1. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. CHAPTER 14 Understanding Accounting Issues

2. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-2 Learning Objectives Explain the role of accountants and distinguish between the kinds of work done by public and private accountants. Explain how the accounting equation and double-entry accounting are used in record keeping. Describe the three basic financial statements and show how they reflect the activity and financial condition of a business. Explain the key standards and principles for reporting financial statements. Show how computing key financial ratios can help in analyzing the financial strengths of a business. Explain some of the special issues facing accountants at firms that do international business.

3. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-3 Accounting Definitions Accounting a comprehensive system for collecting, analyzing, and communicating financial information Bookkeeping recording accounting transactions Accounting information system (AIS) Controller an individual who manages a firm’s operating activities

4. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-4 Users of Accounting Information Business managers set goals & budgets develop plans evaluate opportunities Employees and unions to get paid to plan and receive benefits Government regulatory agencies protect investors’ interests Investors and creditors estimate returns, future growth & credit risk Taxing authorities plan for tax inflows determine tax liabilities aid in collection

5. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-5 Financial Accounting Keeps interested external parties informed about the firm’s financial condition Requires preparation of statements and reports structured according to GAAP requirements Data are summarized to record financial transactions that have occurred in previous reporting periods (historical reports)

6. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-6 Managerial Accounting Keeps internal parties (managers) apprised of how the firm is doing financially with current projects and departmental initiatives Enables managers to keep on top of business circumstances Provides information to facilitate planning, forecasting and decision making

7. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-7 Public Accountants Work as external accountants (CA,CMA,CGA) Auditing examination of financial records to ensure proper procedures have been used Forensic accounting tracking down hidden funds in business firms (generally part of a criminal investigation) Management services advising from personal financial planning to business planning

8. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-8 Tax Services Tax services include helping clients, not only with preparing their tax returns, but also in their tax planning May help a business restructure its operations and services to save dollars in taxes Accountants must stay abreast of developments in the tax law in order to serve clients effectively

9. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-9 Accounting Tools Journal a chronological record of a firm’s financial transactions with a brief description of each transaction Ledger summations of journal entries, by category, that show the effects of transactions on the balance of each account

10. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-10 The Accounting Equation Asset anything of economic value owned by a firm or individual Liability any debt owed by a firm or an individual to others Owners’ Equity any positive difference between a firm’s assets & liabilities Accounting Equation Assets = Liabilities + Owners’ Equity

11. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-11 Double-Entry Bookkeeping System Every transaction must be entered in two ways how it affects assets & how it affects liabilities The accounting equation is always kept in balance

12. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-12 Double Entry Bookkeeping Every account is divided into two sides a debit and a credit Each account is recorded in a T-Account DebitCredit Any Asset or Liability Account Increase in Asset Decrease in Liability/ Owners’ Equity Increase in Liability/ Owners’ Equity Decrease in Asset

13. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-13 Financial Statements Balance Sheet presents the accounting equation factors assets, liabilities, owners’ equity Income or Profit-and-Loss Statement presents revenues and expenses & profits (losses) Statement of Changes in Cash Flow presents generation, and use, of cash

14. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-14 The Balance Sheet

15. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-15 Current Assets Cash and assets that can be converted into cash within the year Accounts receivable amounts owed to the firm by customers Inventory cost of merchandise acquired for sale but not yet sold Prepaid expenses supplies on hand and rent (other bills) paid for coming period

16. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-16 Other Assets Fixed assets have a long-term use or value land, buildings, machinery Depreciation distributing the cost of a major asset over its lifetime, deducted yearly Intangible assets patents, trademarks, copyrights, franchise fees

17. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-17 Liabilities Current liabilities debts owed by the firm that must be repaid within one year Long-term liabilities debts owed by the firm and due in more than one year Owners’ equity: owners’ holdings in the firm retained earnings: net profits less dividends paid to shareholders paid-in capital: money invested by owners common stock: value of shares in the company

18. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-18 The Income Statement

19. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-19 Revenues Monies received by a firm as a result of Selling its product or service Return on investments Rent Licensing fees

20. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-20 Cost of Goods Sold and Gross Profit Expenses directly incurred as a result of producing or selling the good or service in a given time period Gross profit (gross margin) =Revenues - cost of goods sold

21. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-21 Operating Expenses All other costs of doing business including supplies and salaries Net income (net profit or net earnings) =Gross Margin (Profit) - Expenses

22. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-22 Changes in Cash Flows Operations cash from buying and selling of goods and services Investments cash from investment activities (receipts, bonds, stocks, property, equipment) Financing cash from financing activities (dividends, borrowing or issuing stocks, repayment of borrowings)

23. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-23 The Budget

24. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-24 Revenue Recognition The formal recording and reporting of revenues in financial statements once the earnings cycle is completed The sale is complete and the product has been delivered The sale price to the customer has been collected, or is collectable (accounts receivable)

25. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-25 The Matching Principle Expenses will be matched with revenues to determine net income for an accounting period Revenue recognition is matched with expense recognition to determine net income when the earnings cycle is completed Allows users to identify the net income gain for the accounting period

26. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-26 Full Disclosure Financial statements should include numbers, but they should also include interpretations and explanations by management Allows users of the financial statements to understand the circumstances underlying the financial results Allows for more accurate use of financial information

27. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-27 Management’s Discussion & Analysis An interpretation “as seen through the eyes of management” Goes beyond full disclosure in the financial statement to include Manager’s qualitative analysis Detailed discussion of the firm’s activities Allows investors to “judge” the quality of earnings, debt, and assets, to determine if past earnings are a good indicator of future success

28. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-28 Analyzing Financial Statements Key ratios are used to interpret & compare results of financial statements for firms and/or industries Ratios are classified into four groups short-term solvency long-term solvency profitability activity

29. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-29 Short-Term Solvency Ratios Measure the company’s liquidity The higher the ratio, the lower the risk of inability to pay Current Ratio Quick Ratio Current Assets Current Liabilities Quick Assets Current Liabilities

30. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-30 Long-Term Solvency Ratios Measure the company’s ability to pay long-term debts the higher the ratio, the greater the risk of inability to pay also known as Debt Ratios Debt-to-Owners’ Equity Ratio: Debt Owners’ Equity

31. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-31 Profitability Ratios Measure overall company profitability for potential investors the higher the ratio, the more profitable the firm Return on Sales Return on Investment Earnings per Share Net Income Sales Net Income Total Owner’s Equity Net Income # Outstanding Common Shares

32. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-32 Activity Ratios Measure how efficiently the company uses its resources the higher the ratio, the lower the risk of inability to pay Inventory Turnover Ratio Cost of Goods Sold Average Inventory

33. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-33 International Accounting Firms buying and selling products in other countries must adjust the values of revenues and expenses to reflect exchange rates for the foreign currency When the Canadian dollar increases relative to a foreign currency, a firm may enjoy a gain Factors to consider include representing values in Canadian dollars with appropriate exchange rates reflecting gains or losses due to exchange rate changes

34. Business Fifth Canadian edition, Griffin, Ebert & Starke © 2005 Pearson Education Canada Inc. 14-34 International Accounting Standards Professional associations in over 80 countries are members of the International Accounting Standards Committee (IASC) Goal is to eliminate differences in financial reporting from country to country Standardization is far from universal Uniform format is not required across all nations for financial statements, and individual financial accounts (I.e.: inventory) are not consistently treated