Chapter 17 Understanding Accounting and Financial Information

Chapter 17 Understanding Accounting and Financial Information I. The Role of Accounting Information Accounting Definition: the recording, classifying, summarizing, and interpreting of financial events and transactions that affect an organization. All purchases are grouped together and all sales transactions together Helps managers make well informed decisions FASB Definition: Financial Accounting Standards Board Defines the generally accepted accounting principles (GAAP) that accountants must follow II. The Accounting Cycle The Accounting Cycle Definition: a six step procedure that results in the preparation and analysis of major financial statements 1. Analyze source documents (sales slips, travel records, etc.) 2. Record transactions into journals 3. Transfer entries to ledger 4. Take a trial balance 5. Prepare financial statements (balance sheet, income statement, statement of cash flows) 6. Analyze financial statements Journal Definition: The record book or computer program where accounting data is first entered Ledger Definition: a specialized accounting book or computer program Transfer information from accounting journals into specific categories Trial Balance Definition: a statement of all debits and credits in a double-entry account book, with any disagreement indicating an error. Accounting System Definition: method used to record and summarize accounting data into reports Includes inputs, processing, and outputs assets =liabilities +owners equity Bookkeeping Definition: The recording of business transactions, basic part of financial reporting 1. Divide all the firm's transactions into meaningful categories 2. Record financial data from the original transaction into journal 3. Record financial data into ledger Record transactions in two places so they can check one list of transactions against the other to make sure both add up to the same amount is called double entry bookkeeping Trial Balance Definition: summary of all the financial data in the account ledgers that ensures the figures are correct and balanced Sole Proprietorship Definition: a company that uses a capital account for owners equity III. Understanding Key Financial Statements Accounting Statement Definition: the method a company uses to record and summarize accounting data into reports Financial (Income) Statements Definition: summary of all the financial transactions that have occured over a particular period Indicate a firm's financial health and stability Key factors in management's decision making Balance Sheet Definition: the financial statement that reports a firm's financial condition at a specific time. The assets are equal to or “balanced” with the liabilities and owner's equity On a specific day Assets Definition: economic resources owned by a firm Productive, tangible items such as equipment, buildings, land, furniture, motor vehicles etc. Include intangible items such as trademarks, copyrights, and goodwill. ● Current Assets items that can or will be converted into cash within one year. Cash, accounts receivable, inventory. ○ Accounts Receivable: money owed that is going to come in. ○ Notes Receivable: money that was loaned out that is being paid back. ● ● Fixed Assets long term assets that are relatively permanent, hard to sell, such as land buildings and equipment. Intangible Assets long term assets that have no physical form but do have value. Patents, trademarks, copyrights, and goodwill. ○ Goodwill: attached factors to a firm's reputation such as their name brand, location, employees that make them superior. assets =liabilities +owners equity Liquidity Definition: ease with which assets can be converted into cash. The speedier the conversion the higher the liquidity. Owners Equity Definition: the amount of the business that belongs to the owners minus any liabilities the business owes. ● Common Stock ● Retained Earnings value of what stockholders own in a firm minus liabilities Also called Stockholders/Shareholders Equity Liabilities Definition: what business owes to others, the debts. ● Current Liabilities liabilities that are due in one year or less and have not yet been paid ○ Accounts Payable: supplies bought that have to be paid back, “net 60, net 30” ○ Notes Payable: loans due within the next 12 months ○ Accrued Taxes: ○ Accrued Salaries: ● Long-Term Liabilities are short or long term liabilities (such as loans) that a business promises to repay by a certain date. ○ Notes Payable that are due later than one year ○ Bonds Payable: long term liabilities that must be paid back such as loans from bondholders. total liabilities=current liabilities+long term liabilities Income Statements Definition: the financial statement that shows a firm's profit or loss after costs, expenses and taxes. Summarizes all revenue over a particular period of time ● Revenues ○ Gross Sales ○ Sales Discounts ○ Net Sales ● Cost Of Goods Sold: Definition: the cost of merchandise the firm sells or the cost of the raw materials and supplies used in production. cost of goods sold=beginning inventory + purchases −end inventory + freight ○ Beginning Inventory: how much is at the beginning ○ Merchandise Purchases: buying more inventory ○ End inventory= how much inventory is available at end of time. ○ Freight: cost of shipping ● Gross Profit Definition: how much a business earned by buying/making and selling merchandise. Money made - cost of goods ● Operating Expenses: fixed, cost you even if you don't sell anything ○ Selling expenses ■ Salaries for salespeople ■ Advertising ■ Supplies ○ General expenses ■ Office salaries ■ Depreciation ■ Insurance ■ Rent ■ Light, heat, power Retained Earnings Definition: accumulated earnings from the firm's profitable operations that are reinvested in the business and not paid out to stockholders in distributions of company profits. Net Income Definition: the revenue left over Also known as the bottom line Net Loss Definition: the revenue depleted Depreciation Definition: the write-off of the cost of a tangible asset over its estimated useful life. Accumulated over time. true value=original cost−accumulated depreciation Statement of Cash Flows Definition: reports the cash receipts and cash disbursements related to the three major activities of a firm. 1. Operations: Cash transactions associated with running a business 2. Investments: cash used in or provided by the firms investment activities 3. Financing: Cash raised by taking on new debt. Cash used to pay business expenses, past debts or company dividends. Cash Flow Definition: the difference between cash coming in and cash going out of a business. IV. Analyzing Financial Performance Using Ratios Ratio Analysis Definition: the assessment of a firm's financial conditions using calculations and financial ratios Useful in comparing the company's performance to its financial objectives, and comparing one firm to another in the same industry. Liquidity Ratios Definition: measures a firm's ability to turn assets into cash to pay its short term debts ● Current Ratio Definition: a liquidity ratio, ratio of a firm's current assets to its current liabilities. Measured in Dollars. Anything higher than a 2.0 is better or considered a safe risk for lenders. current ratio=current assets ÷ current liabilities ● Acid Test/ Quick Ratio Definition: measures the cash, marketable securities and receivables of a firm compared to current liabilities. Inventories are less liquid than all current assets so you remove it from the equation. Measured in Percent. Anything between 0.5-1 is satisfactory. Acid Test Ratio= cash+ accounts receivable+marketable securities current liabilities Leverage (Debt) Ratios Definition: measures the degree to which a firm relies on borrowed funds in its operations. Anything over 100% means that the firm has more debt than equity, higher means it's quite risky. Debt ¿ owners equity ratio=total liabilities ÷ owners equity Profitability (Performance) Ratios Definition: measures how effectively a firm's managers are using its various resources to achieve profits. ● Earnings Per Share Definition: Earnings Per Share, have to be reported in two ways 1. Basic EPS: helps determine the amount of profit a company earned for each share of outstanding common stock. Cost of shares. basic EPS=net income after taxes ÷ number of common stock shares outstanding ● 2. Diluted EPS: measures the amount of profit earned for each share of outstanding common stock. Shares that have been approved but not issued to the public Return on Sales Definition: tells whether the firm is doing well as its competitors in generating income from sales. Returnon Sales=net income ÷ net sales ● Return on Equity Definition: measures risk by telling how much a firm earned for each dollar invested by its owners. Anything over 15% is considered a reasonable return. Returnon Equity=net income after tax ÷ total owners equity Activity Ratios Definition: how effectively management is turning over inventory Inventory turnover ratio measures the speed that inventory moves through the firm and gets converted into sales Measures the effectiveness of a firm's management in using the assets that are available. Measures the effectiveness of managers in the basic function of creating profits inventory turnover=cost of goods sold ÷ average inventory PE Ratio Definition: how much investors are willing to pay for $1 of earnings from company. Good to compare to different companies. What is the expectations of a company's growth. PE Ratio=stock price (fiscal year ends)÷ earnings per share V. Accounting Disciplines Financial Accounting Definition: financial information and analyses for people primarily outside of the organization. Annual Report Definition: a yearly statement of the financial condition, progress and expectations of an organization Is the organization profitable? Is it able to pay its bills? How much debt do they owe? Managerial Accounting Definition: measuring production costs, preparing budgets, controlling Auditing Definition: reviewing information Chief Financial Officer Definition: user of managerial accounting information Independent Audit Definition: evaluation and unbiased opinion about the accuracy of a company's financial statement Tax Accounting Nonprofit Accounting