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LO 14-1 Define accounting and describe the different uses of accounting information. LO 14-2 Demonstrate the accounting process. LO 14-3 Examine the various components of an income
statement to evaluate a firm’s bottom line. LO 14-4 Interpret a company’s balance sheet to determine its
current financial position. LO 14-5 Analyze the statement of cash flows to evaluate the
increase and decrease in a company’s cash balance. LO 14-6 Assess a company’s financial position using its
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The Nature of Accounting
Accounting • The recording, measurement and interpretation of
financial information
Certified Public Accountant (CPA)
• An individual who has been state certified to provide accounting services ranging from the preparation of financial records and the filing of tax returns to complex audits of corporate financial records
After the accounting scandals of Enron and Worldcom in the early 2000’s, Congress passed the: • Sarbanes-Oxley Act – required firms to be more
rigorous in their accounting and reporting practices During the latest financial crisis, banks developed questionable lending practices, leading to: • Dodd Frank Act – strengthens the oversight of financial
institutions
DID YOU KNOW? Corporate fraud costs are estimated as $3.7 trillion annually
Accounting Standards Different entities have different standards for their accounting
methods
Public and private businesses follow the Generally Accepted Accounting Principles (GAAP) method GAAP is generally used in the United States as the standard for
accounting methods (established by the Financial Accounting Standards Board (FASB))
Local government entities have a different set of accounting standards which are set by the Governmental Accounting Standards Board (GASB)
Federal government follows yet another set of standards determined by the Federal Accounting Standards Advisory Board (FASAB)
Another set of standards for international companies which follow the International Financial Reporting Standards (IFRS)
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Private Accountants
Private Accountants
• Employed by large corporations, government agencies, and other organizations to prepare and analyze their financial statements • Deeply involved in most of the most important
• A firm’s economic resources, or items of value that it owns, such as cash, inventory, land, equipment, buildings, and other tangible and intangible things
Assets
• Debts that a firm owes to others
Liabilities
• Equals assets minus liabilities and reflects historical values
• The process of spreading the costs of long-lived assets such as building and equipment over the total number of accounting periods in which they are expected to be used
1. A manufacturer that purchases a $100,000 machine expected to last about 10 years
2. Rather than showing an expense of $100,000 in the first year and no expense for the item over the next 9 years, manufacturer allowed to depreciation expenses of $10,000/year in each of the next 10 years
3. Better matches the cost of the equipment to the years the item is used
4. Depreciation is “written off” as an expense and book value of the machine is also reduced by $10,000
• The total profit (or loss) after all expenses, including taxes, have been deducted from revenue; also called net earnings
Most companies present the current year’s results along with the previous two years’ income statements Gross profit, earnings before interest and taxes,
and net income are the results of calculations made from the revenues and expenses accounts; they are not actual accounts When corporation elects to pay dividends, it
decreases the cash account as well as a capital account
Owners’ equity includes: ♦ The owners’ contributions to the organization ♦ Along with income earned by the organization retained to
finance continued growth and development
Accounts listed as owners’ equity on a balance sheet may differ dramatically from company to company ♦ Corporations sell stock to investors, who then become
owners of the firm ♦ Many corporations issue several different classes of
common and preferred stock Each with different dividend payments and/or voting
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Pro Forma Financial Statements
Pro forma financial statements are used to make decisions about future operations changes within a company Include balance sheets, income statements, and cash flow
statements. When a company is considering a change, composing pro forma
financial statements will show
o Whether profits will increase or decrease
o The magnitude of expenses involved
o Whether the company needs financing to facilitate the proposed change
Statement of Cash Flows • Explains how the company’s cash changed from
the beginning of the accounting period to the end
Balance sheet shows the cash account in one point of time; most investors want a better picture of how cash flows into and out of the company
Statement of cash flows takes the cash balance from one year’s balance sheet and compares it with the next while providing detail about how the firm used the cash
Financial Ratios A ratio is simply one number divided by another, with the result showing the relationship between the two numbers Financial ratios are used to weigh and evaluate a firm’s
performance
Earnings of $70,000 or accounts receivable of $200,000 rarely provides as much useful information as a well-constructed ratio
Whether numbers are good or bad depends on their relation to other numbers If a company earned $70,000 on $700,000 in sales (10%
return) such an earnings level might be satisfactory
The president of the company earning this same $70,000 on sales of $7 million (1% return) should probably start looking for another job
Asset Utilization Ratios • Ratios that measure how well a firm uses its
assets to generate each $1 of sales
Managers use asset utilization ratios to pinpoint areas of inefficiency in their operations
These ratios – receivables turnover, inventory turnover, and total asset turnover – relate balance sheet assets to sales, which are found on the income statement
Liquidity Ratios • Ratios that measure the speed with which a company
can turn its assets into cash to meet short-term debt
High liquidity ratios may satisfy a creditor’s need for safety, but may indicate the company is not using its current assets efficiently
Liquidity ratios are best examined in conjunction with asset utilization ratios because high turnover ratios imply cash is flowing through very quickly
Compliance to Accounting Principles Strong compliance to accounting principles creates trust
among stakeholders ►Accounting and financial planning is important for all
organizational entities even cities ◄ City of Maricopa in Arizona received the Government Finance
Officers Association of the United States and Canada Distinguished Budget Presentation Award for its government budgeting
◄ City scored proficient in its policy, financial plan, operations guide, and communications device
► Integrity in accounting is crucial to: ◄ Create trust ◄ Understanding the financial position of an organization or entity ◄ Making financial decisions that will benefit the organization
Solve the Dilemma Exploring the Secrets of Accounting
You have been promoted from vice president of marketing of BrainDrain Co. to president and CEO
► You know marketing like the back of your hand, but know next to nothing about finance
► BrainDrain is in danger of failure if steps to correct large and continuing financial losses are not taken at once ♦ You have asked vice president of finance and accounting
for a complete set of accounting statements ♦ Detailing the financial operations of the company over the
past several years ♦ You decide to attack the problem systematically and learn
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Solve the Dilemma Exploring the Secrets of Accounting (cont.)
Searching for answers:
• With the firm’s trusted senior financial analyst by you side, you delve into the accounting statements
• Resolved to “get to the bottom” of the firm’s financial problems
• Set new course that will take the firm from insolvency and failure to financial recovery and perpetual prosperity
Discussion Questions • Describe the 3 basic
accounting statements. What types of information does each provide that can help you evaluate the situation?
• Which of the financial ratios are likely to prove to be of greatest value in identifying problem areas in the company? Why? Which of your company’s financial ratios might you expect to be especially poor?