Chap14 Accounting Instrnotes

BURKS-Instructor Notes-INTRO2BUS-CHAP14-ACCOUNTING LEARNING OBJECTIVES 1. Explain how the success of a company’s business model can be measured by financial accounts and describe the various kinds of activities that accountants perform. 2. Analyze a company’s balance sheet and describe how it balances the assets a company owns against the capital owed to its creditors and stockholders. 3. Explain how the income statement is used to measure a company’s bottom line profit and the various costs and expenses that must be deducted to arrive at this total. 4. Understand why the need for cash, as well as profit, affects a company’s business model, and how the cash flow statement measures the cash that flows into and out of a company. 5. Appreciate how financial ratios can be used to analyze the information in a company’s financial statements and how they help both managers and investors evaluate a company’s current and future profitability.

I. THE NATURE OF ACCOUNTING The primary goal of a company is to make a profit, and it can only do this if the revenues it earns from the sales of its profits exceed the costs and expenses of making them. Accounting makes its functional contribution by providing the tools a company needs to accurately measure its revenues, assets, costs, money, expenses, and capital so managers can evaluate whether the profit their business model is earning is a profitable return on the capital invested in it. 1. Accounting is the process of (a) collecting, measuring and recording raw financial data (b) organizing this data using agreed-upon accounting rules and methods to create useful information about a company’s financial performance (c) analyzing this information and reporting and communicating the results in financial reports and statements. 2. A company’s accounting system is the financial information system it uses to measure, record, analyze, and report all the transactions that are involved in its value creation process. A. Company Accounting and Stakeholders The knowledge and information provided by a company’s accounting function is very important to all of its stakeholders. Financial statements, when compared to other companies and to its own performance over time, provide insights into the source of a company’s competitive advantage (or lack of it) and knowledge about the “key drivers” of success in an industry. It’s important to recognize that accounting provides information about the past, it may or may not be a good predictor of the future, because conditions change rapidly and often. 1. Managers at all levels use financial information to analyze performance over 3,6, 9, and 12 month periods, by breaking down the profitability of products and functions. This information can be used to improve the profits from particular products, eliminate them, or invest more in them.

2. Employees can use accounting information to identify ways to improve different functions through ERP or CRM systems. They are also interested in the general health of a company for employment security, and because they often own stock or have profitsharing programs as part of their compensation. 3. Investors watch a company’s financial information because it affects stock prices. 4. Government agencies such as the SEC and the IRS have a strong interest in a company’s financial reports and want to assure that it follows legally accepted accounting standards. 5. The general public is concerned with the general health of companies in the economy and with their ethical and social responsibility, because they affect the job security, standard of living, and investments of millions of people. B. Types of Accounting Activities Bookkeeping is the process of keeping records of all the financial transactions involved in making and selling goods and services. Five principle accounting activities range from those needed to capture the millions of pieces of raw data about all transactions to preparing financial statements to summarizing overall performance. 1. Recording and managing cash inflows from products sold and cash outflows for resources purchased, including payroll and payment of gross wages or earnings and the taxes associated with them. . 2. Measuring and recording cost-of-goods sold through purchase orders for the materials and parts used to add value to a company’s products, measure the costs of various units, functions, and departments in the company. Depreciation is the expense method used to reduce the value of a company’s assets used in production over time. 3. Preparing tax returns and other financial reports for local, state, and federal governments. 4. Preparing reports on whether a company is meeting goals and objectives on costs, inventory control, and cash balances. 5. Preparing information and reports of a company’s financial statements that show a company’s profitability over time, the success of its business model, and its current financial situation.

C. GAAP Accounting Rules The generally accepted accounting principles (GAAP) is a set of rules and procedures developed over time by accounting experts to ensure a clear and accurate picture of a company’s financial standing. They are legally enforceable and companies or accountants who break them can be punished with fines and/or imprisonment. 1. The use of GAAP allows stakeholders to evaluate a company’s performance relative to others. 2. Managers may try to manipulate this information to increase the value of a company’s stock or prospects, enhancing their own interests. Well-established accounting rules and guidelines greatly reduce the opportunities for fraudulent behavior.

3. In the U.S., independent accountants are required to review a company’s financial statements and make a statement that they have been prepared according to GAAP guidelines, representing a true and fair account of the company’s position. D. Types of Accountants Accountants can be divided into two groups: inside or outside (independent) accountants. Most of them have passed the stringent professional exams developed by the American Institute of Certified Public Accountants required to become a certified public accountant (CPA). 1. External accountants work in the Big Four accounting firms such as Ernst & Young or KPMG, LLP that specialize in auditing large companies or in small independent public companies or partnerships to provide services to medium or small companies and individuals. 2. The Sarbanes-Oxley Act, passed in 2002, requires a company’s CEO and CFO, as well as its external auditors, to sign off that their company’s financial statements accurately reflect its situation. 3. Internal accountants are employed by a company to scrutinize internal data to ensure that transactions are properly recorded, accounting rules have been followed, reports are accurate, that employees are not deliberately defrauding the company, or stealing its assets. 4. Internal accountants may be either managerial accountants with Certified Managerial Accountant (CMA) who prepare information for managerial analysis, or Chartered Financial Analysts (CFA) who prepare financial information for use by outside stakeholders. Protecting the confidentiality of a company’s business model and competitive advantage is an important requirement for internal accountants. 5. Managerial accountants may specialize in financial analysis which provides information for company decisions about the components of its business model such as product lines and acquisitions, tax accounting, or cost accounting which analyzes costs of acquisition of materials, inventory, and physical work arrangements. E. Accounting and ERP Systems Today, IT software has transformed the way accountants work. They are able to use ERP, transaction recording, and CRM systems to develop more and better data than ever before. It can flow freely between different levels, functions, and groups within a company to provide more useful, timely, and accurate information for decisions that will add value and profitability. II. ACCOUNTING CONCEPTS AND FINANCIAL STATEMENTS The strengths and weaknesses of a company’s business model and its functions can be identified from information in its financial statements. Managers at all levels need to understand them and the methods used to prepare them. Investors should be able to read and analyze them using financial ratios to assess potential future risks and returns.

A. The Balance Sheet The balance sheet is the summary of the financial condition of a business on the day at the end of the specific reporting period, such as December 31, 2003. It reports the main assets, what it owns, and liabilities, what it owes, and its stockholder’s equity, or what it’s worth. Its purpose is to track the relationship between capital and assets to see how well a company is using them. 1. Liabilities are the sums of money a company borrows from creditors, which is a major source of capital to build its business model, including money owed to employees and suppliers. 2. Stockholder’s equity or equity is the money obtained from its founders and stockholders over time, and all of the profit that has been retained in its business. 3. Together, liabilities and equity make up the total capital a company has invested in its business. It is used to buy the assets and resources needed to fund its business model. 4. The Accounting Equation is designed so the two sides balance, to show managers and investors how their capital is being used. The basic concept is that what a company owns minus what it owes is what it is worth. Assets-Liabilities= Owner’s Equity, or Assets= Liabilities and Owners’ Equity 5. Double-entry bookkeeping involves recording the dual effects of a financial transaction on a company’s assets and liabilities. 6. Investors are able to evaluate the company’s ability to pay its creditors. Should a company fail, its creditors are paid in an established order. 7. Assets are listed on the balance sheet in order of liquidity, which measures how fast they can be converted to cash. Inventory is the stock of finished products on hand and pre-paid expenses include insurance premiums, rent, salary advances, or equipment maintenance contracts that have already been paid. 8. Current assets or working assets are constantly used to make products that are sold to generate revenue and still more cash. 9. Non-current assets include property, plant, and equipment. 10. Liabilities include current liabilities, due in less than one year, and long-term debt borrowed for more than one year. Total liabilities are listed on the right hand side of the Balance Sheet. 11. Stockholders’ Equity includes the different types of stock issued, such as preferred, common, or capital stock, the original stock used to start the company. . 12. Total equity includes the value of all of the capital stock invested and retained earnings. B. The Income Statement Although the balance sheet shows financial status at a given time, it does not explain how its assets are used. The income statement, or profit and loss statement, summarizes and reports the results of a company’s profit-making activities in a specific time period. The “bottom line” on this statement shows profit or loss for the period. 1. The income statement shows Sales revenue-Expenses= Profit (or loss)

2. To calculate net income, companies deduct the cost of goods sold (COGS) from sales revenue. 3. The GAAP matching principle requires that the expenses incurred in making and selling a company’s products be deducted from the revenues generated by the sale of the company’s products during the same accounting period. The accrual basis of accounting records income when a company makes a sale or provides a service, not when the company actually gets paid. 4. Gross profit or gross margin is left after cost of goods sold is deducted. 5. Net profit, the bottom line, is the total profit or earnings that reflect adjustments for cost of goods sold, all other expenses, interest, and taxes. C. Statement of Cash Flows The cash flow statement shows how much cash a company generates during a period, where it comes from, and how it was used. Cash refers to assets that can be turned into cash immediately, such as money in checking accounts, stocks and bonds that can be sold quickly. 1. Cash flows are divided into three basic categories: a. Cash flows from operating activities b. Cash flows from investing c. Cash flows from financing 2. Working capital is the amount of cash left after current liabilities are subtracted from current assets on the Balance Sheet. 3. Companies may have positive or negative cash flows depending on how they are reinvesting in the business, as well as the success of their operations. III. ANALYZING A COMPANY’S FINANCIAL STATEMENTS Financial ratios are measures of a company’s performance and profitability. They provide useful information to benchmark a company’s performance to study changing performance over time and to compare a company to others in its industry. Managers use financial ratios to understand how profitability will be affected by decisions about pricing, product development, and HRM policies.

A. Liquidity Ratios Liquidity ratios measure a company’s ability to pay its bills when they are due. 1. Current ratio is a test of solvency that tests ability to pay liabilities due within one year. Current assets/Current liabilities = Current Ratio 2. Quick ratio is a more stringent test, excluding inventory. Cash + Receivables/ Current Liabilities = Quick Ratio B. Asset Management Ratios Asset Management Ratios measure how efficiently and effectively managers are using assets to generate revenue and profit.

1. Inventory turnover ratio measures how quickly it is shipped and sold in a given period. Cost of Goods Sold/Inventory = Inventory Turnover 2. Asset turnover measures how well a company’s assets are used to generate sales. Sales/Total Assets = Asset Turnover C. Profitability Ratios Many different profitability ratios are used to relate a company’s performance to different pieces of financial information such as sales, equity, or total capital to measure how effectively a company’s business model is generating profit and cash. 1. Gross margin indicates how much of each sales dollar is left after paying the cost of goods sold. Gross profit (or COGS)/ Sales X 100 = Gross Margin Relatively small improvements in gross margin can lead to major increases in the bottom line. 2. Profit margin or return on sales measures how much profit is generated from sales. Net Income/Sales X 100 = Return on Sales 3. Return on Equity (ROE or ROI) and Earnings Per Share measure tells managers how much profit has been earned on each $100 of stockholders’ equity invested in the business. The higher the Return on Equity, the more a company’s managers are adding to the value of its owners’ investment, so it is sometimes called Return on Investment. Net Income/ Owner’s Equity X 100 = Return on Equity Earning’s per share is another measure used to examine how much profit has been earned for each share of its stock. Net Income/ Total Number of Shares = Earnings Per Share 4. Return on Invested Capital (ROIC) is believed by financial analysts to be the best measure of a company’s profitability. It measures profit for each dollar invested in the business. The more cash generated, the more efficiently and effectively, it is being used. Net Income/Total Capital = Return on Invested Capital D. Changes in the Sporting Goods Industry The value of financial ratios is to analyze the results within a company and to compare it to that of its competitors. How could it improve earnings?

REVIEW OF LEARNING OBJECTIVES 1. Explain how the success of a company’s business model can be measured by financial accounts and describe the various kinds of activities that accountants perform. The primary goal of a company is to make a profit, and it can only do this if the revenues it earns from the sales of its profits exceed the costs and expenses of making them. Accounting makes its functional contribution by providing the tools a company needs to accurately measure its revenues, assets, costs, money, expenses, and capital so managers can evaluate whether the profit their business model is earning is a profitable return on the capital invested in it. Accounting activities include (a) collecting, measuring and recording raw financial data; (b) organizing this data using agreed-upon accounting rules and methods to create useful information about a company’s financial performance; (c) analyzing this information and reporting and communicating the results in financial reports and statements.

2. Analyze a company’s balance sheet and describe how it balances the assets a company owns against the capital owed to its creditors and stockholders. The balance sheet is the summary of the financial condition of a business on the day at the end of the specific reporting period, such as December 31, 2003. It reports the main assets, what it owns, and liabilities, what it owes, and its stockholder’s equity, or what it’s worth. Its purpose is to track the relationship between capital and assets to see how well a company is using them. The basic equation of accounting is what a company owns minus what it owes is what it is worth., or Assets – Liabilities = Owners’ Equity 3. Explain how the income statement is used to measure a company’s bottom line profit and the various costs and expenses that must be deducted to arrive at this total. The income statement, or profit and loss statement, summarizes and reports the results of a company’s profit-making activities in a specific time period. The “bottom line” on this statement shows profit or loss for the period. To calculate net income, companies deduct the cost of goods sold (COGS) from sales revenue. Gross profit or gross margin is left after cost of goods sold is deducted. Net profit, the bottom line, is the total profit or earnings that reflect adjustments for cost of goods sold, all other expenses, interest, and taxes. The income statement shows Sales revenue-Expenses= Profit (or loss) 4. Explain why the need for cash, as well as profit, affects a company’s business model, and how the cash flow statement measures the cash that flows into and out of a company. A company’s business model requires both profit and cash flow objectives to ensure its long-term and short-term survival. It needs cash to pay its bills and invest in new materials, labor, and other resources on a regular basis. The statement of cash flows

shows how much a company generates during a specific period, where it came from, and how it was used. 5. Explain how financial ratios can be used to analyze the information in a company’s financial statements and how they help both managers and investors evaluate a company’s current and future profitability. Financial ratios are measures of a company’s performance and profitability. They provide useful information to benchmark a company’s performance to study changing performance over time and to compare a company to others in its industry. Managers use financial ratios to understand how profitability will be affected by decisions about pricing, product development, and HRM policies.