved budget.

The ACCOUNTING CYCLE LO 17-3 Accounting Cycle -- A six-step procedure that results in the preparation and analysis of the major financial statements.

ACCOUNTING STANDARDS & PROCESSES LO 17-3 Generally Accepted Accounting Principles (GAAP) – accounting standards that are used in the preparation of financial statements Financial Accounting Standards Board (FASB) – private self-regulated board that establishes and enforces GAAP Through GAAP, the FASB aims to ensure that financial statements are: Relevant Reliable Consistent Comparable

THE ACCOUNTING PROCESS LO 17-3 GAAP establishes two main financial accounting rules:  The Accounting Equation Assets = Liabilities + Owner’s Equity Assets – The resources that a business own (ex. Cash, Accounts Receivable, Inventory, Equipment, and Real Estate/Land) Liabilities – The firm’s debts, what it owes others (ex. Accounts Payable and Notes Payable) Owner’s 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 (ex. Retained Earnings, Stock)  Double-Entry Bookkeeping System Each financial transaction is recorded as two separate accounting entries to maintain the balance of the accounting equation

The FUNDAMENTAL ACCOUNTING EQUATION LO 17-4 Fundamental Accounting Equation -- The basis for the balance sheet. The equation must always be balanced and includes the formula:  Assets = Liabilities + Owners Equity

The FUNDAMENTAL ACCOUNTING EQUATION LO 17-4 Owner’s Equity (what’s left over to owner’s once liabilities are taken from assets), shown as: Assets = Liabilities + Owner’s Equity Own = Owed + Owner’s Claims Cash, Accounts Receivable, Inventory, Equipment, Real Estate Accounts Payable, Notes Payable Stock, Retained Earnings (cumulation of company’s profits and losses) $826,000 = $613,000 + $213,000 Assets – Liabilities = Owner’s Equity Accounting Equation:

BOOKKEEPER’S ROLE LO 17-3 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.

BOOKKEEPER’S TOOLS LO 17-3 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.

TECHNOLOGY and ACCOUNTING LO 17-3 Computerized accounting programs post information instantly and from remote locations. Intuit’s QuickBooks address the specific needs of small businesses.QuickBooks

Financial Statement -- A summary of all the financial transactions that have occurred over a particular period. FINANCIAL STATEMENTS LO 17-3 Key financial statements of business are:  Balance sheet  Income statement  Statement of cash flows

The BALANCE SHEET LO 17-4 Assets = Liabilities + Owner’s Equity Owner’s Equity – the claims owners have against their firm’s assets Balance Sheet – summarizes a firm’s financial position at a specific point in time Assets – things of value that the firm owns Liabilities – indicates what the firm owes to non-owners

ASSETS LO 17-4 Assets -- Economic resources owned by a firm. Items can be tangible or intangible. Liquidity -- Ease with which assets can be converted into cash.

CLASSIFYING ASSETS LO 17-4 Current Assets -- Items that can or will be converted to cash within one year. Fixed Assets -- Long-term assets that are relatively permanent such as land, buildings, or equipment. Intangible Assets -- Long-term assets that have no physical form but do have value such as patents, trademarks, and goodwill.

CLASSIFYING LIABILITIES LO 17-4 Liabilities -- What the business owes to others - its debts. Accounts Payable -- Current liabilities a firm owes for merchandise or services purchased on credit. Notes Payable -- Short or long-term liabilities a business promises to pay by a certain date. Bonds Payable -- Long-term liabilities that the firm must pay back.

OWNERS’ EQUITY ACCOUNTS LO 17-4 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.

THE BALANCE SHEET LO 17-4 AssetsLiabilities Current assets Current liabilities + Fixed assets + Long-term liabilities = Total Liabilities Owners’ Equity = Total Assets= Total Liabilities + Owners’ Equity 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, accounts receivable, notes receivable, and merchandise inventory Fixed assets—will be held or used for a period longer than one year  Real estate (Land and buildings), and equipment Depreciation—the process of apportioning the cost of a fixed asset over the period during which it will be used 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 Owners’ or stockholders’ equity Retained earnings—profits not distributed to stockholders

BALANCE SHEET EXAMPLE 17-31

The INCOME STATEMENT LO 17-4 Revenue – Expenses = Net Income (Profit) Revenues > Expenses = Net Income (Profit) Expenses > Revenue = Loss Net Income (Profit) – the profit or loss the firm earns Income Statement – summarizes a firm’s operations over a given period of time in terms of profit and loss. Also called the Profit and Loss Statement Revenue– The $ amount a firm earns from selling its products Expenses – the cash the firm spends or other assets it uses to generate revenue

The INCOME STATEMENT LO 17-4 The formula for the income statement : Revenue (AKA Sales) -Cost of Goods Sold (BI + Purchases – EI) = Gross Profit -Operating Expenses = Net Income before Taxes -Taxes = Net Income or Net Loss

INCOME STATEMENT EXAMPLE LO 17-4

ACCOUNTS of the INCOME STATEMENT LO 17-4 Revenue 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 firm sells or the cost of raw materials and supplies it used in producing items for resale. Gross Profit (or Gross Margin) -- How much a firm earned by buying (or making) and selling merchandise.

THE IN’S and OUT’S of VALUING INVENTORY Generally Accepted Accounting Principles (GAAP) sometimes permits accountants to use different method of accounting for inventory. FIFO: First-In, First-Out LIFO: Last-In, First-Out Each valuation can affect income and ending inventory valuation.

ACCOUNTS of the INCOME STATEMENT LO 17-4 Operating Expenses – Cost involved in operating a business, such as rent, salaries and supplies. Depreciation -- The systematic write-off of the cost of a tangible asset over its estimated useful life.

The STATEMENT of CASH FLOWS LO 17-4 Statement of Cash Flows -- Reports cash receipts and cash disbursements related to the three major activities of a firm: 1. Operations 2. Investments 3. Financing

Cash Flow -- The difference between cash coming in and cash going out of a business. UNDERSTANDING CASH FLOW LO 17-4 Managing cash flow is a key consideration of a business and can be particularly challenging for small and seasonal businesses.

WOULD YOU COOK the BOOKS? You are the only accountant employed by a small, struggling dog food company. The company requests a bank loan to keep operations going and your boss suggests you record some revenue early. This is against accounting principles, but you know if you don’t get the loan, you may lose your job. What do you do?

Ratio Analysis -- The assessment of a firm’s financial condition using calculations and financial ratios developed from the firm’s financial statements. USING FINANCIAL RATIOS LO 17-5 Key ratios include:  Liquidity ratios  Leverage ratios  Performance ratios  Activity ratios

COMMONLY USED LIQUIDITY RATIOS LO 17-5 Liquidity ratios measure a firm’s ability to turn assets into cash to pay its short-term debts. Two key ratios are:  Current ratio  Acid-test ratio This information is found on the firm’s balance sheet.

LEVERAGE RATIOS LO 17-5 Leverage ratios measure the degree to which a firm relies on borrowed funds in its operations. Key ratios include:  Debt to Owner’s Equity Ratio This information is found on the firm’s balance sheet.

PROFITABILITY RATIOS LO 17-5 Profitability ratios measure how effectively a firm’s managers are using the firm’s various resources to achieve profits. Key ratios include:  Basic earnings per share  Return on sales  Return on equity This information is found on the firm’s balance sheet and income statement.

ACTIVITY RATIOS This information is found on the firm’s balance sheet and income statement LO 17-5 Activity ratios measure how effectively management is turning over inventory. Key ratios include:  Inventory turnover ratio

SPEAKING a UNIVERSAL ACCOUNTING LANGUAGE Multinational companies must adapt their accounting reporting to the rules of multiple countries. Many countries have adopted International Financial Reporting Standards (IFRS) and are pushing to make them standard.International Financial Reporting Standards (IFRS) The U.S. Securities & Exchange Commission believes there should be such a standard.

TIMELINE for the MOVE to IFRS Source: IFRS.org, accessed November 2014.IFRS.org LO : SEC offered proposed timeline 2009: 110 large companies had the option of using IFRS 2012: SEC assessed progress of IFRS 2013: Final decision on the move to IFRS 2015: Large public companies will be required to report in IFRS (pending SEC decision) 2016: All companies will be required to report in IFRS (pending SEC decision)