Chapter 7

Understanding Financial
Information and Accounting
 Learning Objectives
1. Described the importance of financial
information and accounting.
2. Define and explain the different areas
of accounting.
3. List the steps in the accounting cycle.
4. Explain how the major financial
statements differ.
5. Explain the importance of ratio
analysis in reporting financial
information.
 The Importance of Financial
Information
All individuals need a basic working knowledge
of accounting.
1. Accounting has a unique language.
2. Many people use accounting information, not
just managers.
Financial transactions include:
i. buying and selling goods and services
ii. acquiring insurance
iii. paying employees
iv. Using supplies.
Transactions are usually classified into groups
with common characteristics.
 The Importance of Financial
Information
Accounting:
Is the recording, classifying, summarizing, and interpreting of
financial events and transactions to provide management and
other interested parties with the information they need to make
good decisions.
Accounting System
Is the method used to record and summarize accounting data
into reports.

Purposes Of Accounting:
To give managers basic financial information so they may make
better decisions
To report financial information to people outside the firm such
as owners, creditors, suppliers, employees, investors, and the
government.
Areas Of accounting
Manageri
al & Tax
Financial Auditing Accounti
Accounti ng
Governm
ng
ent &
Non- Accounti
Profit ng Tools
Accounti
ng
 AREAS OF ACCOUNTING
MANAGERIA

:Concerned with
ACCOUNTIN
Provides
information Measuring and
reporting costs of
and production, marketing,
and other functions
analysis to (cost accounting)
Preparing budgets
managers (planning)
Checking whether or
within the not units are staying
organizatio within their budgets
(controlling)
Designing strategies to
n to assist
G

minimize taxes (tax

L

them in .accounting)

decision
 AREAS OF ACCOUNTING
FINANCIAL
ACCOUNTIN
G
Generates
information for use The information
outside the prepared by financial
organization :accounting is used by
Company owners,
Financial managers, and
accountants are employees
responsible for
Creditors and lenders
preparing the
ANNUAL REPORT a Employee unions,
yearly statement of customers, suppliers,
government agencies,
the financial and the general public
condition, progress,
and expectations of
. an organization
The independent FINANCIAL
ACCOUNTING STANDARDS BOARD
(FASB)
Is the group that oversees accounting practices.

GENERALLY ACCEPTED ACCOUNTING

PRINCIPLES (GAAP),
Users know the information is reported
professionally if financial reports are prepared in
accordance with GENERALLY ACCEPTED
ACCOUNTING PRINCIPLES (GAAP), a set of
principles followed by accountants in preparing
results.
 : Professions
Is a professional accountant who has met
Certified certain educational and experience
Management requirements, passed a qualifying exam in
Accountant the field, and has been certified by the
(CMA) institute of certified management
Is an accountant who has passed a series
accountants.
Certified of examinations established by the
Public American institute of certified public
Accountant accountants (AICPA) and does accounting
(CPA) work for no one particular firm.
Is an accountant who works for a single
Private firm, government agency, or non- profit
Accountant organization, on the payroll of the
company or organization.

Public Is an accountant who does not work for a

Accountant specific company.
Public accountants help firms by:
Designing an accounting system for a firm.
Helping select the correct computer and
software to run the system.
Analyzing the financial strength of an
organization.
Professional accounting
Assures the users of financial information
that financial reports of organizations are
accurate.
Workshop No.1.docx

WORKSH
OP No.1
 .Budgetary Control: Weinstein Manufacturing Co

EXPENSE BUDGETED ACTUAL

DIFFERENCE
CATEGORY AMOUNT EXPENDITURE FROM
BUDGET
____________________________________________________________________

Labor $162,500 $195,000 +32,500

+20.0%

Raw materials 172,500 151,500 -21,000 -

12.2%

Utilities 6,500 6,300 -200

-3.1%

Maintenance 9,750 8,950 -800

-8.2%

Other variable exp. 16,750 18,000 +1,250

Auditing
Is the job of reviewing and evaluating
the records used to prepare the
companys financial statements.
Accountants within the organization
often perform internal audits to make
sure the organization is using proper
accounting procedures.
Public accountants also conduct
independent audits of accounting
records.
Auditing
An INDEPENDENT AUDIT is an
evaluation and unbiased opinion about
the accuracy of companys financial
statements.
A CERTIFIED INTERNAL AUDITOR
(CIA) is an accountant who has a
bachelors degree and two years of
experience in internal auditing, and
who has passed an exam administered
by the Institute of Internal Auditors.
Tax Accounting
A tax accountant is an
accountant trained in tax law
and responsible for preparing
tax returns and developing
tax strategies.
As the burden of taxes grows,
the role of the tax accountant
becomes more important.
Government and Not-for-Profit
Accounting
Is the accounting system used by organizations
whose purpose is not generating a profit.
The purpose of these organizations is to serve
ratepayers, taxpayers, and others according to a duly
.approved budget
Users of government accounting information, such as
citizens and special interest groups, want to ensure
that government is making the proper use of
GOVERNMENTAL
.taxpayers money
ACCOUNTING
STANDARDS BOARD (GASB)
Is the group that sets standards for governmental
agencies accounting practices
 BOOKKEEPIN is the recording of business
G
transactions.
DOUBLE- is the concept of writing (or typing)
ENTRY
every
BOOKKEEPIN
transaction in two places.
G
JOURNAL LEDGER
Is the record book in
accounting (can also be a
is a specialized
computer program). accounting book
Transactions for each day, or computer
week, or month are kept in
the journal. program in which
The journals main information from
purpose is to have a accounting
chronological listing of the
business transactions that journals is
take place. accumulated into
The journal doesnt specific
provide info about the
Sarbanes-Oxley Act
The SARBANES-OXLEY ACT, signed into law in
2002 after many accounting scandals, requires
higher standards of accounting practices and
auditing firms.
Criticisms:
Businesses feel the standards are too
stringent and limit their ability to make
business decisions.
Supporters feel that the law protects the
American public, but does not go far enough.
The Six-Step Accounting Cycle
 statement
which provides a summary of money
coming into and going out of the firm.
cash flows
statement
Profit and loss statement, or
P&L for short, reports revenues,
income
expenses, and profits (or losses) for a
specific period of time.
The
sheet
which reports the firms financial balance
condition on a specific date.
firms financial health and stability.
a particular period to indicate a
overThe
of all transactions that have occurred
A FINANCIAL STATEMENT is the summary
Financial Statements
 Financial Statements
The differences among the financial
statements:
BALANCE SHEET details what the
company owns and owes on a certain day.
INCOME STATEMENT shows what a firm
sells its products for and what its selling
costs are over a specific period.
CASH FLOWS STATEMENT shows the
The Accounting
difference between Equation
cash coming in and
cash going =
Assets out of a business.
Liabilities +
Owners Equity
 The Balance Sheet
Three major accounts
Assets
Liquidity
Accounts receivable
Current assets
Fixed assets
Intangible assets
Liabilities
Current
Long-term
Owners equity
Owners equity is a way of stating the difference
between what is owned versus what is owed.
Assets
Are economic resources (things of value) owned by the
company.
Assets are characterized based on LIQUIDITY, how fast an asset
can be converted into cash.
Accounts
Current Fixed Intangibl
Receivab
Assets Assets e Assets
le Are long- long-term
Are term assets assets
Is the
that are (e.g.,
amount of items relatively patents,
money that can permanent, trademarks
owed to the
firm that it
or will be also ,
expects to converte referred to copyrights)
d to cash as that have
be paid
property, no real
within one within plant, and physical
year. one year. equipment. form but do
have value.
 LIABILITIES
. are what the business owes to others (debts)

1.Current liabilities are debts due in one year or less.

2.Long-term liabilities are debts not due for one year
or longer.
Common liability accounts:
Accounts payable are current liabilities involving
money owed for merchandise and services purchased
on credit but not paid for yet.
Notes payable are short-term or long-term liabilities
that a business promises to repay by a certain date.
Bonds payable are long-term liabilities that represent
money lent to the firm that must be paid back.
 Equity
Equity: The value of things you own
(assets) minus the amount of money you
owe others (liabilities)
SHAREHOLDERS OWNERS
EQUITY EQUITY
The value of what Is the amount of the
stockholders own in a
business that
firm (minus liabilities)
belongs to the
owners minus any
liabilities owned by
the business.
CRITICAL THINKING EXERCISE 7.docx

WORKSH
OP No.2
 Understanding the
Take home message about Balance Sheet

BALANCE SHEET
provides you with an
OVERALL PICTURE of
your companys
financial health which
allows you to make
better management
decisions
INCOME STATEMENT
The income statement reports the results
of operations over a particular period of
time and summarizes:
All the resources (called revenue)that have
come into the firm from operating
activities.
The money resources that were used up.
The expenses incurred in doing business.
What resources were left after all costs and
expenses, including taxes, were paid out.
 The income statement is
arranged according to the
following formula:
REVENUE is the value of what is received for goods sold, services rendered,
and other financial sources.

Most revenue comes from sales, but other sources of revenue

include rents earned, interest earned, and so forth.

Gross sales
are the total of all sales the firm
Net sales completed.
are gross sales minus returns, discounts,
and allowances.
is a measure of the cost of merchandise sold,
Cost of or the cost of raw materials and supplies used
Goods Sold for producing items for resale.
The cost of goods sold includes the purchase price plus
any costs associated with obtaining and storing the
goods.
Gross profit is how much a firm earned by buying (or making) and
selling merchandise, without expenses.

Selling expenses are expenses related to the

marketing and distribution of the firms goods or
Operating services.
Expenses
and Net General expenses are administrative
Profit or expenses of the firm.
Loss
INCOME STATEMENT Take home message

Understanding the
INCOME STATEMENT
Reveals whether the
business is actually
earing a profit or loss.
 The Statement of Cash Flows
reports cash receipts and
disbursement related to the
firms three major activities.
Three activities
OPERATIONS cash transactions associated with
running the business
INVESTMENTS cash used in or provided by the
firms investment activities
FINANCING cash raised from the issuance of new
debt.
The statement of cash flows is different from the
income statement in that The statement of cash flows
shows the cash position, how much money is on hand
CASH FLOW STATEMENT Take home
message
Regular review of CASH
FLOW STATEMENT
allows the business
owners to be assured
he or she will have
enough cash on hand
to pay for immediate
needs.
Analyzing Financial Statements:
Ratio Analysis
Is the assessment of a firms financial condition and performance through
calculations and interpretations of financial ratios developed from the
firms financial statements.
They also give insight into the firms performance compared to other firms
in the industry
DEBT
LIQUIDITY PROFITABI BUSINESS
(LEVERAG
RATIOS LITY ACTIVITY
E)
Debt To Inventory
Current Earnings
Owners Turnover
Ratio Per Share
Equity Ratio

Quick Return On
Ratio Sales

Return On
Equity
 :Liquidity Ratios
Liquidity ratios measure the companys ability to turn
assets into cash to pay its short-term debts.
These short-term debts are expected to be repaid
within one year.
These short-term debts are of particular importance to
creditors of the firm, who expect to be paid on time.

THE CURRENT RATIO is the ratio of a firms current

assets to its current liabilities.

Generally a number higher than tow means a company

is a safe risk for granting a short term loan.
 :Liquidity Ratios
THE ACID-TEST RATIO (or quick ratio)
measures the cash, marketable securities
(stocks and bonds), and receivables of the
firm, compared to its cur-rent liabilities.

This ratio is important to firms having

difficulty converting inventory into quick
cash.
A number between 0.5 and 1.0 is usually
considered satisfactory
 Leverage (debt) Rations

Leverage ratios measure the degree to which a

firm relies on borrowed funds in its operations.
The DEPT TO OWNERS EQUITY ratio measures
the degree to which the company is financed
by borrowed funds that must be repaid.
Comparisons with past debt ratios can also
identify trends that may be occurring within the
firm or industry.
Profitability (Performance) Ratios
Profitability ratios measure how

effectively a firm is using its various

resources to achieve profits.

Profitability (Performance) Ratios
Earning Per Share
EPS is a very important ratio for a company,

because earnings help stimulate growth in the firm

and pay for such things as stockholders dividends.

EPS = Net income after taxes

No of common stocks outstanding
A larger number would mean the company either

has high net income or does not have any

outstanding stock.
 Profitability (Performance) Ratios
Return On Sales (net profit margin)

This measures the return on sales based on

how much profit a company earns for every

dollar it generates in revenue.

ROS= Net income

Net Sales
This ratio is an indicator of the companys

ability to generate income from sales.

 Profitability (Performance) Ratios
Return On Equity

The higher the risk involved in an industry,

the higher the return investors expect.

ROS= Net income afer tax

Total Owners equity
Return on equity measure how much was

earned for each dollar invested by owners.

Activity Ratios
The inventory turnover ratio measures the speed of inventory

moving through the firm and its conversion into sales.

Inventory turn over = cost of goods sold

inventory
An acceptable turnover ratio is usually determined industry

by industry.

A lower number means that the company has poor buying

practices.
Workshop 3.docx

WORKSH
OP No.3
THANK YOU