Accounting and Financial Information
Accounting provides the financial information that managers, owners, investors, creditors, government agencies, and other interested parties use to understand a business. Accounting is the recording, classifying, summarizing, and interpreting of financial events and transactions so that useful financial information can be provided to interested parties.
An accounting system begins with business transactions and supporting documents. Those transactions are recorded and organized, then summarized into reports and financial statements. The quality of the final information depends on accurate records and integrity throughout the accounting process.
Managerial and Financial Accounting
Managerial accounting provides information and analysis to managers inside an organization to assist them in decision making. Managers may use accounting information to analyze production and marketing costs, prepare and control budgets, evaluate alternatives, plan investments, and manage tax obligations.
Financial accounting produces financial information primarily for people outside the organization. External users may want to know whether the organization is profitable, whether it can pay its bills, and how much debt it owes.
An annual report is a yearly statement of a firm's financial condition, progress, and expectations. Important parts to examine include management's discussion and analysis, the balance sheet, income statement, statement of cash flows, and the auditor's opinion.
Accounting Careers and Professional Roles
Private accountants work for a single business, government agency, or nonprofit organization. Public accountants provide accounting services to individuals or businesses. Certified Public Accountants (CPAs) meet education and experience requirements and pass professional examinations.
Accounting also includes specialists in auditing, taxation, and government or nonprofit accounting. Tax accountants are trained in tax law and may prepare tax returns or develop tax strategies. Government and not-for-profit accounting supports organizations whose primary purpose is service rather than generating a profit and often emphasizes accountability to an approved budget.
Auditing and Financial Accountability
Auditing is the process of reviewing and evaluating information used to prepare a company's financial statements. An independent audit provides an outside evaluation and an unbiased opinion about the accuracy of those statements.
Certified Internal Auditors (CIAs) work in internal auditing and meet specified education, experience, and examination requirements. Internal and external auditing help organizations improve reliability, accountability, and confidence in financial reporting.
The chapter also discusses financial-reporting regulation, including the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, as examples of efforts to strengthen oversight and accountability.
The Accounting Cycle
The accounting cycle is a six-step procedure that results in the preparation and analysis of the major financial statements. It begins with source documents that provide evidence of business transactions and continues through recording, classification, summarization, and reporting.
Bookkeeping is the recording of business transactions. Transactions are first organized into meaningful categories and recorded in a journal. With double-entry bookkeeping, transactions are recorded in two places so the records can be checked against one another for accuracy.
Information is then transferred to a ledger, where account information is collected. A trial balance summarizes information from the account ledgers and helps determine whether the records are in balance before financial statements are prepared.
Financial Statements
A financial statement summarizes financial transactions that occurred during a particular period or describes the firm's financial condition at a specific point in time. Three major financial statements are especially important:
- Balance sheet — reports the firm's financial condition at a specific time.
- Income statement — reports revenues, costs, expenses, taxes, and the resulting net income or net loss over a period.
- Statement of cash flows — reports cash receipts and cash disbursements associated with operating, investing, and financing activities.
The Fundamental Accounting Equation
The balance sheet is built around the fundamental accounting equation:
Assets = Liabilities + Owners' Equity
Assets are economic resources owned by the firm. Liabilities are amounts the business owes to others. Owners' equity represents the owners' interest in the business after liabilities are considered.
Understanding Assets
Assets may be tangible or intangible. Liquidity describes how easily an asset can be converted into cash.
- Current assets are assets that can or will be converted to cash within one year, such as cash, accounts receivable, and inventory.
- Fixed assets are relatively permanent long-term assets such as land, buildings, and equipment.
- Intangible assets are long-term assets without physical form that still have value, such as patents, trademarks, and goodwill.
Understanding Liabilities and Owners' Equity
Liabilities are debts owed by the business. Accounts payable are current liabilities owed for merchandise or services purchased on credit. Notes payable are short- or long-term liabilities that a business promises to pay by a specified date. Bonds payable are long-term liabilities that the firm must repay.
Owners' equity is the owners' financial interest in the business. Retained earnings are accumulated earnings from profitable operations that are reinvested in the business rather than distributed to owners.
The Income Statement
The income statement shows a firm's financial performance over a period and ultimately reports its bottom line. A simplified sequence is:
Revenue − Cost of Goods Sold = Gross Profit
Gross Profit − Operating Expenses = Net Income Before Taxes
Net Income Before Taxes − Taxes = Net Income or Net Loss
Revenue is the monetary value a firm receives for goods sold, services rendered, and other payments. Cost of goods sold measures the cost of merchandise sold or the raw materials and supplies used to produce goods for resale. Gross profit, or gross margin, shows how much the firm earned from buying or producing and then selling merchandise before operating expenses are deducted.
Operating expenses include costs such as rent, salaries, and supplies. Depreciation is the systematic write-off of the cost of a tangible asset over its estimated useful life. After costs, expenses, and taxes are considered, the company reports net income or a net loss.
The Statement of Cash Flows
The statement of cash flows reports cash receipts and cash disbursements related to three major activities:
- Operations
- Investments
- Financing
Cash flow is the difference between cash coming into and cash going out of a business. Managing cash flow is critical because a business must have enough available cash to meet its obligations even when its income statement reports a profit.
Ratio Analysis
Ratio analysis uses calculations developed from financial statements to assess a firm's financial condition. Ratios become especially useful when a company's results are compared over time, against financial objectives, or with other firms in the same industry.
Profitability Ratios
Profitability ratios examine how effectively a firm uses its resources to generate profits. Examples in this chapter include:
Profit Margin = Net Income ÷ Sales
Return on Assets = Net Income ÷ Assets
Return on Equity = Net Income ÷ Equity
Asset Utilization Ratios
Asset utilization, or activity, ratios examine how effectively management uses assets. Examples include:
Receivables Turnover = Sales ÷ Receivables
Inventory Turnover = Sales ÷ Inventory
Total Asset Turnover = Sales ÷ Total Assets
Liquidity Ratios
Liquidity ratios measure the firm's ability to use short-term assets to meet short-term obligations.
Current Ratio = Current Assets ÷ Current Liabilities
Quick Ratio = (Current Assets − Inventory) ÷ Current Liabilities
The quick ratio is also called the acid-test ratio.
Debt and Leverage Ratios
Debt or leverage ratios measure the extent to which a firm relies on borrowed funds. Examples include:
Debt to Total Assets = Total Liabilities ÷ Total Assets
Times Interest Earned = Income Before Interest and Taxes ÷ Interest Expense
The chapter also identifies the debt-to-owners'-equity ratio as an important measure of reliance on borrowed funds.
Per-Share Data
For corporations, investors may also examine financial information on a per-share basis:
Earnings per Share = Net Income ÷ Number of Shares Outstanding
Dividends per Share = Dividends Paid ÷ Number of Shares Outstanding
Putting Chapter 17 Together
Accounting turns individual business transactions into useful financial information. The accounting cycle organizes those transactions, the financial statements summarize the results, and ratio analysis helps managers and outside users interpret what those results mean. Understanding the balance sheet, income statement, statement of cash flows, and basic financial ratios gives you a foundation for evaluating the financial health and performance of a business.