Understanding Principles of

Accounting
 Chapter Outline
 What Is Accounting and Who Uses
Accounting Information?
 Who Are Accountants and What Do They
Do?
 Tools of the Accounting Trade
 Financial Statements
 Analyzing Financial Statements
 International Accounting
 What Is Accounting and Who Uses
Accounting Information?
 Accounting is a comprehensive system for
collecting, analyzing and communicating
financial information
 Bookkeeping is the recording of transactions
 What Is Accounting and Who Uses
Accounting Information?
• Accounting
information system
(AIS) is an organized
means by which
financial information is
identified, measured,
recorded and retained
for use in accounting
statements and
management reports
Users of Accounting Information
 Business Managers use it to develop goals and plans,
set budgets, and evaluate future prospects
 Employees and Unions use it to plan for and receive
compensation and benefits
 Investors and Creditors use it to estimate returns to
stock holders, determine growth prospects, and decide
whether a firm is a good credit risk
 Tax Authorities use it to plan for tax inflows, determine
the tax liability, and ensure that correct amount are paid
on time
 Government Regulatory Agencies rely on it to fulfill their
duties toward the public
 What is a Controller?
Person who manages all of a
firm’s accounting activities
(chief accounting officer
 Who Are Accountants and
What Do They Do?
 Financial Versus Managerial Accounting
 Financial accounting system is concerned with
external information users: consumer groups,
unions, stock holders and government agencies
 It regularly prepares income statements and
balance sheet, as well as other financial reports
published for share holders and the public
 These documents focus on the activities of the
company as a whole rather than on individual
departments or divisions
Who Are Accountants and
What Do They Do?
 Managerial (or Management) accounting system
serves internal users
 Managers at all levels need information to make
departmental decisions, monitor projects, , plan
future activities
 To make products or operations improvement
engineers must know certain costs
 To set performance goals, sales people need past
sales data organized by geographic regions
 Purchasing agents use information on materials
cost to negotiate terms with suppliers
 What is an Audit?
Systematic examination of a
company’s accounting system
to determine whether its
financial reports fairly
represent its operations
What is GAAP (or Generally Accepted
Accounting Principles)?

Accepted rules and

procedures
governing the
content and form of
financial report
The Accounting Equation

Assets = Liabilities + Owners’ Equity

 The Accounting Equation
 Asset is any economic resource expected to benefit a firm or an
individual who owns it
 Assets include land, buildings, equipment, inventory and due to
the company (account receivable)
 Liability is a debt owned by a firm to an outside organization or
individual
 Owners’ equity is the amount of money that owners would
receive if they sold all of a firm’s assets and paid all of its liabilities
 Assets – Liabilities = Owners’ equity
 Owners’ equity consists of two sources of capital
 The amount that the owner originally invested
 Profits earned by and reinvested in the company
 The Accounting Equation
 When a company operates profitably its assets
increase faster than its liabilities
 Owners’ equity will increase if profits are
retained in the business instead of paid out as
dividends to stock holders
 Owners’ equity will also increase if if owners
invest more of their money to increase assets
 Owners’ equity can shrink if the company
operates at a loss or if owners withdraw assets
What is Double-Entry Accounting?
Bookkeeping system that balances the
accounting equation by recording the dual
effects of every financial transaction
 if business buys inventory by cash you
decrease cash and increase inventory
 If you buy supplies on credit you
increase your supplies and increase your
accounts receivables
 If you invest more cash in your business
you increase the company’s cash and
increase your owners’ equity
 Financial Statements
 Also known as a statement of financial position, is a
kind of “snapshot” of where a company is, financially
speaking, at one moment in time.
 The balance sheet includes all the elements in the
accounting equation, showing the balance between
assets on one side and liabilities and owners’ equity on
the other.
 Every company prepares a balance sheet at least once a
year, most often at the end of the calendar year,
January 1 to December 31.
The fiscal year, any 12 consecutive months, is used by
many business and government bodies.
 Financial Statements
• Assets
• There are three types:
– Current Asset—asset that can or will be converted into cash
within the following year.
» Liquidity—ease with which an asset can be converted
into cash.
» Nonliquid Assets—Includes marketable securities which
vary in liquidity and three other forms:
• accounts receivable—amount due from a customer
who has purchased goods on credit
• merchandise inventory—cost of merchandise that
has been acquired for sale to customers and is still
on hand
• prepaid expense—expense that is paid before the
upcoming period in which it is due
 Financial Statements
Fixed Asset—asset with long-term use or value
» depreciation—process of distributing the cost of an asset
over its life
– Intangible Asset—nonphysical asset that has economic value in
the form of expected benefits.
» goodwill—amount paid for an existing business above the
value of its other assets
• Liabilities are the debts that a business has incurred and appear after
assets because they are claims against the assets as shown in the
accounting equation: Assets = Liabilities + Owners’ Equity
– Current Liability—debt that must be paid within the year.
– Account Payable—current liabilities consisting of bills owed to
suppliers, plus wages and taxes due within the upcoming year.
– Long-Term Liability—debt that is not due for more than one year.
 Financial Statements
• Owners' Equity is the owners’ investment in a business.
This is also the section that shows a corporation’s
retained earnings, the portion of shareholders’ equity
earned by the company, but not distributed to its
owners in the form of dividends.
– Common Stock
– Paid-In Capital—additional money, above proceeds from
stock sale, paid directly to a firm by its owners.

• Retained Earnings—earnings retained by a

firm for its use rather than paid as dividends
 Financial Statements
a. Income Statements—financial statement listing a firm’s
annual revenues and expenses so that a bottom line shows
annual profit or loss. If the balance sheet is a “snapshot,” the
income statement is a “movie.”
i. Revenues—funds that flow into a business from the sale of goods or
services.
ii.Cost of Goods Sold—total cost of obtaining materials for making the
products sold by a firm during the year.
iii.Gross Profit (or Gross Margin)—revenues obtained from goods sold
minus cost of goods sold.
iv.Operating Expenses—costs, other than the cost of goods sold,
incurred in producing a good or service.
v. Operating Income—gross profit minus operating expenses.
1. net income (or net profit or net earnings)—gross profit minus operating
expenses and income taxes
 Financial Statements
 Statement of cash flows describes a firm’s
yearly cash receipts and cash payments.
Three activities:
 Cash Flows from Operations
 Cash Flows from Investing
 Cash Flows from Financing
 Financial Statements
 Cash Flows from Operations:
 Cash transactions involved in buying and selling goods
and services
 It reveals how much of the year’s income results from
main line of business
 Starting from net income accountants must make
several adjustment to reveal true cash flows
 Depreciation amount must be added back to cash
although it is an expense in determining net income
because it did not reduce cash
 Three additional operating activities, inventories,
accounts receivable and accounts payable requires
adjustments
 Financial Statements
 Cash Flows from Investing
 This section reports net cash used in or provided by
investing
 It includes cash receipts and payments from buying and
selling stocks, bonds, property, equipment, and other
productive assets
 These sources of cash are not the company’s main line of
business
 Cash Flows from Financing:
 Reports net cash from all financing activities
 It includes cash inflows from borrowing or issuing stock
as well as outflows for paying dividends and repayment
of borrowed money
An Internal Financial Statement:
What is the Budget?
 A detailed statement of estimated receipts and
expenditures for a period of time in the future.
 The budget is probably the most crucial internal
financial report.
 Most companies use their budgets for internal
planning, controlling, and decision-making.
 Although the accounting staff coordinates the
budget process, many different employees
contribute to creating and updating the budget.
 Analyzing Financial Statements

• Organizations and individuals use financial

statements to spot problems and opportunities.
• Managers and outsiders use them to evaluate a
company’s performance in relation to the
economy, the
• competition, and past performance. To perform
this analysis, most users look at historical trends
and key ratios. Three major classifications of
ratios: solvency, profitability, activity
 Analyzing Financial Statements

Solvency Ratio
Financial ratio, either short- or long-term, for
estimating the risk in investing in a firm
Profitability Ratio
Financial ratio for measuring a firm’s potential
earnings
Activity Ratio
Financial ratio for evaluating management’s use of a
firm’s assets
 Analyzing Financial Statements
 Solvency ratios, both short- and long-term,
estimate risk. They include:
 Short-Term Solvency Ratios
Liquidity ratio measures a firm’s
ability to pay its immediate debts
Current Ratio
 Working Capital
 Short-Term Solvency Ratios

Liquidity Ratio
Solvency ratio measuring a firm’s ability to pay its immediate
debts

Current Ratio
Solvency ratio that determines a firm’s credit worthiness by
measuring its ability to pay current liabilities

Current assets $57,210

  2.61
Current liabilitie s $21,935
 Short-Term Solvency Ratios
Working Capital
Difference between a firm’s current assets and current liabilities
Quick (or Acid-Test) Ratio
Solvency ratio for determining a firm’s ability to meet emergency
demands for cash
Quick Asset
Cash plus assets one step removed from cash (marketable
securities and accounts receivables

Quick assets $7,050  2,300  26,210  650

  1.59
Current liabilitie s $21,935
 Long-Term Solvency Ratios
Debt Ratio
Solvency ratio measuring a firm’s ability to meet its long-term debts
Debt-to-Owners’ Equity Ratio (or Debt-to-Equity Ratio)
Solvency ratio describing the extent to which a firm is financed
through borrowing
Debt
A firm’s total liabilities

Debt $61,935
  0.56
Owners' equity $111 ,155
 Profitability Ratios

Net Profit Margin (or Return on Sales)

Profitability ratio indicating the percentage of its income that is
a firm’s profit
Net income $12,585
  0.049  4.9%
Sales $256,425
Return on Equity
Profitability ratio measuring income earned for each
dollar invested

Net income $12,585

  11 .3%
Total owners' equity $111,155
 Profitability Ratios

Earnings Per Share

Profitability ratio measuring the size

of the dividend that a firm can pay
shareholders

Net income $12,585

  $1.57 per share
Number of common shares outstandin g 8,000
 Activity Ratios

Inventory Turnover Ratio

Activity ratio measuring the average number of times that inventory
is sold and restocked during the year

Cost of goods sold Cost of goods sold


Average inventory (Beginning inventory  Ending inventory) /2

$104,765
 4.8 times
($22,380  $21,250)/2