Download Chapter 1 - Faculty of Business and Economics Courses

Part 6
Chapter 14
Financing the
Enterprise
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CHAPTER 14
Accounting and Financial Statements
CHAPTER 15
Money and the Financial System
CHAPTER 16
Financial Management and Securities Markets
APPENDIX D
Personal Financial Planning
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2
Learning Objectives
LO 14-1 Define accounting and describe the different uses of
accounting information.
LO 14-2 Demonstrate the accounting process.
LO 14-3 Examine the various components of an income
statement to evaluate a firm’s bottom line.
LO 14-4 Interpret a company’s balance sheet to determine its
current financial position.
LO 14-5 Analyze the statement of cash flows to evaluate the
increase and decrease in a company’s cash balance.
LO 14-6 Assess a company’s financial position using its
accounting statements and ratio analysis.
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3
The Nature of Accounting
• Accounting
– The recording, measurement
and interpretation of financial
information
• Certified Public Accountant
– An individual who has been
state certified to provide
accounting services ranging
from the preparation of
financial records and the
filing of tax returns to
complex audits of corporate
financial records
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4
Prestige Rankings of Accounting Firms
2015
Rank
2014
Rank
Company
1
1
(PricewaterhouseCoopers) LLP
2
2
Ernst & Young LLP
3
3
Deloitte LLP
4
4
KPMG LLP
5
5
Grant Thornton LLP
6
6
McGladrey LLP
7
7
BDO USA LLP
8
8
Crowe Horwath LLP
9
9
Moss Adams LLP
10
10
Baker Tilly Virchow Krause
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Legislation
o After the accounting scandals of Enron and Worldcom
in the early 2000s, Congress passed
– Sarbanes-Oxley Act – required firms to be more rigorous
in their accounting and reporting practices
o During the latest financial crisis, banks developed
questionable lending practices, leading to
– Dodd Frank Act – strengthens the oversight of financial
institutions
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Accounting Standards (1 of 2)

Public and private businesses follow the Generally
Accepted Accounting Principles (GAAP) method
 GAAP is generally used in the United States as the standard
for accounting methods (established by the Financial
Accounting Standards Board (FASB))

Local government entities have a different set of
accounting standards which are set by the
Governmental Accounting Standards Board (GASB)
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Accounting Standards (2 of 2)

Federal government follows yet another set of
standards determined by the Federal Accounting
Standards Advisory Board (FASAB)

Another set of standards for international companies
which follow the International Financial Reporting
Standards (IFRS)
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Forensic Accounting
Accounting that is fit for legal review
 Involves analyzing financial documents in search
of fraudulent entries or financial misconduct
 Function as much as detectives as accountants
 Used since the 1930s
 Booming since the accounting scandals of the
early 2000s
 Root out evidence of “cooked books” for federal
agencies
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9
Private Accountants
Private Accountants
– Employed by large corporations, government
agencies, and other organizations to prepare and
analyze their financial statements
– Deeply involved in most of the most important
financial decisions of the organization
Certified Management Accountants (CMAs)
– Private accountants who are certified by the National
Association of Accountants and who have some
managerial responsibility
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Accounting or Bookkeeping?
 Bookkeeping is typically limited to the routine, dayto-day recording of business transactions
 Much narrower and far more mechanical than
accounting
 Require less training than accountants
 Responsible for obtaining and recording the
information accounts require to analyze a firm’s
financial position
 Accountants usually complete course work beyond
their basic 4 or 5 year college degree
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Users of Accounting Information
(1 of 3)
• Managers and owners use financial statements:
1. Aid in internal planning and control
2. External purposes such as reporting to the Internal
Revenue Service, stockholders, creditors,
customers, employees, and other interested parties
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Users of Accounting Information
(2 of 3)
• Organizational Use






Board of Directors
Owners, shareholders
Managers
Management Information Systems
Business research
Internal control
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Users of Accounting Information
(3 of 3)
• Stakeholder Use







Tax collecting agencies
Regulatory agencies
Special interest groups
Customers
Financial analysis
Employees
Media
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Internal Uses of Accounting Information
Managerial Accounting
– The internal use of accounting statements by
managers in planning and directing the organization’s
activities
Cash Flow
– The movement of money through an organization
over a daily, weekly, monthly or yearly basis
Budget
– An internal financial plan that forecasts expenses and
income over a set period of time
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External Uses of Accounting Information
 Used for filing income taxes,
obtaining credit and reporting
results to stockholders
 Annual Report
 A summary of a firm’s financial
information, products, and growth
plans for owners and potential
investors
 Audited financial statements are
those signed off on by a certified
public accountant
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Greece and Deceptive Accounting Practices
 During global financial crisis, Greece was engaging in deceptive
accounting practices with the help of U.S. investment banks
♦ Used financial techniques to hide massive amounts of debt
from its public balance sheet
♦ Eventually markets discovered the country might not be able to
pay off its creditors
♦ European Union and International Monetary Fund gave some
credit relief
 PIGS (Portugal, Italy, Ireland, Greece, Spain) all had debt problems
 Germany demanded austerity, but others wanted more growthoriented strategies
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Banks and Financial Statements
 Wells Fargo specializes in
banking, mortgage, and financial
services
 Data it provides can be used in
financial statements
 Short-term lender examines a
firm’s cash flow to assess its
ability to repay a loan quickly with
cash generated from sales
 Long-term lender more interested
in the company’s profitability and
indebtedness to other lenders
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The Accounting Equation
Assets = Liabilities + Owner’s Equity
 Assets
o A firm’s economic resources, or items of value that it owns, such
as cash, inventory, land, equipment, buildings, and other tangible
and intangible things
 Liabilities
o Debts that a firm owes to others
 Owner’s Equity
o Equals assets minus liabilities and reflects historical values
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Owner’s Equity
 The owner’s equity portion of a company’s balance sheet:
► Rendezvous Barbecue in Memphis, TN
► Includes the money the company’s owners have put into the firm
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Double-Entry Bookkeeping
• A system of recording and classifying business
transactions that maintains the balance of the
accounting equation
 Balance: To keep the accounting equation in balance,
each transaction must be recorded in two separate
accounts
 Classification: All business transactions are classified
as either assets, liabilities, or owner’s equity
 Break Down: Assets broken down into cash, inventory
and equipment; Liabilities broken down into bank loans,
supplier credit, and other debts
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21
The Accounting Cycle (1 of 2)
►The four-step procedure of
an accounting system
♦ Examining source
documents
♦ Recording transactions in
an accounting journal
♦ Posting recorded
transactions
♦ Preparing financial
statements
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The Accounting Cycle (1 of 2)
►Journal
♦ A time-ordered list of
account transactions
►Ledger
♦ A book or computer file
with separate sections for
each account
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Income Statement
 Income Statement
♦ A financial report that shows an organization’s profitability
over a period of time – month, quarter, or year
 Revenue
♦ The total amount of money received from the sale of goods or
services, as well as from related business activities
 Cost of Goods Sold
♦ The amount of money a firm spent to buy or produce the
products it sold during the period to which the income
statement applies
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Equivalent Terms in Accounting
Term
Equivalent Term
Revenues
Sales
Goods or services sold
Gross profit
Gross income
Gross earnings
Operating income
Operating profit
Earnings before interest and taxes
(EBIT)
Income before taxes (IBT) Earnings before taxes (EBT)
Profit before taxes (PBT)
Net income (NI)
Earnings after taxes (EAT)
Profit after taxes (PAT)
Income available to
common stockholders
Earnings available to common
stockholders
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Gross Income and Expenses
 Gross Income (or Profit)
 Revenues minus the cost of goods sold required to generate the
revenues
 The income available after paying all expenses of production
 Expenses
 The costs incurred in the day-to-day operations of an
organization
1. Selling, general, and administrative expenses (including
depreciation)
2. Research, development and engineering expenses
3. Interest expenses
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Depreciation
 The process of spreading the costs of long-lived assets such
as building and equipment over the total number of
accounting periods in which they are expected to be used
1.A manufacturer purchases a $100,000 machine expected to
last about 10 years
2.Rather than showing an expense of $100,000 in the first year
and no expense for the item over the next 9 years,
manufacturer allowed to depreciation expenses of
$10,000/year in each of the next 10 years
3.Better matches cost of equipment to years item is used
4.Depreciation is “written off” as an expense and book value of
the machine is also reduced by $10,000
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Net Income
 The total profit (or loss) after all expenses,
including taxes, have been deducted from
revenue; also called net earnings
 Most companies present the current year’s
results along with the previous two years’
income statements
 Gross profit, earnings before interest and
taxes, and net income are the results of
calculations made from the revenues and
expenses accounts; they are not actual
accounts
 When corporation elects to pay dividends, it
decreases the cash account as well as a
capital account
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Balance Sheet
 A “snapshot” of an organization’s financial position at a
given moment
• Shows assets and the funding used to pay for these assets, such
as bank debt or owners’ equity
• Takes its name from its reliance on the accounting equation:
assets must equal liabilities plus owners’ equity
• An accumulation of all financial transactions since company’s
founding
• Traditional balance sheet places assets on the left side and its
liabilities and owners’ equity on the right
• Vertical format has assets on the top followed by liabilities and
owners’ equity
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Balance Sheet - Assets
Listed in descending order of liquidity – how fast
they can be turned into cash

Current Assets
o Assets used or converted into cash within the course of a
calendar year
o Cash, temporary investments, accounts receivable and
inventory

Accounts Receivable
o Money owed a company by its clients or customers who have
promised to pay for the products at a later date
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Balance Sheet - Liabilities

Current Liabilities
o A firm’s financial obligation to short-term creditors, which must
be repaid within one year

Accounts Payable
o The amount a company owes to suppliers for goods and
services purchased with credit

Accrued Expenses
o An account representing all unpaid financial obligations
incurred by the organization
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Balance Sheet – Owners’ Equity
 Owners’ equity includes:
♦
The owners’ contributions to the organization
♦
Income earned by the organization retained to finance
continued growth and development
 Accounts listed as owners’ equity on a balance
sheet may differ dramatically from company to
company
♦
Corporations sell stock to investors, who then become
owners of the firm
♦
Many corporations issue several different classes of
common and preferred stock
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Pro Forma Financial Statements
• Pro forma financial statements are used to make
decisions about future operations changes within a
company

Include balance sheets, income statements, and cash
flow statements.

Pro forma financial statements will show
o Whether profits will increase or decrease
o The magnitude of expenses involved
o Whether the company needs financing to facilitate the
proposed change
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Statement of Cash Flows (1 of 2)
• Explains how the company’s cash changed from the
beginning of the accounting period to the end
 Balance sheet shows the cash account in one point of
time; most investors want a better picture of how cash
flows into and out of the company
 Statement of cash flows takes the cash balance from
one year’s balance sheet and compares it with the next
while providing detail about how the firm used the cash
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34
Statement of Cash Flows (2 of 2)
• Cash from operating activities
– Calculated by combining the changes in the revenue,
expense, current assets and current liability accounts
• Cash from investing activities
– Calculated from changes in the long-term or fixed asset
accounts
• Cash from financing activities
– Calculated from changes in the long-term liability
accounts and the contributed capital accounts in owners’
equity
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35
Ratios
• Ratio Analysis
– Calculations that measure an organization’s financial
health
 Brings complex information from the income statement and
balance sheet into sharper focus
 To measure and compare the organization’s productivity,
profitability, and financing mix with other similar entities
• Profitability Ratios
– Ratios measuring the amount of operating income or net
income an organization is able to generate relative to its
assets, owners’ equity, and sales
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36
Financial Ratios
A ratio is simply one number divided by another, with the result
showing the relationship between the two numbers
 Financial ratios used to weigh and evaluate firm
performance
 Whether numbers are good or bad depends on their relation
to other numbers
 If a company earned $70,000 on $700,000 in sales (10%
return) such an earnings level might be satisfactory
 The president of the company earning this same $70,000 on
sales of $7 million (1% return) should probably start looking
for another job
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Profit Margin
 Net income divided by sales
 Microsoft’s profit margin calculated by taking net
income (net earnings) and dividing by sales (total net
revenues)
 $21,863 million divided by $77,849 million equals a
profit margin ratio of 28.08%
 For every $1 in sales, Microsoft generated profits after
taxes of nearly 28 cents
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Return on Assets
 Net income divided by assets
 Microsoft’s return on assets
calculated by taking net income
(net earnings) and dividing by total
assets
 $21,863 million divided by
$142,431 million equals a return
on assets of 15.35%
 For every $1 in assets, Microsoft
generated a return of 15.34% or
profits of $15.35
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Return on Equity
 Net income divided by owners’ equity; also
called return on investment (ROI)
 Microsoft’s return on equity calculated by taking net
income (net earnings) and dividing by stockholders’
equity
 $21,863 million divided by $78,944 million equals a
return on equity of 27.69%
 For every $1 invested by Microsoft stockholders, the
company earns 27.69% return or $27.69
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Asset Utilization Ratios
• Ratios that measure how well a firm uses its assets to
generate each $1 of sales
 Managers use asset utilization ratios to pinpoint areas
of inefficiency in their operations
 These ratios – receivables turnover, inventory turnover,
and total asset turnover – relate balance sheet assets to
sales, which are found on the income statement
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Receivables Turnover
 Sales divided by accountants receivable
 Microsoft’s receivables turnover calculated by taking
sales (total net revenues) and dividing by receivables
 $77,849 million divided by $17,486 million equals a
receivables turnover of 4.45X
 Microsoft collected it receivables 4.45 times per year;
which translates to about 80 days that receivables are
outstanding
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Inventory Turnover
 Sales divided by total inventory
 Microsoft’s inventory turnover calculated by taking
sales (total net revenues) and dividing by inventory
 $77,849 million divided by $1,938 million equals an
inventory turnover of 40.17X
 Microsoft’s inventory turnover indicates they replaced
inventory 40.17 times last year, or about every nine days
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Total Asset
Turnover
 Sales divided by total assets
 Microsoft’s total asset turnover calculated by taking
sales (total net revenues) and dividing by total assets
 $77,849 million divided by $142,431 million equals a
total asset turnover of 0.55X
 Microsoft generated $0.55 in sales for every $1 in total
corporate assets
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Liquidity Ratios
• Ratios that measure the speed with which a company
can turn its assets into cash to meet short-term debt
 High liquidity ratios may satisfy a creditor’s need for
safety, but may indicate the company is not using its
current assets efficiently
 Liquidity ratios are best examined in conjunction with
asset utilization ratios because high turnover ratios
imply cash is flowing through very quickly
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Current Ratio
 Current assets divided by current liabilities
 Microsoft’s current ratio calculated by taking current
assets and dividing by current liabilities
 $101,466 million divided by $37,417 million equals a
current ratio of 2.71X
 Microsoft’s current ratio indicates that for every $1 of
current liabilities, the firm had $2.71 of current assets on
hand
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Quick Ratio (Acid Test)
 A stringent measure of liquidity that eliminates inventory
 Microsoft’s quick ratio calculated by taking current
assets minus inventory and dividing by current liabilities
 $99,528 million divided by $37,417 million equals a quick
ratio of 2.66X
 In 2011, Microsoft’s had $2.66 of current assets (after
subtracting inventory) for every $1 of current liabilities
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Debt Utilization Ratios
 Ratios that measure how much debt an organization is
using relative to other sources of capital, such as
owners’ equity

Debt financing riskier than equity as it demands a
monthly payment regardless of profitability

Recessions affect heavily indebted firms far more than
those financed through equity

Companies tend to keep debt-to-asset levels below 5%
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Debt to Total Assets Ratio
 A ratio indicating how much of the firm is financed by
debt and how much by owners’ equity
 Microsoft’s ratio calculated by taking debt (total
liabilities) and dividing by total assets
 $63,487 million divided by $142,431 million equals debt
to total assets ratio of 45%
 For every $1 of Microsoft’s total assets, 45% is financed
with debt and 55% with owners’ equity
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Times Interest
Earned Ratio
 Operating income divided by interest expense
 Microsoft’s times interested earned ratio calculated by
taking EBIT (operating income) and dividing by
interest (from note 3)
 $26,863 million divided by $429 million equals times
interest earned ratio of 62.39X
 Microsoft paid $429 million in interest expense, but that
amount was covered 62.39 times by income before
interest and taxes
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Diluted Earnings Per Share (1 of 2)
• Per Share Data
– Data used by investors to compare the performance of one
company with another on a equal, per share basis
• Earnings Per Share
– Net income or profit divided by the number of stock shares
outstanding
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51
Diluted Earnings Per Share (1 of 2)
 Microsoft’s diluted earnings per share calculated by
taking net income and dividing by the number of shares
outstanding (diluted)
 $21,863 million divided by $8,470 million equals a diluted
earnings per share of $2.58
 Microsoft’s basic earnings per share declined from $2.69
per share to $2.58, and this decline also shows up in
diluted earnings per share
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This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Dividends Per Share
 The actual cash received for each share owned
 Microsoft’s dividends per share calculated by taking
dividends paid and dividing by the number of shares
outstanding
 $7,456 million divided by $8,103 million equals
dividends per share of $0.92
 Since 2004, Microsoft has raised its dividend every year,
from $0.16 per share to $0.92 per share
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This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Importance of Integrity in Accounting
 The recent financial crisis and recession showed
another example of a failure in accounting reporting
 Many firms attempted to exploit loopholes and
manipulate accounting reporting
 Banks and other financial institutions often held assets
off their books by manipulating accounts
 Transparency and accuracy in reporting revenue,
income and assets develops trust from investors and
other stakeholders
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This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Compliance to Accounting Principles
Strong compliance to accounting principles creates trust
among stakeholders
► Accounting and financial planning is important for all
organizational entities even cities
► Integrity in accounting is crucial to:
◄ Create trust
◄ Understanding the financial position of an organization or entity
◄ Making financial decisions that will benefit the organization
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This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Solve the Dilemma (1 of 3)
Exploring the Secrets of Accounting
You have been promoted from vice president of marketing
of BrainDrain Co. to president and CEO
► You know marketing like the back of your hand, but
know next to nothing about finance
► BrainDrain is in danger of failure if steps to correct large
and continuing financial losses are not taken at once
♦
You asked vice president of finance and accounting for a
complete set of accounting statements
♦
Statements detail the financial operations of the company
♦
You decide to attack the problem systematically and learn
“hidden secrets” of the company statement by statement
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56
Solve the Dilemma (2 of 3)
Exploring the Secrets of Accounting
 Searching for answers
– With the firm’s trusted senior financial analyst by you
side, you delve into the accounting statements
– Resolved to “get to the bottom” of the firm’s financial
problems
– Set new course that will take the firm from
insolvency and failure to financial recovery and
perpetual prosperity
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This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
57
Solve the Dilemma (3 of 3)
Exploring the Secrets of Accounting
 Discussion Questions
– Describe the three basic accounting statements.
What types of information does each provide that
can help you evaluate the situation?
– Which of the financial ratios are likely to prove to be
of greatest value in identifying problem areas in the
company? Why? Which of your company’s financial
ratios might you expect to be especially poor?
– Discuss the limitations of ratio analysis.
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This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
58
Discussion
?
?
?
?
Why are accountants so important to a corporation?
What function do they perform?
Describe the accounting process and cycle.
The income statements of all corporations are in the
same format. True or false? Discuss.
Why are debt ratios important in assessing the risk of
the firm?
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner.
This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.