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Understanding Accounting and
Financial Statements
Learning Goals
Explain the functions and identify the
three basic activities involving accounting.
Describe the roles played by public,
management, government, and not-forprofit accountants.
Identify the foundations of the accounting
system, including GAAP and the role of
the Financial Accounting Standards
Board (FASB).
Outline the steps in the accounting cycle,
and define double-entry bookkeeping and
the accounting equation.
Explain the functions and major
components of the four principal
financial statements: the balance
sheet, the income statement, the
statement of owner’s equity, and the
statement of cash flows.
Discuss how financial ratios are
used to analyze a company’s
financial strengths and weaknesses.
Describe the role of budgets in a
Outline accounting issues facing
global business and the move
toward one set of worldwide
accounting rules.
Accounting is the process of measuring, interpreting,
and communicating financial information to enable
people inside and outside the firm to make informed
Open Book Management
Open book management- sharing sensitive
financial information with employees and
teaching them how to understand and use
financial statements.
Viewing financial information may help them
better understand how their work contributes
to the company’s success.
Outsiders use financial data to evaluate
investment opportunities.
Business Activities Involving
Financing activities provide necessary funds to
start a business and expand it after it begins
Investing activities provide valuable assets
required to run a business.
Operating activities focus on selling goods and
services, but they also consider expenses as
important elements of sound financial
Accounting Professionals
Public Accountants
Provide accounting services (auditing,
tax preparation, consulting) to individuals
or business firms for a fee
Management Accountants
Provide timely, relevant, accurate, and
concise information that executives can
use to operate their firms
Government and Not-forProfit Accountants
Foundation of Accounting
Generally accepted accounting principles (GAAP) encompass
the conventions, rules, and procedures for determining
acceptable accounting practices at a particular time.
Financial Accounting Standards Board (FASB) is primarily
responsible for evaluating, setting, or modifying GAAP in the
Sarbanes-Oxley Act (SOX) responded to cases of accounting
Created the Public Accounting Oversight Board, which sets
audit standards and investigates and sanctions accounting
firms that certify the books of publicly traded firms.
Senior executives must personally certify that the financial
information reported by the company is correct.
Resulted in increase in demand for accountants.
The Accounting Cycle
Accounting cycle- set of activities involved in
converting information about transactions into
financial statements.
The Accounting Equation
Assets- anything of value owned or leased by a
Liability- claim against a firm’s assets by a creditor.
Owner’s equity- all claims of the proprietor, partners, or
stockholders against the assets of a firm, equal to the
excess of assets over liabilities.
Basic accounting equation- relationship that states
assets equal liabilities plus owners’ equity.
Double-entry bookkeeping- process by which
accounting transactions are entered; each individual
transaction always has an offsetting transaction.
Impact of Technology on
Simplifies the accounting process by automating data
entry and calculations.
Available products are customized for businesses of
different sizes.
Entrepreneurs and small businesses use: QuickBooks,
Peachtree, and BusinessWorks.
Larger firms use larger scale software packages like: Computer
Associates, Oracle, and SAP.
Software that handles accounting information for
international businesses is another option. Offers
different country information/language.
Some systems offer web-based packages for small and
medium businesses.
Balance Sheet
Balance sheet— statement of a firm’s
financial position—what it owns and the
claims against its assets—at a particular point
in time
Photograph of firm’s assets together with its
liabilities and owner’s equity
Follows the accounting equation
Sample Balance Sheet
Income Statement
Income Statement— financial record of a
company’s revenues and expenses and
profits over a period of time
Firm’s financial performance in terms of
revenues, expenses, and profits over a given
time period
Reports profit or loss
Focus on revenues and costs associated with
Sample Income Statement
Statement of Owners’ Equity
Statement of Owners’ Equity— is designed
to show the components of the change in
equity from the end of one fiscal year to the
end of the next
Begins with the amount of equity shown on
the balance sheet
Net income is added, and cash dividends
paid to owners are subtracted
Sample Statement of Owners’
Statement of Cash Flows
Statement of cash flows— a firm’s cash
receipts and cash payments that presents
information on its sources and uses of cash
Accrual accounting— method that records
revenue and expenses when they occur, not
necessarily when cash actually changes
Sample Statement of Cash Flows
Financial Ratios Analysis
Ratio analysis— tool for measuring a firm’s liquidity,
profitability, and reliance on debt financing as well as
the effectiveness of management’s resource utilization
Liquidity Ratios
Total current assets
Current ratio compares
current assets to current
Total current liabilities
Acid-test (or quick) ratio
measures the ability of a
firm to meet its debt
payments on short notice.
Cash and equivalents
+ short-term investments
+ accounts receivable
Total current liabilities
Activity Ratios
Net sales
Inventory turnover
ratio indicates the
number of times
merchandise moves
through a business.
Average of inventory
Net sales
Total asset turnover ratio
indicates how much in
sales each dollar invested
in assets generates.
Average of total assets
Profitability Ratios
Profitability ratios measure the organization’s overall
financial performance by evaluating its ability to
generate revenues in excess of operating costs and
other expenses.
Leverage Ratios
Leverage ratios measure the extent to which a firm
relies on debt financing.
Total liabilities to total assets ratio > 50 percent indicates that
a firm is relying more on borrowed money than owners’ equity.
Budget- planning and control tool that reflects a firm’s
expected sales revenues, operating expenses, and
cash receipts and outlays
Management estimates of expected sales, cash inflows
and outflows, and costs
Budgets are a financial blueprint that serves as a
financial plan
Cash budget- tracks the firm’s cash inflows and
Sample Budget
International Accounting
Accounting procedures and practices must be adapted to
accommodate an international business environment.
The International Accounting Standards Committee (IASC) was
established in 1973 to promote worldwide consistency in financial
reporting practices. The IASC soon developed its first set of
accounting standards and interpretations and, in 2001, became the
International Accounting Standards Board (IASB). International
Financial Reporting Standards (IFRS) are the standards and
interpretations adopted by the IASB.
Exchange rates- ratio at which a country’s currency can be
exchanged for other currencies
Consolidated financial statements must reflect gains and losses due
to changes in exchange rates
Can have significant impact on financial statement