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1-1McGraw-Hill/IrwinUnderstanding Business, 8e © 2008 The McGraw-Hill Companies, Inc., All Rights

Reserved.

Nickels McHugh McHughNickels McHugh McHugh

**Understanding

FinancialInformation

andAccounting 17

CH

AP

TE

R*

* *

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Importance ofImportance of Accounting InformationAccounting Information

• Definition- Definition- AccountingAccounting

• AudiencesAudiences

• ManagersManagers

• GovernmentGovernment

• Investors, Investors, Suppliers & Suppliers & CreditorsCreditors

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The Accounting SystemThe Accounting System

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The Influence ofThe Influence of Accounting InformationAccounting Information

• ManagersManagers- Financial reports pinpoint - Financial reports pinpoint problems/opportunitiesproblems/opportunities

• GovernmentGovernment- assists with tax collection- assists with tax collection

• Investors, Suppliers, & CreditorsInvestors, Suppliers, & Creditors- provides a - provides a means to analyze businessmeans to analyze business

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Areas of AccountingAreas of Accounting

• Managerial Managerial AccountingAccounting

• Inside Inside OrganizationOrganization

• C.M.A. C.M.A.

• Tax AccountingTax Accounting

• Government & Government & Not-for-profit Not-for-profit AccountingAccounting

• Financial Financial AccountingAccounting

• Annual ReportAnnual Report

• Private Private AccountantAccountant

• Public Public AccountantAccountant

• C.P.A.C.P.A.

• AuditingAuditing

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0% 20% 40% 60% 80% 100% 120%

Tax/Auditing

Cash Mgmt. &Forecasting

Market Strategy &Planning

Personal FinancialPlanning

Valuation, Merger,Acquistion

Top BusinessTop Business Uses of AccountantsUses of Accountants

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How to Read aHow to Read a Corporate Annual ReportCorporate Annual Report

• Read management’s discussion of changes in operations. Try to identify strengths or weaknesses.

• Review the firm’s consolidated balance sheet. (Its assets, liabilities, and owners’ equity.)

• Analyze the Income Statement. Look beyond the year. (Sales drops can spell trouble.)

• Review the statement of changes in cash flows.

• Review auditor’s opinion.

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PublicPublic• AuditingAuditing

• Tax Consulting Tax Consulting & Compliance& Compliance

• Management Management ConsultingConsulting

PrivatePrivate• Management Management

AccountingAccounting

• Government Government AccountingAccounting

• AcademiaAcademia

Types of AccountantsTypes of Accountants

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““Cooking the Books”Cooking the Books”

• Early Recognition of RevenueEarly Recognition of Revenue

• Late Recognition of ExpenseLate Recognition of Expense

• Inadequate Reserves for Bad Inadequate Reserves for Bad Debts, Returns, & LiabilitiesDebts, Returns, & Liabilities

• Changing Inventory Valuation Changing Inventory Valuation Methods- 1 Time Boost to IncomeMethods- 1 Time Boost to Income

• Phony Transactions With Phony Transactions With PartnershipsPartnerships

Courtesy of B. Lilly- De Anza College

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5 Tips To Be Ahead of 5 Tips To Be Ahead of Sneaky Accountant TricksSneaky Accountant Tricks

1.1. Who’s whoWho’s who

2.2. Pick out the bad applesPick out the bad apples

3.3. Don’t fall for rapid refundDon’t fall for rapid refund

4.4. Know their loyaltyKnow their loyalty

5.5. Watch what you signWatch what you sign

Source: CNNMoney.com, March 17, 2006

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5 Ways to Avoid 5 Ways to Avoid More EnronsMore Enrons

1.1. Bring hidden liabilities back onto the Bring hidden liabilities back onto the balance sheetbalance sheet

2.2. Highlight the things that matterHighlight the things that matter

3.3. List the risks and assumptions built List the risks and assumptions built into the numbersinto the numbers

4.4. Standardize operating incomeStandardize operating income

5.5. Provide aid in figuring free-cash flowProvide aid in figuring free-cash flow

Source: Business Week, February 18, 2002

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Sarbanes-Oxley TimelineSarbanes-Oxley Timeline

EffectiveEffective RequirementsRequirements

July 30, 2002July 30, 2002Prohibit personal loans to officers/directors.Prohibit personal loans to officers/directors.

CEOs/CFOs return incentive-based CEOs/CFOs return incentive-based compensation after erroneous financial report.compensation after erroneous financial report.

August 29, 2002August 29, 2002CEOs/CFOs must certify annual/quarterly CEOs/CFOs must certify annual/quarterly reports. Officers must make certifications reports. Officers must make certifications

regarding company’s internal controls.regarding company’s internal controls.

January 26, 2003January 26, 2003Responsibilities for attorneys/audit firms Responsibilities for attorneys/audit firms

increased. Disclosure requirements for off-increased. Disclosure requirements for off-balance sheets transactions tightened. balance sheets transactions tightened.

April 26, 2003April 26, 2003Audit committees must: be independent Audit committees must: be independent

directors, be responsible for compensation & directors, be responsible for compensation & oversight of certifying accountants.oversight of certifying accountants.

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Not-for-Profits’ Policies Not-for-Profits’ Policies Due to Sarbanes-Oxley Due to Sarbanes-Oxley

0%

10%

20%

30%

40%

50%

60%

70%

Conflict-of-Interest Policy

Audit CommitteeCharter

Records-Retention Policy

Code-of-EthicsStatement

Whistle-blowerPolicy

Source: USA Today

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How can Sarbanes-OxleyHow can Sarbanes-Oxley be Improved? be Improved?

0%

10%

20%

30%

40%

50%

60%

70%

80%

No changes Exempt smallercompanies

Scale it back orremove it

completely

Separatepervasive

control matters

Provide betterguidance

Source: USA Today

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Steps to Control Steps to Control Accounting PracticesAccounting Practices

Source: USA Today, “Snapshots”, Section B, pg. 1, March 26, 2003

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Review ChangeCurrent

Procedures

Create/ExpandInternal Audits

Hire IndependentFirm for

Consulting

RestructureExecutive

CompensationPlans

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Bookkeeping vs. AccountingBookkeeping vs. Accounting

BookkeepingBookkeeping

• Start of AccountingStart of Accounting

• Record/JournalizeRecord/Journalize

AccountingAccounting

• AnalyzeAnalyze

• RecommendRecommend

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Steps In TheSteps In The Accounting CycleAccounting Cycle

Analyze Source Documents

Record Transactions

in Journals

Post Journal Entries to Ledger

Take a Trial Balance

Prepare Financial

Statements

Analyze Financial

Statements

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Computers & AccountingComputers & Accounting

• Tool Not Decision MakerTool Not Decision Maker

• SimplificationSimplification

• Accounting PackagesAccounting Packages

• Up-To-the-Minute Up-To-the-Minute InformationInformation

• Less MonotonyLess Monotony

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Financial StatementsFinancial Statements

• Balance Sheet- Statement of Financial Balance Sheet- Statement of Financial PositionPosition

• Income Statement- Statement of Income Statement- Statement of Revenues & ExpensesRevenues & Expenses

• Statement of Cash Flows – Statement Statement of Cash Flows – Statement of Cash Receipts & Disbursementsof Cash Receipts & Disbursements

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Accounting EquationAccounting Equation

AssetsAssets Liabilities + Owner’s Liabilities + Owner’s EquityEquity

OwneOwnedd

Owed + Owner’s Owed + Owner’s ClaimsClaims

==

==

$826,00$826,0000

== $613,00$613,0000

++ $213,00$213,0000

Very Vegetarian Company

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Very Vegetarian’sVery Vegetarian’s Balance Sheet (Assets)Balance Sheet (Assets)

Period ending 12/31/07Period ending 12/31/07

AssetsAssets

Current AssetsCurrent AssetsCashCash $ 15,000$ 15,000Accounts ReceivableAccounts Receivable 200,000 200,000Notes ReceivableNotes Receivable 50,000 50,000InventoryInventory 335,000335,000Total Current AssetsTotal Current Assets $600,000$600,000

Fixed AssetsFixed AssetsLandLand $ 40,000$ 40,000Buildings (net)Buildings (net) 110,000 110,000Equipment & Vehicles (net)Equipment & Vehicles (net) 40,000 40,000Furniture & Fixtures (net)Furniture & Fixtures (net) 16,000 16,000Total Fixed AssetsTotal Fixed Assets $206,000$206,000

Intangible AssetsIntangible AssetsGoodwillGoodwill $ 20,000$ 20,000Total Intangible AssetsTotal Intangible Assets $ 20,000$ 20,000

Total AssetsTotal Assets $826,000$826,000

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Very Vegetarian’s Balance Very Vegetarian’s Balance SheetSheet

(Liabilities & Owner’s Equity)(Liabilities & Owner’s Equity)Period ending 12/31/07Period ending 12/31/07

Liabilities & Owners’ EquityLiabilities & Owners’ EquityCurrent LiabilitiesCurrent Liabilities

Accounts PayableAccounts Payable $ 40,000$ 40,000Notes PayableNotes Payable 8,000 8,000Accrued Taxes & SalariesAccrued Taxes & Salaries 240,000240,000Total Current LiabilitiesTotal Current Liabilities $288,000$288,000

Long-term LiabilitiesLong-term LiabilitiesNotes PayableNotes Payable $ 35,000$ 35,000Bonds PayableBonds Payable 290,000 290,000Total Long-term LiabilitiesTotal Long-term Liabilities $325,000$325,000

Total LiabilitiesTotal Liabilities $613,000$613,000Owners’ EquityOwners’ Equity

Common Stock (1M shares)Common Stock (1M shares) $100,000 $100,000Retained EarningsRetained Earnings 113,000113,000

Total Owners’ EquityTotal Owners’ Equity $213,000$213,000

Total Liabilities & Owners’ EquityTotal Liabilities & Owners’ Equity $826,000$826,000

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Very Vegetarian Very Vegetarian Income StatementIncome Statement

Period Ending 12/31/07Period Ending 12/31/07

RevenueRevenueNet SalesNet Sales $ 700,000$ 700,000

Cost of Goods SoldCost of Goods SoldBeginning InventoryBeginning Inventory $ 200,000 $ 200,000Net PurchasesNet Purchases $ 440,000$ 440,000Cost of Goods Cost of Goods $ 640,000 $ 640,000Less: Ending Inventory - Less: Ending Inventory - $ 230,000$ 230,000

Less: Cost of Goods SoldLess: Cost of Goods Sold - - $ 410,000$ 410,000Gross Profit (Gross Margin)Gross Profit (Gross Margin) $ 290,000$ 290,000

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Very Vegetarian’s Very Vegetarian’s Income Statement (cont’d)Income Statement (cont’d)

Gross Profit Gross Profit $290,000$290,000Operating ExpensesOperating Expenses

Selling ExpensesSelling ExpensesSalariesSalaries $ 90,000$ 90,000Advertising & SuppliesAdvertising & Supplies $ 20,000$ 20,000

Total Selling ExpensesTotal Selling Expenses $ 110,000$ 110,000General ExpensesGeneral Expenses

Office SalariesOffice Salaries $ 67,000$ 67,000DepreciationDepreciation $ 1,500$ 1,500InsuranceInsurance $ 1,500$ 1,500RentRent $ 28,000$ 28,000UtilitiesUtilities $ 12,000$ 12,000MiscellaneousMiscellaneous $ 2,000$ 2,000

Total General ExpensesTotal General Expenses $ 112,000$ 112,000Less: Total Operating ExpensesLess: Total Operating Expenses - - $ 222,000$ 222,000

Net Income (Profit) Before TaxesNet Income (Profit) Before Taxes $ 68,000$ 68,000Less: Income Tax ExpensesLess: Income Tax Expenses - - $ 19,000$ 19,000Net Income (Profit) After TaxesNet Income (Profit) After Taxes $ 49,000$ 49,000

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Very Vegetarian’sVery Vegetarian’sStatement of Cash FlowStatement of Cash Flow

Net Cash Flow from OperationsNet Cash Flow from Operations $ 52,000$ 52,000

Net Cash Flows from InvestmentsNet Cash Flows from Investments ( 6,000)( 6,000)Net Cash Flow from FinancingNet Cash Flow from Financing (19,000)(19,000)Net Change in Cash & EquivalentsNet Change in Cash & Equivalents $ $ 27,00027,000Beginning Cash BalanceBeginning Cash Balance ( 2,000)( 2,000)Ending Cash BalanceEnding Cash Balance $ 25,000$ 25,000

==================

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Liquidity RatiosLiquidity Ratios

Current AssetsCurrent Liabilities

Quick (Acid-Test) RatioQuick (Acid-Test) Ratio

Cash + Marketable Securities + Cash + Marketable Securities + ReceivablesReceivables

Current LiabilitiesCurrent Liabilities

Current RatioCurrent Ratio

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Very Vegetarian Very Vegetarian Current RatioCurrent Ratio

$600,000$600,000$288,000$288,000

== 2.082.08

$265,000$265,000$288,000$288,000 == 0.920.92

Quick (Acid-Test) RatioQuick (Acid-Test) Ratio

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Leverage RatiosLeverage Ratios

Total LiabilitiesOwners’ Equity

Debt-to-Owners’ Equity RatioDebt-to-Owners’ Equity Ratio

$613,000$613,000$213,000$213,000

== 287%287%

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Profitability RatiosProfitability Ratios

Net Income After Tax

Total Owners’ Equity

Basic Earnings Per Basic Earnings Per ShareShare

Net Income After TaxesNet Income After TaxesNumber of Common Stock Shares Number of Common Stock Shares

OutstandingOutstanding

Return on Return on EquityEquity

Net IncomeNet Sales

Return on Return on SalesSales

Profitability = Operating Profitability = Operating SuccessSuccess

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Profitability RatiosProfitability Ratios

Earnings per ShareEarnings per Share $ 49,000$ 49,000 = = $.049$.049

$1,000,000$1,000,000

Return on Sales Return on Sales $ 49,000$ 49,000 = = 7%7%

$700,000$700,000

Return on Equity Return on Equity $ 49,000$ 49,000 = = 23%23%

$213,000$213,000

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Activity RatiosActivity Ratios

Inventory Turnover Inventory Turnover $410,000$410,000 = = 1.91.9

$215,000$215,000

Cost of Goods SoldAverage Inventory

Inventory TurnoverInventory Turnover