> > > > > > > > Chapter 16

Understanding
Accounting and
Financial Statements

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Explain the functions and major

components of the four principal financial
statements: the balance sheet, the
income statement, the statement of
owners equity, and the statement of
cash flows.

Discuss how financial ratios are used to

analyze a companys financial strengths
and weaknesses.

Describe the role of budgets in a

business.

Outline accounting issues facing global

business and the move toward one set of
worldwide accounting rules.

Explain the functions and importance

of accounting, and identify the three
basic activities involving accounting.
Describe the roles played by public,
management, government and not-forprofit accountants.
Identify the foundations of the
accounting system, including GAAP
and the role of the Financial
Accounting Standards Board (FASB).
Outline the steps in the accounting
cycle, and define double-entry
bookkeeping and the accounting
equation.

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

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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
companys success.
Outsiders use financial data to evaluate investment
opportunities.

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Business
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Involving
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.

Accounting
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Public Accountants
Provide accounting services to
individuals or business firms for a fee

Management Accountants
Provide timely, relevant, accurate, and
concise information that executives
can use to operate their firms

Government and Not-for-Profit

Accountants

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The F
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Accoun

Generally accepted accounting principles (GAAP) encompass the

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

Financial Accounting Standards Board (FASB) is primarily

responsible for evaluating, setting, or modifying GAAP in the U.S.

Sarbanes-Oxley Act responded to cases of accounting fraud.

Created the Public Accounting Oversight Board, which sets audit
standards and investigates and sanctions accounting firms that certify the
books of publicly traded firms.
Senior executives must personally certify that the financial information
reported by the company is correct.
Resulted in increase in demand for accountants.

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Th e A
Cycle
Accounting process - set of activities involved in
converting information about transactions
into financial statements.

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T h e A c c ou n
Assets - anything of value owned or leased by a business.
Liability - claim against a firms assets by a creditor.
Owners 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.

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I n te r n e t o n A

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, Peachtree,
and BusinessWorks.
Larger firms use larger scale software packages like: Computer
Associates, Oracle, and SAP.

Software that handles accounting information for international

businesses is another option. Offers different country
information/language.

Some systems offer web-based packages for small

and medium businesses.

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Balance sheet - statement of a firms financial
positionwhat it owns and the claims against its
assetsat a particular point in time.
Photograph of firms assets together with its liabilities
and owners equity
Follows the accounting equation

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Income Statement - financial record of a companys

revenues and expenses, and profits over a period of
time.
Firms financial performance in terms of revenues,
expenses, and profits over a given time period.
Reports profit or loss.
Focus on revenues and costs associated with
revenues.

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Statement of Owners Equity - is designed to show
the components of the change in equity from the end
of one fiscal year to the end of the next.
Begins with the amount of equity shown on the
balance sheet.
Net income is added, and cash dividends paid to
owners are subtracted.

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Statement of cash flows - a firms cash receipts and
cash payments that presents information on its
sources and uses of cash.
Accrual accounting - method that records revenue
and expenses when they occur, not necessarily when
cash actually changes hands.

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Financial Ra
Ratio analysis - tool for measuring a firms liquidity, profitability,
and reliance on debt financing, as well as the effectiveness of
managements resource utilization.

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L iq uid i t
Totalcurrentassets

Current ratio compares

current assets to current
liabilities.
Totalcurrentliabilities

Acid-test (or quick)

ratio measures the
ability of a firm to meet
its debt payments on
short notice.

Cashandequivalents
+shortterminvestments
+accountsreceivable

Totalcurrentliabilities

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Inventory turnover
ratio indicates the
number of times
merchandise moves
through a business.

Netsales

Averageofinventory
Netsales

Total asset turnover ratio

indicates how much in
sales each dollar invested
in assets generates.
Averageoftotalassets

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

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Leverag
Leverage ratios measure the extent to which a firm relies on
debt financing.

Total liabilities to total assets ratio > 50 percent indicates that a

firm is relying more on borrowed money than owners equity.

Budgets

Budget - planning and control tool that reflects a

firms expected sales revenues, operating
expenses, and cash receipts and outlays.

Management estimates of expected sales, cash

inflows and outflows, and costs.

Budgets are a financial blueprint that serves as a

financial plan.

Cash budget - tracks the firms cash inflows and

outflows.

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International Accounting Standards Committee (IASC)

promotes worldwide consistency in financial reporting practices.
In 2001, became the International Accounting Standards
Board (IASB). International Financial Reporting Standards
(IFRS) are the standards.

Exchange Rates - ratio at which a countrys currency can be

exchanged for other currencies.
Consolidated financial statements must reflect gains and losses
due to changes in exchange rates.
Can have significant impact on financial statement.