2. Financial Information and Accounting Concepts
Chapter 17

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Learning Objectives
Define accounting and describe the roles of private and public accountants
Explain the impact of accounting standards such as GAAP and the Sarbanes-Oxley Act on corporate accounting
Describe the accounting equation and explain the purpose of double-entry bookkeeping and the matching principle
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Learning Objectives
Identify the major financial statements and explain how to read a balance sheet
Explain the purpose of the income statement and the statement of cash flows
Explain the purpose of ratio analysis and list the four main categories of financial ratios
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5. Understanding Accounting
Measuring, interpreting, and communicating financial information to support internal and external decision-making
Accounting is the system a business uses to identify, measure, and communicate financial information to others, inside and outside the organization. Accurate and timely financial to businesses for two reasons: First, it helps managers and owners plan and control a company’s operations and make informed business decisions. Second, it helps outsiders evaluate a business. Suppliers, banks, and other parties want to know whether a business is creditworthy; shareholders and other investors are concerned with its profit potential; government agencies are interested in its tax accounting.
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6. Understanding Accounting
Financial Accounting
The area of accounting concerned with preparing financial information for users outside the organization
Management Accounting
The area of accounting concerned with preparing data for use by managers within the organization
Because outsiders and insiders use accounting information for different purposes, accounting has two distinct facets. Financial accounting is concerned with preparing financial statements and other information for outsiders such as stockholders and creditors (people or organizations that have lent a company money or have extended its credit); management accounting is concerned with preparing cost analyses, profitability reports, budgets, and other information for insiders such as management and other company decision makers. To be useful, all accounting information must be accurate, objective, consistent over time, and comparable to information supplied by other companies.
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Private Accountants
Private Accountants
In-house accountants employed by organizations and businesses other than a public accounting firm
Also called corporate accountants
Private accountants work for corporations, government agencies, and not-for-profit organizations. Their titles vary by function and include corporate accountant, managerial accountant, and cost accountant.
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8. Private Accountants (cont.)
Controller
The highest-ranking accountant in a company, responsible for overseeing all accounting functions
Certified Public Accountants (CPAs)
Professionally licensed accountants who meet certain requirements for education and experience and who pass a comprehensive examination
Private accountants generally work together as a team under the supervision of the organization’s controller, who reports to the vice president of finance or the chief financial officer (CFO). Exhibit 17.1 shows the typical finance department of a large company. In smaller organizations, the controller may be in charge of the company’s entire finance operation and report directly to the president.
Although certification is not required of private accountants, many are licensed certified public accountants (CPAs). Specific requirements vary by state, but to receive a CPA license, an individual must complete a certain number of hours of college-level coursework, have a minimum number of years of work experience in the accounting field, and pass the Uniform CPA Exam.
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Public Accountants
Public Accountants
Professionals who provide accounting services to other businesses and individuals for a fee
Audit
Formal evaluation of the fairness and reliability of a client’s financial statements
In contrast to private accountants, public accountants are independent of the businesses, organizations, and individuals they serve. Most public accountants are employed by public accounting firms that provide a variety of accounting and consulting services to their clients. The largest of these, four international networks known as the “Big Four,” are Deloitte Touche Tohmatsu ( Ernst & Young ( KPMG ( and Pricewaterhouse Coopers, or PwC (
CPAs and must obtain CPA and state licensing certifications before they are eligible to conduct an audit—a formal evaluation of a company’s accounting records and processes to ensure the integrity and reliability of a company’s financial statements.
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10. Typical Finance Department
Exhibit 17.1
Here is a typical finance department of a large company. In smaller companies, the controller may be the highest-ranking accountant and report directly to the president. The top executive in charge of finance is often called the chief financial officer (CFO).
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11. The Rules of Accounting
GAAP (Generally Accepted Accounting Practices)
Standards and practices used by publicly held corporations in the United States and a few other countries in the preparation of financial statements; on course to converge with IFRS
To help ensure consistent financial reporting so that all stakeholders understand what they’re looking at, over the years regulators, auditors, and company representatives have agreed on a series of accounting standards and procedures. GAAP (generally accepted accounting principles), overseen in the United States by the Financial Accounting Standards Board (FASB), aims to give a fair and true picture of a company’s financial position and to enable outsiders to make confident analyses and comparisons. GAAP can’t prevent every reporting abuse, but it does make distorting financial results in order to fool outsiders more difficult.
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12. The Rules of Accounting
External Auditors
Independent accounting firms that provide auditing services for public companies
International Financial Reporting Standards (IFRS)
Accounting standards and practices used in many countries outside the United States
As Chapter 18 notes, companies whose stock is publicly traded in the United States are required to file audited financial statements with the Securities and Exchange Commission (SEC). During an audit, CPAs who work for an independent accounting firm, also known as external auditors, review a client’s financial records to determine whether the statements that summarize these records have been prepared in accordance with GAAP.
Most other countries use international financial reporting standards (IFRS) maintained by the London-based International Accounting Standards Board. After a decade-long effort to harmonize the GAAP and IFRS, the two systems are closer in some respects but still different in some significant ways. The prospect of further modifying or even replacing GAAP remains controversial because IFRS isn’t as strict as GAAP in some key reporting areas and the transition cost for U.S. companies would be significant.
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Sarbanes-Oxley
Sarbanes-Oxley
The informal name of comprehensive legislation designed to improve integrity and accountability of financial information
Its major provisions include:
• Outlawing most loans by corporations to their own directors and executives
• Creating the Public Company Accounting Oversight Board (PCAOB) to oversee external auditors
• Requiring corporate lawyers to report evidence of financial wrongdoing
• Prohibiting external auditors from providing certain non-audit services
• Requiring that audit committees on the board of directors have at least one financial expert and that the majority of board members be independent (not employed by the company in an executive position)
• Prohibiting investment bankers from influencing stock analysts
• Requiring CEOs and CFOs to sign statements attesting to the accuracy of their financial statements
• Requiring companies to document and test their internal financial controls and processes
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14. Fundamental Accounting Concepts
Assets
Any things of value owned or leased by a business
Liabilities
Claims against a firm’s assets by creditors
Owners’ Equity
The portion of a company’s assets that belongs to the owners after obligations to all creditors have been met
For thousands of years, businesses and governments have kept records of their assets— valuable items they own or lease, such as equipment, cash, land, buildings, inventory, and investments. Claims against those assets are liabilities, or what the business owes to its creditors—such as lenders and suppliers. For example, when a company borrows money to purchase a building, the lender has a claim against the company’s assets. What remains after liabilities have been deducted from assets is owners’ equity.
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15. The Accounting Equation
The basic accounting equation, stating that assets equal liabilities plus owners’ equity
Using the principles of algebra, this equation can be restated in a variety of formats. The most common is the simple accounting equation, which serves as the framework for the entire accounting process.
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16. Double-Entry Bookkeeping and The Matching Principle (cont.)
Depreciation
An accounting procedure for systematically spreading the cost of a tangible asset over its estimated useful life
Depreciation, or the allocation of the cost of a tangible long-term asset over a period of time, is another way that companies match expenses with revenue. (For intangible assets, this allocation over time is known as amortization.)
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17. Using Financial Statements: The Balance Sheet
A statement of a firm’s financial position on a particular date; also known as a statement of financial position
Fiscal Year
Any 12 consecutive months used as an accounting period
The balance sheet, also known as the statement of financial position, is a snapshot of a company’s financial position on a particular date (see Exhibit 17.3 on page 396). In effect, it freezes all business actions and provides a baseline from which a company can measure change from that point forward. This statement is called a balance sheet because it includes elements in the accounting equation and shows the balance between assets on one side of the equation and liabilities and owners’ equity on the other side.
Every company prepares a balance sheet at least once a year, most often at the end of the calendar year, covering January 1 to December 31. However, many business and government bodies use a fiscal year, which may be any 12 consecutive months.
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The Accounting Cycle
Perform transactions
Analyze and record transactions in a journal
Post journal entries to the ledger
Prepare a trial balance
Here are the general steps in the accounting process, or accounting cycle, from recording transactions to making sure the books are in balance to
closing the books for a particular accounting period (usually a month). Steps 1 through 3 are done as transactions occur; steps 4 through 8 are usually
performed at the end of the accounting period.
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19. The Accounting Cycle (cont.)
Make adjusting entries, as needed
Prepare an adjusted trial balance
Prepare financial statements
Close the books for the accounting period
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Balance Sheet
Current Assets
Cash and items that can be turned into cash within one year
Fixed Assets
Assets retained for long-term use, such as land, buildings, machinery, and equipment
also referred to as property, plant, and equipment
The asset section of the balance sheet is often divided into current assets and fixed assets. Current assets include cash and other items that will or can become cash within the following year, such as short-term investments such as money-market funds and accounts receivable (amounts due from customers). Fixed assets (sometimes referred to as property, plant, and equipment) are long-term investments in buildings, equipment, furniture and fixtures, transportation equipment, land, and other tangible property used in running the business. Fixed assets have a useful life of more than one year.
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Balance Sheet (cont.)
Current Liabilities
Obligations that must be met within a year
Long-Term Liabilities
Obligations that fall due more than a year from the date of the balance sheet
Liabilities may be current or long term, and they are listed in the order in which they will come due. The balance sheet gives subtotals for current liabilities (obligations that will have to be met within one year of the date of the balance sheet) and long-term liabilities (obligations that are due one year or more after the date of the balance sheet), and then it gives a grand total for all liabilities.
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Balance Sheet (cont.)
Retained Earnings
The portion of shareholders’ equity earned by the company but not distributed to its owners in the form of dividends
In a corporation, the shareholders’ total investment value is the sum of two amounts: the total value of the all the shares currently held, plus retained earnings—cash that is kept by the company rather than distributed to shareholders in the form of dividends.
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23. Using Financial Statements: Income and Cash Flow Statements
Income Statement
A financial record of a company’s revenues, expenses, and profits over a given period of time
also known as a profit and loss statement
If the balance sheet is a snapshot, the income statement is a movie. The income statement, or profit-and-loss statement or simply “P&L,” shows an organization’s profit performance over a period of time, typically one year.
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24. Using Financial Statements: Income and Cash Flow Statements (cont.)
Expenses
Costs created in the process of generating revenues
Net Income
Profit earned or loss incurred by a firm, determined by subtracting expenses from revenues
referred to as the bottom line
The income statement summarizes revenue from all sources as well as all expenses, the costs that have arisen in generating revenues. Expenses and income taxes are then subtracted from revenues to show the actual profit or loss of a company, a figure known as net income—also called profit or, informally, the bottom line.
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25. Using Financial Statements: Income and Cash Flow Statements (cont.)
Cost of Goods Sold
The cost of producing or acquiring a company’s products for sale during a given period
Gross Profit
The amount remaining when the cost of goods sold is deducted from net sales
also known as gross margin
If a company manufactures or purchases inventory, the cost of storing the product for sale (such as heating the warehouse, paying the rent, and buying insurance on the storage facility) is added to the difference between the cost of the beginning inventory and the cost of the ending inventory in order to compute the actual cost of items that were sold during a period—or the cost of goods sold. The computation can be summarized as follows:
Cost of goods sold = Beginning inventory + Net purchases − Ending inventory.
As shown in Exhibit 17.4, cost of goods sold is deducted from sales to obtain a company’s gross profit—a key figure used in financial statement analysis. In addition to the costs directly associated with producing goods, companies deduct operating expenses, which include both selling expenses and general expenses, to compute a firm’s net operating income.
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26. Using Financial Statements: Income and Cash Flow Statements (cont.)
Operating expenses
All costs of operation that are not included under cost of goods sold.
As shown in Exhibit 17.4, cost of goods sold is deducted from sales to obtain a company’s gross profit—a key figure used in financial statement analysis. In addition to the costs directly associated with producing goods, companies deduct operating expenses, which include both selling expenses and general expenses, to compute a firm’s net operating income.
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27. Using Financial Statements: Income and Cash Flow Statements (cont.)
EBITDA
Earnings before interest, taxes, depreciation, and amortization.
An alternative—and controversial—measure of profitability is earnings before interest, taxes, depreciation, and amortization, or EBITDA. Because it doesn’t include various items such as the interest payments on loans or the effects of depreciating expensive capital equipment, EBITDA is viewed by some investors as a “purer” measure of profitability and an easier way to compare financial performance across companies or industries. And even though it is a non-GAAP indicator and must be labeled as such, many public companies publish EBITDA because it can suggest greater profitability than the standard operating profit number.
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28. Statement of Cash Flows
A statement of a firm’s cash receipts and cash payments that presents information on its sources and uses of cash.
In addition to preparing a balance sheet and an income statement, all public companies and many privately owned companies prepare a statement of cash flows, or cash flow statement, to show how much cash the company generated over time and where it went (see Exhibit 17.5).
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Profitability Ratios
Earnings Per Share
A measure of a firm’s profitability for each share of outstanding stock, calculated by dividing net income after taxes by the average number of shares of common stock outstanding
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Liquidity Ratios
Working Capital
Current assets minus current liabilities
Current Ratio
A measure of a firm’s short-term liquidity, calculated by dividing current assets by current liabilities
A company’s working capital (current assets minus current liabilities) is an indicator of liquidity because it represents current assets remaining after the payment of all current liabilities. The dollar amount of working capital can be misleading, however. For example, it may include the value of slow-moving inventory items that cannot be used to help pay a company’s short-term debts.
A different picture of the company’s liquidity is provided by the current ratio—current assets divided by current liabilities. This figure compares the current debt owed with the current assets available to pay that debt.
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31. Liquidity Ratios (cont.)
Quick Ratio
A measure of a firm’s short-term liquidity, calculated by adding cash, marketable securities, and receivables, then dividing that sum by current liabilities
Also known as the acid-test ratio
The quick ratio, also called the acid-test ratio, is computed by subtracting inventory from current assets and then dividing the result by current liabilities. This ratio is often a better indicator of a firm’s ability to pay creditors than the current ratio because the quick ratio leaves out inventories, which can take a long time to convert to cash. A quick ratio below 1.0 is a sign that the company could struggle to meet its near-time financial obligations and therefore might not be a safe credit risk, a good investment, or possibly a smart place to accept a job.
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Activity Ratios
Inventory Turnover Ratio
A measure of the time a company takes to turn its inventory into sales, calculated by dividing cost of goods sold by the average value of inventory for a period
Activity ratios analyze how well a company is managing and making use of its assets. For companies that maintain inventories, the most common activity ratio is the inventory turnover ratio, which measures how fast a company’s inventory is turned into sales. Inventory is a constant balancing act—hold too little, and you risk being out of stock when orders arrive; hold too much, and you raise your costs. When inventory sits on the shelf, money is tied up without earning interest; furthermore, the company incurs expenses for its storage, handling, insurance, and taxes.
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