Chapter 16Understanding Accounting and Financial

StatementsLearning Goals

Explain the functions and importance of accounting.

Identify the three basic activities involving accounting.

Describe the roles played by public, management, government and not-for-profit accountants.

Outline the steps in the accounting process.

Explain the three principal financial statements.

Discuss how financial ratios are used to analyze a firm’s financial strengths and weaknesses.

Describe the role of budgets in a business.

Explain uniform financial statements and how exchange rates influence international accounting practices.

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Accounting Process of measuring, interpreting, and communicating financial information to support internal and external business decision making.

USERS OF ACCOUNTING INFORMATION

• Open book management Sharing sensitive financial information with employees and teaching them how to understand and use financial statements.

• Viewing financial information may help them better understand how their work contributes to the company’s success.

• Outsiders use financial data to evaluate investment opportunities.

• Accountants serve public good.

• Example: Volunteer programs that provide free help for low- and middle-income senior citizens file their taxes. AARP’s Tax Aide

BUSINESS ACTIVITIES INVOLVING ACCOUNTING

• Accounting plays a key role in each of a businesses three key areas:

• Financing activities Provide necessary funds to start and expand a business.

• Investing activities Provide valuable assets required to run a business.

• Operating activities Focus on selling goods and services, but they also consider expenses as important elements of sound financial management.

ACCOUNTING PROFESSIONALS

Public AccountantsPublic accountant Accountant who works for an independent accounting firm.

Certified public accountant (CPA) Accountant who meets specified educational and experiential requirements and has passed a comprehensive examination on accounting theory and practice.

Management Accountants• Management accountant Accountant employed by a business other than a

public accounting firm.

Government and Not-for-Profit Accountants• Perform professional services similar to those of management

accountants.

THE ACCOUNTING PROCESS

Accounting process Set of activities involved in converting information about transactions into financial statements.

The Impact of Computers and the Internet on the Accounting Process

• Simplifies the accounting process by automating data entry and calculations.

• Software that handles accounting information for international businesses is also available.

The Foundation of the Accounting System• Generally accepted accounting principles (GAAP) Principles that encompass

the conventions, rules, and procedures for determining acceptable accounting practices at a particular time.

• Financial Accounting Standards Board (FASB) Organization primarily responsible for evaluating, setting, or modifying GAAP in the U.S.

Sarbanes-Oxley Act A response to cases of accounting fraud.

• Created the Public Accounting Oversight Board.

• Added to the reporting requirements for publicly traded companies.

The Accounting EquationAssets Anything of value owned or leased by a business.

• Tangible: Equipment, buildings, inventory.

• Intangible: Patents, trademarks

Liability Claim against a firm’s assets by a creditor.

Owner’s equity All claims of the proprietor, partners, or stockholders against the assets of a firm, equal to the excess of assets over liabilities.

Basic accounting equation Relationship that states that assets equal liabilities plus owners’ equity.

Double-entry bookkeeping Process by which accounting transactions are entered; each individual transaction always has an offsetting transaction.

FINANCIAL STATEMENTS

• Provide managers with information for evaluating organization’s ability to meet current obligations and needs, its profitability, and its overall financial health.

The Balance SheetBalance sheet Statement of a firm’s financial position—what it owns and the

claims against its assets—at a particular point in time.

The Income StatementIncome statement Financial record of a company’s revenues, expenses, and profits over a period of time.

• Helps decision makers focus on overall revenues and the costs involved in generating these revenues.

• Sometimes called a profit-and-loss, or P&L, statement.

The Statement of Cash FlowsStatement of cash flows Statement of a firm’s cash receipts and cash payments

that presents information on its sources and uses of cash.

Accrual accounting Accounting method that records revenue and expenses when they occur, not necessarily when cash actually changes hands.

• Inadequate cash flow is a reason for many business failures.

FINANCIAL RATIO ANALYSIS

• Ratio analysis Tool for measuring a firm’s liquidity, profitability, and reliance on debt financing, as well as the effectiveness of management’s resource utilization.

BUDGETS

Budget Planning and control tool that reflects a firm’s expected sales revenues, operating expenses, and cash receipts and outlays.

• Cash budget Tracks the firm’s cash inflows and outflows.

INTERNATIONAL ACCOUNTING

• Global firms must translate financial statements of the firm’s international affiliates, branches, and subsidiaries and convert data about foreign currency transactions to dollars.

Exchange Rates• Ratio at which a country’s currency can be exchanged for other currencies.

• Consolidated financial statements must reflect gains and losses due to changes in exchange rates.

International Accounting Standards• International Accounting Standards Committee (IASC) promotes worldwide

consistency in financial reporting practices.