Pride/Hughes/Kapoor Business, 10th Edition

Audio Review Transcript
Chapter 17 Using Accounting Information

1. Explain why accurate accounting information and audited financial statements are important

Accounting involves a wide range of activities that are critical to the success of a business. It can be used to answer questions about what has happened in the past; it also can be used to help make decisions about the future. A firm’s accountants and its accounting system often translate goals, objectives, and plans into dollars and cents to help determine if a decision or plan of action makes financial sense. What exactly is accounting? It is the process of systematically collecting, analyzing, and reporting financial information. Because of the need for accuracy and trust, a company’s books are audited. An audit is an examination of the company’s financial statements and the accounting practices that produced them to make sure the firm used generally accepted accounting principles. Generally accepted accounting principles, or simply GAAPs, are an accepted set of guidelines and practices for companies reporting financial information and for the accounting profession. Even with an audit, a number of firms have used questionable accounting practices in recent years. In response to these problems, the U.S. Congress enacted the Sarbanes-Oxley Act in 2002 to improve corporate accountability, to provide penalties for noncompliance, and to protect whistle-blowers. (LO 1 ends)

2. Identify people who use accounting information and possible careers in the accounting industry

To be successful in the accounting industry, employees must be responsible, honest, and ethical; have a strong background in financial management; know how to use a computer and software to process data into accounting information; and be able to communicate with people who need accounting information. Accounting information is management information and the primary users of the information are managers. Much of the accounting information is proprietary, meaning it is not divulged to anyone outside the firm. There are, however, outside groups to whom information must be supplied. These include lenders, who require financial statements and suppliers, who want financial information before they will lend money or extend credit to a firm; stockholders, who receive quarterly reports with a summary of the firm’s financial position and potential investors, who must also be provided with financial information; and government agencies, who require a great deal of information about a firm’s tax liabilities, payroll deductions, and new issues of stocks and bonds.
Accounting is usually broken down into two broad categories. Managerial accounting provides managers and employees with the information needed to make decisions about a firm’s financing, investing, and operating activities. Financial accounting generates financial statements and reports for interested people outside of an organization. Other special areas of accounting include cost accounting, tax accounting, government accounting, and not-for-profit accounting.
A private accountant is employed by a specific organization. A firm may hire one or more private accountants to design its accounting information system and provide advice and assistance to managers.
Smaller firms may hire the services of a public accountant, who provides services to clients on a fee basis. A public accountant may be self-employed or an employee in a large accounting firm. Most accounting firms have at least one certified public accountant on their staffs. These individuals, also called CPAs, have met state requirements for accounting education and experience and have passed a rigorous two-day accounting examination prepared by the AICPA. Only an independent CPA can audit the financial statements in a corporation’s annual report and express an opinion regarding the acceptability of the firm’s accounting practices. A certified management accountant (CMA) is an accountant who has met the requirements for education and experience, passed a rigorous exam, and is certified by the Institute of Management Accountants. The CMA exam develops and measures not only accounting skills but also decision-making and critical-thinking skills (LO 2 ends)

3. Discuss the accounting process

Let’s now turn to the actual accounting process and see how accounting turns raw data into information. We’ll start with the accounting equation, which shows the relationship between a firm’s assets—the resources that a business owns, such as cash, inventory, equipment, and real estate; liabilities—a firm’s debts and obligations, and owners’ equity—the difference between a firm’s assets and its liabilities, or what would be left over for the owners if assets were used to pay off liabilities. This relationship, the basis for the accounting process, is expressed as assets equal liabilities plus owners’ equity—the accounting equation. To use this equation, the firm’s accountants record the firm’s raw data using double-entry bookkeeping, a system in which each financial transaction is recorded as two separate accounting entries to maintain the balance shown in the accounting equation.
Raw data are transformed into financial statements in a series of five steps called the accounting cycle. The first step is analyzing source documents. The analysis determines which accounts are affected by the documents and how. The second step is recording the transactions. After analysis, every transaction is recorded in a journal, a process called journalizing. The transaction may be recorded in a general journal, a book of original entry in which the typical transactions are recorded in order of their occurrence, or in a specialized journal, used for transactions that occur frequently, such as cash receipts, cash disbursements, purchases, and sales. The third step is posting the transactions. Posting is the process of transferring journal entries to the general ledger. The general ledger is a book of accounts containing a separate sheet or section for each account. Today, most companies use a computer and commercial accounting packages to journalize and post entries.
These three steps are performed on a regular basis throughout the accounting cycle. The last two, preparing the trial balance and preparing the financial statements and closing the books are performed at the end of the accounting period.
The fourth step is preparing the trial balance. The trial balance is a summary of the balances of all the general ledger accounts at the end of the accounting period. The accountant determines and lists all the balances, then totals them. If the trial balance totals are correct and the accounting equation is still in balance, the accountant can prepare the financial statements. The fifth and final step in the accounting cycle is preparing financial statements and closing the books. A firm’s financial statements are prepared at least once a year and are included in the firm’s annual report, which is a report distributed to stockholders and other interested parties that describes a firm’s operating activities and its financial condition; most firms also prepare statements monthly, quarterly, and semi-annually. Once these statements are prepared and checked, the firm’s books are “closed” for that accounting period, and a new one begins. Three important financial statements are generated at the end of this process: the balance sheet, the income statement, and the statement of cash flows. Let’s look at each of these statements individually, starting with the balance sheet. (LO 3 ends)

4. Read and interpret a balance sheet

The balance sheet, or statement of financial position, is a summary of the dollar amounts of a firm’s assets, liabilities, and owners’ equity accounts at the end of a specific accounting period. On a balance sheet, assets are listed in order, from the most liquid to the least liquid. Liquidity refers to the ease with which an asset can be converted into cash. The most liquid assets are current assets, which can quickly be converted into cash or that will be used in one year or less. Current assets start with cash itself, followed by marketable securities (such as stocks and bonds) and accounts receivable (resulting from allowing customers to buy on credit). Since not all receivables will be paid, firms include an allowance for doubtful accounts. Notes receivable are those for which customers have signed promissory notes and are generally repaid over a longer time frame. The next section is merchandise inventory, the value of goods on hand for sale to customers. The last current asset is prepaid expenses, which are assets that have been paid for in advance but not yet used, such as insurance premiums.
The next group consists of fixed assets, or assets that will be held or used for a period longer than one year. In this category are land, buildings, and equipment, including vehicles used in the business. The value of fixed assets (except land and buildings) is systematically decreased by their accumulated depreciation, the process of apportioning the cost of a fixed asset over the period during which it will be used.
The last group of assets are the intangible assets, those that do not exist physically but that have a value based on the rights or privileges they confer on a firm. They include such things as patents, copyrights, trademarks, franchises, and goodwill.
Now let’s move to the other side of the balance sheet and discuss liabilities and owners’ equity. We start with current liabilities, debts that will be repaid in one year or less. The most common are accounts payable, which are short-term obligations that arise as a result of making credit purchases, and notes payable, obligations that have been secured with promissory notes. Salaries payable and taxes payable are also current liabilities. The next group is long-term liabilities, debts that need not be repaid for at least one year, such as a mortgage payable.
Owners’ equity is the difference between assets and liabilities, for a sole proprietorship or a partnership. For a corporation, this section is called stockholders’ equity, which represents the total value of stock, plus any retained earnings that have been accumulated. Retained earnings are the portion of a business’s profit that is not distributed to stockholders. (LO 4 ends)

5. Read and interpret an income statement

Now let’s turn to the income statement. An income statement is a summary of a firm’s revenues and expenses during a specified accounting period. A firm’s income statement consists of four sections: revenues, cost of goods sold, operating expenses, and net income. Revenues are the dollar amounts earned by a firm from selling goods, providing services, or performing business activities. The revenues section begins with gross sales, the total dollar amount of all goods and services sold during the accounting period. From gross sales we deduct sales returns, sales allowances, and sales discounts to determine net sales, the actual dollar amounts received by a firm for the goods and services it has sold.
The next section is cost of goods sold, the dollar amount equal to beginning inventory plus net purchases less ending inventory. For a manufacturer, this includes raw materials inventories, work in progress, and direct manufacturing costs. At the end of the accounting period, a firm’s gross profit is its net sales less the cost of goods sold.
The third section is operating expenses, which are all business costs other than the cost of goods sold. These expenses are generally classified as selling expenses or general expenses.
The last section, net income (or net loss), is the profit earned (or loss suffered) by a firm during an accounting period, after all expenses have been deducted from revenues. After total operating expenses have been deducted from gross profit to produce net income, federal income taxes are assessed based on that income, ultimately producing net income after taxes. (LO 5 ends)

6. Describe business activities that affect a firm’s cash flow

The third major financial statement is the statement of cash flows, which illustrates how the operating, investing, and financing activities of a company affect cash during an accounting period. The statement is divided into three sections: (1) cash flows from operating activities, which addresses the firm’s primary revenue source; (2) cash flows from investing activities, includes the purchase or sale of land, equipment, and other fixed assets, as well as investments, and (3) cash flows from financing activities, including loans and repayments, the sale and repurchase of the company’s own stock, and cash dividends. (LO 6 ends)

7. Summarize how managers evaluate the financial health of a business

The three financial statements provide answers to questions about a firm’s ability to do business and stay in business. Even more can be learned by comparing current and previous statements to determine trends that might not be immediately apparent. To determine how a firm is doing when compared to the previous year or years or with competing firms, financial analysts may compute financial ratios. A financial ratio is a number that shows the relationship between two elements of a firm’s financial statements. Three profitability ratios, for example, can indicate how effectively the firm’s resources are being used. Return on sales is calculated by dividing net income after taxes by net sales. It shows how effectively a firm transforms sales into profits. Return on owners’ equity, calculated by dividing net income after taxes by owners’ equity, indicates how much income is generated by each dollar of equity. And earnings per share, calculated by dividing net income after taxes by the number of shares of common stock outstanding. An increase is generally the sign of a healthy business.
One calculation and two short-term financial ratios allow managers and lenders to evaluate the ability of a firm to pay its current liabilities. The amount of a firm’s working capital is the difference between current assets and liabilities; it indicates how much would remain if a firm paid off all current liabilities with cash and other current assets. The current ratio is computed by dividing current assets by current liabilities. A high current ratio  indicates that a firm can pay its current liabilities. The acid-test ratio, or quick ratio, is calculated by adding cash, marketable securities, and receivables and dividing the total by current liabilities. This measures a firm’s ability to pay current liabilities quickly.
Two activity ratios can also be calculated. Accounts receivable turnover is calculated by dividing net sales by accounts receivable. It shows the number of times a firm collects its accounts receivable and reflects credit policies. Inventory turnover is calculated by dividing the cost of goods sold in one year by the average value of the inventory.
The last important ratio is the debt-to-owners’ equity ratio, calculated by dividing total liabilities by owners’ equity. It indicates the degree to which a firm’s operations are financed through borrowing. (LO 7 ends)