1. Using Accounting Information
Chapter 15

2. Why Accounting Information Is Important
Recent accounting scandals
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 of the validity of a firm’s financial statements.

3. Why Accounting Information Is Important (cont.)
What is an audit?
An examination of a company’s financial statements and accounting practices
Generally accepted accounting principles (GAAPs)— an accepted set of guidelines and practices for U.S. companies reporting financial information and the accounting profession
The FASB (Financial Accounting Standards Board) is developing a new set of standards combining those of GAAP and the International Financial Reporting Standards
An audit does not guarantee that a company has not “cooked” the books

4. Why Accounting Information Is Important (cont.)
Reform: The Sarbanes-Oxley Act of 2002
Top executives must certify periodic financial reports and are liable for intentional violations of reporting requirements.
Auditors must maintain financial documents and audit work papers for five years.
Auditors and accountants can be imprisoned for up to twenty years and subject to fines for destroying documents and violating securities laws.
A public corporation must change its lead auditing firm every five years.
There is protection for whistle-blowers who report violations of the Sarbanes-Oxley Act.

5. Who Uses Accounting Information
Managers are the primary users
Proprietary: information that is not divulged to anyone outside the firm
Lenders, suppliers, stockholders, potential investors, and government agencies are other users

6. Users of Accounting Information

7. Different Types of Accounting
Managerial accounting provides managers and employees within the organization with information needed to make decisions about a firm’s financing, investing, marketing, and operating activities.
Financial accounting generates financial statements and reports for interested people outside an organization.

8. Using the Internet www.aicpa.org
The American Institute of Certified Public Accountants (AICPA) is the preeminent governing body of the profession. Its website includes online articles and publications, guidelines, career resources, and links to other sites important to the field of accountancy.

9. 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)
Double-entry bookkeeping system: each financial transaction is recorded as two separate accounting entries to maintain the balance of the accounting equation

10. The Accounting Process (cont.)
The accounting cycle
Done on a regular basis-gather receipts, record in journal, post in general ledger
Done at the end of the period
Prepare the trial balance of all general ledger accounts
Prepare financial statements
Close the books

11. The Accounting Cycle 1. Analyzing source documents (receipts etc)
2. Recording transactions (journal)
3. Posting transactions (general ledger)
4. Preparing the trial balance
5. Preparing the financial statements

12. The 3 Most Important Financial Statements
Balance Sheet
Income Statement
Cash Flow Budget

13. Balance Sheet

14. The Balance Sheet must balance!!
Total Assets
Liabilities + Owners Equity

15. 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
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, marketable securities, accounts receivable, notes receivable, merchandise inventory, and prepaid expenses

16. The Balance Sheet (cont.)
Assets (cont.)
Fixed assets—will be held or used for a period longer than one year
Land, buildings, and equipment
Depreciation
Intangible assets—do not exist physically but have a value based on the rights or privileges they confer on the firm
Patents, copyrights, trademarks, and goodwill

17. The Balance Sheet (cont.)
Liabilities
Current liabilities—debts to be repaid in one year or less
Accounts payable—short-term obligations
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

18. The Balance Sheet (cont.)
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—stockholders’ equity
Retained earnings—profits not distributed to stockholders

19. Balance Sheet Assets Listed
Most Liquid
Least Liquid

20. Most liquid to Least liquid
Break into teams for this exercise

21. 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

22. The Income Statement (cont.)
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

23. The Income Statement (cont.)
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

24. Find Operating Expenses
Brainstorming Exercise

25. Business Income Statement

26. Class Exercise
For each of the following accounts, indicate whether it belongs on a balance sheet or an income statement.
Rent
Cash
Patent
Mortgage payment
Net income
Salaries payable
Purchase
Delivery equipment
Sales
Cost of goods sold
Common stock

27. Personal Income Statement

28. 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 assets and investments)
Cash flows from financing activities (changes in debt obligation and owners’ equity accounts)

29. Statement of Cash Flows

30. Comparison of Financial Statements
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

31. Evaluating Financial Statements
Using accounting information to evaluate a potential investment or to see if a firm is healthy
Use common sense to interpret the numbers.
Determine the firm’s ability to pay its debts and borrow money in the future.
Understand the financial ratios. (compare them to the ratios for other businesses in that industry)
Data are available from annual reports of public corporations.
Industry averages are available from Dun & Bradstreet, Standard & Poor’s, and industry trade associations.

32. 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, income statement, and statement of cash flows

33. Financial Ratios (cont.)

34. 4 Kinds of Ratios
Profitability Ratios
Short-term Ratios
Activity Ratios
Debt-to-Owner’s Equity Ratio

35. Profitability Ratios
Return on Sales
Return on Owner’s Equity
Earnings Per Share

36. Return on Sales Also called “Profit Margin”
Answers the question: “How effectively is firm turning sales into profits?”
Return on Sales = Net income after taxes
Net Sales
Example: Northeast Art Supply
Return on Sales = $30,175 = .067 = 6.7%
$451,000
Compare your answer to industry average of 4-5%.

37. Return on Owner’s Equity
Answers: “How much income is generated by each dollar of equity?”
Return on Owner’s Equity = Net income after taxes
Owner’s Equity
Example: Northeast Art Supply
Return on Owner’s Equity = $30,175 = .13 = 13%
$230000
Compare your answer to industry average of 12-15%.

38. Earnings Per Share
Answers: “How much income is being contributed toward each share of stock?”
Earnings Per Share = Net income after taxes
Common stock shares outstanding
Example: Northeast Art Supply
Earnings Per Share = $30,175 = $1.21 per share
25000
Comparisons are not helpful if comparing to other businesses, but stockholders will compare to other stock they hold or are thinking about buying.

39. Short-term Ratios: Working Capital
Answers: “If our creditors came calling today would we be able to pay our bills?”
Working Capital = Current Assets-Current Liabilities
Example: Northeast Art Supply
Working Capital= $182,000-$70000 = $112,000
If this isn’t enough to pay our bills, we may have to borrow. Not an ideal situation.

40. Short-term Ratios: Current Ratio
Answers: “For every $1 of current assets that we have, how much current liabilities do we have?”
Current Ratio = Current Assets
Current Liabilities
Example: Northeast Art Supply
Current Ratio = $182,000 = 2.6
$70,000
We have $2.60 in assets for every $1 in liabilities.
Compare that to the industry average of 2.0.

41. Short-term Ratios: Quick Ratio (the “Acid Test”)
Answers: “If we had to liquidate quickly and pay all our debts, but we didn’t have time to sell off inventory, would we be able to pay all our debts?”
Quick = Cash+Marketable Securities +All Receivables
Current Liabilities
Example: Northeast Art Supply
Current Ratio =$139,000 = 1.99
$70,000
If your answer is higher than 1 (the minimum desired quick ratio) then it shows that you are able to pay your current liabilities quickly.

42. Activity Ratios (“How many times a year do we do…….?”)
Two Activity Ratios:
Acounts Receivable Turnover
Inventory Turnover

43. Activity Ratios (“How many times a year do we do…….?”)
Answers: “How many times in one year do we collect our accounts receivable?”
Accounts Receivable Turnover =
Net Sales
Accounts Receivable
Example: Northeast Art Supply
AR Turnover =$451,000 = times per year
$38,000
An AR Turnover of 11.9 times per year is about every 30 days.
If your policy says that invoices are due every 25 days, then an AR Turnover of 30 days is within reason.
Hard to compare one company’s AR Turnover to another’s.

44. Activity Ratios (“How many times a year do we do…….?”)
Answers: “How many times in one year do we sell our inventory?”
Inventory Turnover = COGS
Average Inventory
Average Inventory = Beginning + Ending Inventory 2
Example: Northeast Art Supply
Inventory Turnover = $334,000 = 8.2 times per year
$40,500
Compare this to the industry average of 9.

45. Debt-to-Owner’s Equity Ratio
Answers: “How much of our operations are financed through borrowing?”
Debt-to-Owner’s Equity = Total Liabilities
Owner’s Equity
Example: Northeast Art Supply
Debt-to-Owner’s Equity = $110,000 = .48 = 48%
$230,000
The higher this ratio, the riskier it is for lenders so they may hesitate to lend you more money.

46. 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

47. 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.

48. 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.

49. 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.