Using Financial Information and Accounting

Using Financial Information and Accounting Accounting: More than Numbers accounting is the backbone of any business, providing a framework to understand the firm’s financial condition. Accounting is the process of collecting, recording, classifying, summarizing, reporting, and analyzing financial activities. All types of organizations—businesses, hospitals, schools, government agencies, and civic groups—use accounting procedures. provides a framework for looking at past performance, current financial health, and possible future performance. It also provides a framework for comparing the financial positions and financial performances of different firms. Financial reports include financial statements, such as balance sheets and income statements, and special reports, such as sales and expense breakdowns by product line. The accounting system generates two types of financial reports, as shown in Exhibit 14.4: internal and external. Internal reports are used within the organization. managerial accounting provides financial information that managers inside the organization can use to evaluate and make decisions about current and future operations. For instance, the sales reports prepared by managerial accountants show how well marketing strategies are working, as well as the number of units sold in a specific period of time. Financial accounting focuses on preparing external financial reports that are used by outsiders; that is, people who have an interest in the business but are not part of the company’s management. used primarily by lenders, suppliers, investors, government agencies, and others to assess the financial strength of a business. To ensure accuracy and consistency in the way financial information is reported, accountants in the United States follow generally accepted accounting principles (GAAP) when preparing financial statements. Financial Accounting Standards Board (FASB) is a private organization that is responsible for establishing financial accounting standards used in the United States. Currently there are no international accounting standards. a multinational company must make sure that its financial statements conform to both its own country’s accounting standards and those of the parent company’s country. Financial Accounting Standards Board and the International Accounting Standards Board (IASB) worked together to develop global accounting standards However, as of this writing, the two organizations have not agreed on a global set of accounting standards. Financial statements are the chief element of the annual report, a yearly document that describes a firm’s financial status. Three primary financial statements included The balance sheet The income statement The statement of cash flows The Accounting Profession Independent accountants who serve organizations and individuals on a fee basis are called public accountants offer a wide range of services, including preparation of financial statements and tax returns, independent auditing of financial records and accounting methods, and management consulting. Auditing, the process of reviewing the records used to prepare financial statements, is an important responsibility of public accountants. They issue a formal auditor’s opinion indicating whether the statements have been prepared in accordance with accepted accounting rules. The largest public accounting firms, called the Big Four, operate worldwide In order of size, they are Deloitte, PwC (PricewaterhouseCoopers), EY (Ernst & Young), and KPMG International. A former member of this group, Arthur Andersen, disbanded in 2002 To become a certified public accountant (CPA), an accountant must complete an approved bachelor’s degree program and pass a test prepared by the American Institute of CPAs (AICPA). Only CPAs can issue the auditor’s opinion on a firm’s financial statements. Most CPAs first work for public accounting firms and later may become private accountants Accountants employed to serve one particular organization are private accountants. Their activities include preparing financial statements, auditing company records to be sure employees follow accounting policies and procedures, developing accounting systems, preparing tax returns, and providing financial information for management decision-making. managerial accountants also have a professional certification program. Requirements to become a certified management accountant (CMA) include passing an examination. Investors, now aware of the possibility of various accounting shenanigans, are avoiding companies that use complicated financial structures and off-the-books financing. In 2002, the Sarbanes-Oxley Act (commonly referred to as SOX) went into effect. was designed to address the investing public’s lack of trust in corporate America. It redefines the public corporation–auditor relationship and restricts the types of services auditors can provide to clients. The Act clarifies auditor-independence issues, places increased accountability on a company’s senior executives and management, strengthens disclosure of insider transactions (an employee selling stock based on information not known by the public), and prohibits loans to executives. An independent five-member Public Company Accounting Oversight Board (PCAOB) was given the authority to set and amend auditing, quality control, ethics, independence, and other standards for audit reports. The Act specifies that all PCAOB members be financially literate. Two members must have their CPA designation, PCAOB can also inspect accounting firms; investigate breaches of securities law, standards, competency, and conduct; and take disciplinary action. Altering or destroying key audit documents now carries felony charges Other key provisions of the Act cover the following areas: Auditing standards: Financial disclosure: Financial statement certification: Internal controls: Consulting work: Basic Accounting Procedures Brother Luca Pacioli. He defined the three main accounting elements as assets, liabilities, and owners’ equity. Assets are things of value owned by a firm. Liabilities—also called debts—are what a firm owes to its creditors. Owners’ equity is the total amount of investment in the firm minus any liabilities. Another term for owners’ equity is net worth. The accounting equation must always be in balance Suppose you start a coffee shop and put $10,000 in cash into the business. At that point, the business has assets of $10,000 and no liabilities. This would be the accounting equation: The equation balances. To keep the accounting equation in balance, every transaction must be recorded as two entries. As each transaction is recorded, there is an equal and opposite event so that two accounts or records are changed. This method is called double-entry bookkeeping. Suppose that after starting your business with $10,000 cash, you borrow another $10,000 from the bank. The accounting equation will change as follows: Computerized and online accounting programs now do many different things to make business operations and financial reporting more efficient. The Balance Sheet The balance sheet, one of three financial statements generated from the accounting system, summarizes a firm’s financial position at a specific point in time. The assets are listed in order of their liquidity, the speed with which they can be converted to cash. most liquid assets come first, and the least liquid are last. Because cash is the most liquid asset, it is listed first. Buildings, on the other hand, have to be sold to be converted to cash, so they are listed after cash. liabilities due in the short term are listed before those due in the long term. Current assets are assets that can or will be converted to cash within the next 12 months. important because they provide the funds used to pay the firm’s current bills. Cash: Funds on hand or in a bank Marketable securities: Temporary investments of excess cash that can readily be converted to cash Accounts receivable: Amounts owed to the firm by customers who bought goods or services on credit Notes receivable: Amounts owed to the firm by customers or others to whom it lent money Inventory: Stock of goods being held for production or for sale to customers Fixed assets are long-term assets used by the firm for more than a year. Depreciation is the allocation of the asset’s original cost to the years in which it is expected to produce revenues. A portion of the cost of a depreciable asset—a building or piece of equipment, for instance —is charged to each of the years in which it is expected to provide benefits. This practice helps match the asset’s cost against the revenues it provides. Because it is impossible to know exactly how long an asset will last, estimates are used. based on past experience with similar items or IRS guidelines Intangible assets are long-term assets with no physical existence. Common examples are patents, copyrights, trademarks, and goodwill. Patents and copyrights shield the firm from direct competition, so their benefits are more protective than productive. Trademarks are registered names that can be sold or licensed to others. Liabilities are the amounts a firm owes to creditors. Current liabilities are those due within a year of the date of the balance sheet. Current liabilities include: Accounts payable: Amounts the firm owes for credit purchases due within a year. This account is the liability counterpart of accounts receivable. Notes payable: Short-term loans from banks, suppliers, or others that must be repaid within a year. For example, Delicious Desserts has a six-month, $15,000 loan from its bank that is a note payable. Accrued expenses: Expenses, typically for wages and taxes, that have accumulated and must be paid at a specified future date within the year although the firm has not received a bill Income taxes payable: Taxes owed for the current operating period but not yet paid. Taxes are often shown separately when they are a large amount. Current portion of long-term debt: Any repayment on long-term debt due within the year. Delicious Desserts is scheduled to repay $5,000 on its equipment loan in the coming year. Long-term liabilities come due more than one year after the date of the balance sheet. include bank loans (such as Delicious Desserts’ $10,000 loan for bakery equipment), mortgages on buildings, and the company’s bonds sold to others. Owners’ equity is the owners’ total investment in the business after all liabilities have been paid. For sole proprietorships and partnerships, amounts put in by the owners are recorded as capital. Retained earnings are the amounts left over from profitable operations since the firm’s beginning. They are total profits minus all dividends (distributions of profits) paid to stockholders. The Income Statement The income statement summarizes the firm’s revenues and expenses and shows its total profit or loss over a period of time. Revenues are the dollar amount of sales plus any other income received from sources such as interest, dividends, and rents. Revenues are determined starting with gross sales, the total dollar amount of a company’s sales. deductions from gross sales. Sales discounts Returns and allowances Net sales is the amount left after deducting sales discounts and returns and allowances from gross sales. Expenses are the costs of generating revenues. Two types are recorded on the income statement: cost of goods sold and operating expenses. The cost of goods sold is the total expense of buying or producing the firm’s goods or services. The amount a company earns after paying to produce or buy its products but before deducting operating expenses is the gross profit The other major expense category is operating expenses. These are the expenses of running the business that are not related directly to producing or buying its products. The two main types of operating expenses are selling expenses and general and administrative expenses. Selling expenses are those related to marketing and distributing the company’s products. They include salaries and commissions paid to salespeople and the costs of advertising, sales supplies, delivery, and other items that can be linked to sales activity, such as insurance, telephone and other utilities, and postage. General and administrative expenses are the business expenses that cannot be linked to either cost of goods sold or sales. Examples of general and administrative expenses are salaries of top managers and office support staff; utilities; office supplies; interest expense; fees for accounting, consulting, and legal services; insurance; and rent. The final figure—or bottom line—on an income statement is the net profit (or net income) or net loss. calculated by subtracting all expenses from revenues. The Statement of Cash Flows The statement of cash flows, a summary of the money flowing into and out of a firm, is the financial statement used to assess the sources and uses of cash during a certain period, typically one year. All publicly traded firms must include a statement of cash flows in their financial reports to shareholders. tracks the firm’s cash receipts and cash payments. the statement of cash flows divides the firm’s cash flows into three groups: Cash flow from operating activities: Those related to the production of the firm’s goods or services Cash flow from investment activities: Those related to the purchase and sale of fixed assets Cash flow from financing activities: Those related to debt and equity financing Analyzing Financial Statements Ratio analysis involves calculating and interpreting financial ratios using data taken from the firm’s financial statements in order to assess its condition and performance. Period-to-period and industry ratios provide a meaningful basis for comparison, so that we can answer questions such as, “Is this particular ratio good or bad?” It’s important to remember that ratio analysis is based on historical data and may not indicate future financial performance. Ratios are also important to a firm’s present and prospective creditors (lenders), who want to see if the firm can repay what it borrows Ratios can be classified by what they measure: liquidity, profitability, activity, and debt. Liquidity ratios measure the firm’s ability to pay its short-term debts as they come due. The current ratio is the ratio of total current assets to total current liabilities. Traditionally, a current ratio of 2 Whether it is sufficient depends on the industry in which the firm operates. Public utilities, which have a very steady cash flow, operate quite well with a current ratio well below 2. A current ratio of 2 might not be adequate for manufacturers and merchandisers that carry high inventories and have lots of receivables. means little without a basis for comparison. If the analyst found that the industry average for small bakeries was 2.4, Delicious Desserts would appear to have low liquidity. The acid-test (quick) ratio is like the current ratio except that it excludes inventory, which is the least-liquid current asset. used to measure the firm’s ability to pay its current liabilities without selling inventory. The name acid-test implies that this ratio is a crucial test of the firm’s liquidity. An acid-test ratio of at least 1 is preferred. But again, what is an acceptable value varies by industry. good measure of liquidity when inventory cannot easily be converted to cash If inventory is liquid, the current ratio is better. Delicious Desserts’ acid-test ratio for 2018 is 1.1. Because the bakery’s products are perishable, it does not carry large inventories. Profitability ratios measure how well the firm is using its resources to generate profit and how efficiently it is being managed. The main profitability ratios are net profit margin, return on equity, and earnings per share. The ratio of net profit to net sales is the net profit margin, also called return on sales. It measures the percentage of each sales dollar remaining after all expenses, including taxes, have been deducted. Higher net profit margins are better than lower ones. measure the firm’s earning power. A grocery store usually has a very low net profit margin, perhaps below 1 percent, whereas a jewelry store’s net profit margin would probably exceed 10 percent. Delicious Desserts’ net profit margin for 2018 is 11.9 percent. In other words, Delicious Desserts is earning 11.9 cents on each dollar of sales. The ratio of net profit to total owners’ equity is called return on equity (ROE). It measures the return that owners receive on their investment in the firm, a major reason for investing in a company’s stock. Delicious Desserts has a 40.9 percent ROE for 2018. On the surface, a 40.9 percent ROE seems quite good. But the level of risk in the business and the ROE of other firms in the same industry must also be considered. The higher the risk, the greater the ROE investors look for. Earnings per share (EPS) is the ratio of net profit to the number of shares of common stock outstanding. It measures the number of dollars earned by each share of stock. EPS values are closely watched by investors and are considered an important sign of success. also indicates a firm’s ability to pay dividends. Note that EPS is the dollar amount earned by each share, not the actual amount given to stockholders in the form of dividends. Some earnings may be put back into the firm. Delicious Desserts’ EPS for 2018 is $3.22. Activity ratios measure how well a firm uses its assets. They reflect the speed with which resources are converted to cash or sales. A frequently used activity ratio is inventory turnover. The inventory turnover ratio measures the speed with which inventory moves through the firm and is turned into sales. It is calculated by dividing cost of goods sold by the average inventory. Debt ratios measure the degree and effect of the firm’s use of borrowed funds (debt) to finance its operations. important to lenders and investors. They want to make sure the firm has a healthy mix of debt and equity. The most important debt ratio is the debt-to-equity ratio. The debt-to-equity ratio measures the relationship between the amount of debt financing (borrowing) and the amount of equity financing (owners’ funds). It is calculated by dividing total liabilities by owners’ equity. In general, the lower the ratio, the better. A ratio above 100 percent means the firm has more debt than equity. In such a case, the lenders are providing more financing than the owners. https://openstax.org/books/introduction-business/pages/16-1-the-role-of-finance-and-the-financial-manager 13/13