Understanding Accounting and Financial Statements

Chapter

15

LO 15.1 Explain the functions of accounting, and identify the three basic activities involving accounting.

LO 15.2 Describe the roles played by public, management, government, and not-for-profit accountants.

LO 15.3 Identify the foundations of the accounting system, including GAAP, IFRS, and the role of the Accounting Standards Board (AcSB).

LO 15.4 Outline the steps in the accounting cycle, and define double-entry bookkeeping and the accounting equation.

Learning Objectives

LO 15.5 Explain the functions and major components of the four principal financial statements: the balance sheet, the income statement, the statement of owner’s equity, and the statement of cash flows.

LO 15.6 Discuss how financial ratios are used to analyze a company’s financial strengths and weaknesses.

LO 15.7 Describe the role of budgets in a business.

LO 15.8 Outline accounting issues facing global business.

Accounting: The process of measuring, interpreting, and communicating financial information to support internal and external business decision-making

Users of Accounting Information

Open-book management is 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.

Open Book Management

Financing activities provide necessary funds to start a business and expand it after it begins operating.

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.

Business Activities Involving Accounting

Public accountant: An accountant who provides accounting services to other organizations Auditing, tax preparation, consulting Provided to individuals or business firms for a fee

Chartered Accountants (CA)

Management accountants provide timely, relevant, accurate, and concise information that executives can use to operate their firms profitably and effectively

Certified Management Accountant (CMA)

Government and not-for-profit accountants

Accounting Professionals

Generally accepted accounting principles (GAAP): Principles that outline the conventions, rules, and procedures for deciding on the acceptable accounting practices at a particular time

Accounting Standards Board (AcSB): The organization that interprets and modifies GAAP in Canada for private and not-for-profit businesses

Canadian public companies are required to use International Financial Reporting Standards (IFRS). These standards allow for financial statements to be more easily compared from country to country.

Senior executives must personally certify that the financial information reported by the company is correct.

Corruption of Foreign Public Officials Act: A federal law that prohibits Canadian citizens and companies from bribing foreign officials to win or continue business.

The Foundation of the Accounting System

Because of the increasing amount of worldwide trade, many Canadian public firms are moving from _______ to ________ when constructing financial statements. a. GAAP; IRSb. IFRS; GAAPc. GATT; IFRSd. GAAP; IFRS 

Test Your Knowledge

Because of the increasing amount of worldwide trade, many Canadian public firms are moving from _______ to ________ when constructing financial statements. a. GAAP; IRSb. IFRS; GAAPc. GATT; IFRSd. GAAP; IFRS

Answer: D 

Test Your Knowledge

Accounting cycle: The set of activities involved in converting information and individual transactions into financial statements

The Accounting Cycle

Asset: anything with future benefit owned or controlled by a firm

Liability: A claim against a firm’s assets by creditors Owner’s equity: The funds that owners invest in the

business plus any profits not paid to owners in the form of cash dividends

Accounting equation: The relationship that should reflect a firm ’s financial position at any time: assets should always equal the sum of liabilities and owners’ equity

Double-entry bookkeeping: The process used to record accounting transactions; each individual transaction is always balanced by another transaction

The Accounting Equation

Simplifies the accounting process by automating data entry and calculations.

Available products are customized for businesses of different sizes. Entrepreneurs and small businesses use QuickBooks and

Sage 50 (formerly Simply Accounting). Larger firms use more sophisticated software packages

like Oracle and SAP. Software that handles accounting information

(other languages/currencies for international businesses is another option.

Some systems offer Web-based packages for small and medium-sized businesses.

The Impact of Computers and the Internet on the Accounting Process

Balance sheet: A statement of a firm’s financial position—what it owns and the claims against its assets—at a particular point in time

Photograph of firm’s assets together with its liabilities and owner’s equity

Follows the accounting equation

Financial Statements

The Macro Corporation has purchased land for $100,000, and has financed 50% of the cost using long-term debt. The effect on its balance sheet is

a. an increase in assets of $50,000; an increase in liabilities of $50,000.b. an increase in assets of $100,000; a decrease in owners’ equity of $100,000.c. an increase in assets of $100,000; an increase in liabilities of $50,000.d. a decrease in assets of $50,000; a decrease in owners’ equity of $50,000.

Test Your Knowledge

The Macro Corporation has purchased land for $100,000, and has financed 50% of the cost using long-term debt. The effect on its balance sheet is

a. an increase in assets of $50,000; an increase in liabilities of $50,000.b. an increase in assets of $100,000; a decrease in owners’ equity of $100,000.c. an increase in assets of $100,000; an increase in liabilities of $50,000.d. a decrease in assets of $50,000; a decrease in owners’ equity of $50,000. Answer: A

Test Your Knowledge

The Balance Sheet

Income statement: A financial record of a company’s revenues, expenses, and profits over a specific period of time

Reports profit or loss Focus on revenues and costs associated 

with revenues

The Income Statement

The Income Statement

Statement of changes in equity: A record of the change in equity from the end of one fiscal period to the end of the next fiscal period

Begins with the amount of equity shown on the balance sheet

Net income is added, and cash dividends paid to owners are subtracted

Statement of Changes in Equity

Statement of Changes in Equity

Statement of cash flows: A record of the sources and uses of cash during a period of time

Accrual accounting: An accounting method that records revenue and expenses when they occur, not when cash actually changes hands

Statement of Cash Flows

Statement of Cash Flows

Many former owners of failed firms blame ______ for their company’s failure.

a. GAAP rules b. inaccurate budgeting c. inadequate cash flows d. excessive government regulation 

Test Your Knowledge

Many former owners of failed firms blame ______ for their company’s failure.

a. GAAP rules b. inaccurate budgeting c. inadequate cash flows d. excessive government regulation Answer: C

Test Your Knowledge

Ratio analysis is a tool for measuring a firm’s liquidity, profitability, and reliance on debt financing, and how effectively management uses the firm’s resources

Financial Ratio Analysis

Liquidity Ratios

Current ratio compares current assets to current

liabilities.

Acid-test (or quick) ratio measures the ability of a firm to meet its

debt payments on short notice.

Liquidity ratios measure a firm’s ability to meet its short-term

obligations.

Activity Ratios

Inventory turnover ratio indicates the number of times merchandise

moves through a business.

Total asset turnover ratio indicates how much in sales each dollar

invested in assets generates.

Activity ratios measure how effectively management uses the firm’s resources.

Profitability Ratios

Profitability ratios measure the organization’s overall financial performance by evaluating its ability to generate revenues in excess of operating costs and other expenses.

Leverage Ratios

Leverage ratios measure how much a firm relies on debt financing.

A total liabilities to total assets ratio (debt ratio) greater than 50 percent indicates that a firm is relying more on borrowed money than owners’ equity.

Budgeting

Budget: An organization’s plans for how it will raise and spend money during a specific period of time Shows the firm’s expected sales revenues,

operating expenses, cash receipts, and cash expenses.

Budgets are a financial blueprint that serves as a financial plan.

The cash budget tracks the firm’s cash inflows and outflows.

Budgeting

International Accounting

Accounting procedures and practices must be adapted to accommodate an international business environment.

Exchange rates are the value of one country ’s currency in terms of the currencies of other countries. Consolidated financial statements must reflect

gains and losses due to changes in exchange rates

Can have significant impact on financial statement