Accounting and

Financial
Statements

Chapter 14

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 Learning Objectives
14-1 Define accounting and describe the different uses of
accounting information.
14-2 Demonstrate the accounting process.
14-3 Examine the various components of an income
statement in order to evaluate a firm’s “bottom line.”
14-4 Interpret a company’s balance sheet to determine its
current financial position.
14-5 Analyze financial statements, using ratio analysis, to
evaluate a company’s performance.
14-6 Assess a company’s financial position using its
accounting statements and ratio analysis.

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 The Nature of Accounting 1
Public Accountants
• Certified public accountants
• Accounting scandals
• Sarbanes-Oxley Act
• Dodd-Frank Act

• Forensic accounting
• Certified fraud examiners
Private Accounts
• Certified management accountants

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 Public Accounting Firms

Ernst & Young is part of

the Big Four, or the four
largest international
accounting firms. The
other three are KPMG,
PricewaterhouseCoopers,
and Deloitte.

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 The Nature of Accounting 2
Accounting or Bookkeeping?
• Bookkeeping is typically limited to the routine, day-to-
day recording of business transactions
• Much narrower and far more mechanical than accounting
• Requires less training than accountants
• Responsible for obtaining and recording the information
accountants require to analyze a firm’s financial position
• Accountants usually have additional training that allow
them to record, understand, interpret, and develop
sophisticated accounting systems

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 The Uses of Accounting Information 1
Managers and owners use financial statements
1. To aid in internal planning and control
2. For external purposes such as reporting to the
Internal Revenue Services, stockholders, creditors,
customers, employees, and other interested parties

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 The Uses of Accounting Information 2
Internal Uses
• Managerial accounting
• Cash flow
• Budget
• Master budgets

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 Gina is a Business major and wants to run her
POLLING QUESTION
own business someday. However, she dislikes
her Accounting classes. In your opinion, which
aspect of Accounting is most important for
Gina to learn?
A. The importance of understanding financial
statements
B. The importance of using accounting information
C. The importance of budgeting

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 The Uses of Accounting Information 3
External Uses
• Accounting statements are used for filing income
taxes, obtaining credit, and reporting results to
stockholders and potential investors
• Annual report
• Audited financial statements

• Stockholders
• Banks and other lenders
• Labor unions and employees

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 Figure 14.1 The Users of Accounting Information
Organizational Use of Stakeholder Use of
Accounting Information Accounting Information
• Boards of directors • Tax collecting agencies
• Owners, shareholders • Regulatory agencies
• Managers • Special interest groups
• Management Information • Supply chain members
systems
• Financial analysts
• Business analytics
• Employees
• Internal control
• Media

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 The Accounting Process 1
The Accounting Equation

Assets
• 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
• Debts that a firm owes to others
Owners’ Equity
• Equals assets minus liabilities and reflects historical
values
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 The Accounting Process 2
Double-Entry Bookkeeping
• A system of recording and classifying business
transactions that maintains the balance of the
accounting equation
• To keep the accounting equation in balance, each
transaction must be recorded in two separate
accounts
• All business transactions are classified as either
assets, liabilities, or owner’s equity

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 The Accounting Process 3
The Accounting Cycle
• The four-step procedure of an accounting system
• Step one: examine source documents
• Step two: record transactions
• Step three: post transactions
• Step four: prepare financial statements

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 The Accounting Process 4
The Accounting Cycle continued
Journal
• A time-ordered list of account transactions
Ledger
• A book or computer file with separate sections for
each account
Trial balance
• A summary of the balances of all the accounts in the
general ledger

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 Financial Statements 1
The end result of the accounting process is a
series of financial statements
• Income statement
• Balance sheet
• Statement of cash flows
Not all financial statements follow the same format
but must adhere to generally accepted accounting
principles (GAAP)

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 Table 14.2 Equivalent Terms in Accounting
Term Equivalent Terms
Revenues Sales
Goods or services sold
Gross profit Gross income
Gross earnings
Operating income Operating profit
Earnings before interest and taxes (EBIT)
Income before interest and taxes (IBIT)

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 Earnings available to common stockholders
stockholders

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 Financial Statements 2
The Income Statement
• Shows an organization’s profitability over a period of
time
• Offers one of the clearest pictures of the company’s
overall revenues and costs incurred to generate that
revenue
Revenue
• The total amount of money received from the sale of
goods and services, as well as from related business
activities

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 Financial Statements 3
Cost of Goods Sold (COGS)
• The amount of money spent to buy or produce the
products sold during the income statement period

Gross Income (or Profit)

• Revenues minus the cost of goods sold required to
generate revenues
• Profit is the difference between what it costs to make
and sell a product and what a customer pays for it

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 Financial Statements 4
Expenses
• The costs incurred in the day-to-day operations of an
organization
• Selling, general, and administrative expenses (including
depreciation)
• Research, development, and engineering expenses
• Interest expenses

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 Financial Statements 5
Depreciation
• A process where the costs of long-lived assets are
spread out over the total number of accounting
periods in which they are expected to be used
• Depreciating items better match the cost of the item to the
years the item is used

Net Income
• The total profit (or loss) after all expenses, including
taxes have been deducted from revenue

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 Financial Statements 6
Temporary Nature of Income Statement Accounts
• 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
• At the end of the accounting period, the dollar amount
in revenue and expense accounts are moved to
“retained earnings”
• This results in the owners’ equity account being equal
to net income; zeros out the accounts

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 When considering the “bottom line” for an
POLLING QUESTION
investment in the Wallstreet Wolf, Jordan
Belfort evaluates the Net Profit/Loss line item
on the Income Statement. It shows _____.
A. Net Profit/Loss on a specific date
B. Net Profit/Loss for a specific period
C. Sales Revenue as of a specific date
D. Sales Revenue for a specific period

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 Financial Statements 7
The Balance Sheet
• A “snapshot” of an organization’s financial position at a
given moment
• Takes it name from its reliance on the accounting
equation: assets must equal liabilities plus owners’
equity
• Often presented in two different formats
• Traditional format
• Vertical format

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 Financial Statements 8
The Balance Sheet continued
• Assets
• Current assets
• Assets used or converted into cash within the course of a calendar
year
• Accounts receivable
• 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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 Financial Statements 9
The Balance Sheet continued
• Liabilities
• Current liabilities
• A firm’s financial obligation to short-term creditors, which must be
repaid within one year
• Accounts payable
• The amount a company owes to suppliers for goods and services
purchased with credit
• Accrued expenses
• An account representing all unpaid financial obligations incurred by
the organization

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 Financial Statements 10
The Balance Sheet continued
• Owners’ equity includes:
• The owners’ contribution to the organization
• Income earned by the organization and retained to finance
continued growth and development
• Accounts listed as owners’ equity vary dramatically
from company to company
• Stock shares represent ownership in a company
• Each type of stock must be represented by a separate owners’
equity account, called contributed capital

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 Captain Blackbeard, owner of Capsizing Ships,
POLLING QUESTION
knows his company’s Balance Sheet shows
more current liabilities than current assets.
This means that he can/should _____.
A. Purchase more assets
B. Acquire more debt
C. Be unable to pay current liabilities with current
assets
D. Be able to pay current liabilities with current assets

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 Financial Statements 11
The Statement of Cash Flows
• Explains how the company’s cash changed from the
beginning of the accounting period to the end
• Cash from operating activities
• Cash from financing activities
• Cash from investing activities

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 Ratio Analysis: Analyzing Financial Statements 1
Ratio Analysis
• Calculations that measure an organization’s financial
health
• Brings complex information from the income statement and
balance sheet into sharper focus
• Aids in measuring and comparing the organization’s
productivity, profitability, and financing mix with other similar
entities
• To be useful, ratios should be compared to:
• The previous years performance
• The company’s competitors
• The company’s stated goals

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 Ratio Analysis: Analyzing Financial Statements 2
Profitability Ratios
• Measure how much operating income or net income
and organization is able to generate relative to its
assets, owners’ equity, and sales
• Common profitability ratios
• Profit margin
• Return on assets
• Return on equity

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 Ratio Analysis: Analyzing Financial Statements 3
Profitability Ratios continued
• Profit Margin
• Shows the overall percentage of profits earned by the company
• Based solely on data obtained from the income statement
• Calculated as follows:

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 Ratio Analysis: Analyzing Financial Statements 4
Profitability Ratios continued
• Return on assets
• Shows how much income the firm produces for every dollar
invested in assets
• Requires data from both the income statement and the balance
sheet
• Calculated as follows:

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 Ratio Analysis: Analyzing Financial Statements 5
Profitability Ratios continued
• Return on equity
• Also called return on investment (ROI)
• Shows how much income is generated by each $1 the owners
have invested in the firm
• Calculated as follows:

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 Ratio Analysis: Analyzing Financial Statements 6
Asset Utilization Ratios
• 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
• Common asset utilization ratios
• Receivables turnover
• Inventory turnover
• Total asset turnover

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 Ratio Analysis: Analyzing Financial Statements 7
Asset Utilization Ratios continued
• Receivables turnover
• Indicates how many times a firm collects its accounts
receivable in one year
• Demonstrates how quickly a firm is able to collect payments on
its credit sales
• Calculated as follows:

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 Ratio Analysis: Analyzing Financial Statements 8
Asset Utilization Ratios continued
• Inventory turnover
• Indicates how many times a firm sells and replaces inventory
over the course of a year
• Calculated as follows:

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 Ratio Analysis: Analyzing Financial Statements 9
Asset Utilization Ratios continued
• Total asset turnover
• Measures how well an organization uses all of its assets in
creating sales
• Indicates whether a company is using its assets productively
• Calculated as follows:

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 Ratio Analysis: Analyzing Financial Statements 10
Liquidity Ratios
• Measure the speed with which a company can turn its
assets into cash to meet its debts as they fall due
• High liquidity ratios may satisfy a creditor’s need for
safety but may indicate the company is not using its
current assets efficiently
• Common liquidity ratios
• Current ratio
• Quick ratio

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 Ratio Analysis: Analyzing Financial Statements 11
Liquidity Ratios continued
• Current ratio
• Calculated as follows:

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 Ratio Analysis: Analyzing Financial Statements 12
Liquidity Ratios continued
• Quick ratio
• Also known as the acid test
• Far more stringent measure of liquidity because it eliminates
inventory, the least current asset
• Measures how well an organization can meet its current
obligations without resorting to the sale of its inventory
• Calculated as follows:

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 Ratio Analysis: Analyzing Financial Statements 13
Debt Utilization Ratios
• Measure how much debt an organization is using
relative to other sources of capital, such as owners’
equity
• Common debt utilization ratios
• Debt to total assets ratio
• Times interest earned ratio

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 Ratio Analysis: Analyzing Financial Statements 14
Debt Utilization Ratios continued
• Debt to total assets ratio
• Indicates how much of the firm is financed by debt and how
much by owners’ equity
• Calculated as follows:

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 Ratio Analysis: Analyzing Financial Statements 15
Debt Utilization Ratios continued
• Times interest earned ratio
• Measure of the safety margin a company has with respect to
the interest payments it must make to its creditors
• A low times interest earned ratio indicates that even a small
decrease in earnings may lead the company into financial
straits
• Calculated as follows:

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 Ratio Analysis: Analyzing Financial Statements 16
Per Share Data
• Used by investors to compare the performance of one
company with another on an equal, per share basis
• Generally, the more share of stock a company issues,
the less income is available for each share
• Common per share data ratios
• Earnings per share
• Dividends per share

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 Ratio Analysis: Analyzing Financial Statements 17
Per Share Data continued
• Earnings per share
• Important calculation as it helps determine a company’s overall
stock price
• When earnings go up, so does a company’s stock price—and
so does the wealth of its stockholders
• Calculated as follows:

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 Ratio Analysis: Analyzing Financial Statements 18
Per Share Data continued
• Dividends per share
• Paid to stockholders for each share owned
• Dividends result in double taxation: the corporation pays tax on
its earnings; the stockholder pays tax on his or her dividend
income
• Calculated as follows:

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 Richard Branson, owner of Virgin Galactic, is
POLLING QUESTION
perusing the financial statements of SpaceX
and debating whether he should purchase a
majority shareholder stake in the company. In
your opinion, which aspect is the most
important consider?
A. Debt to asset ratio
B. Total asset turnover ratio
C. Return on equity ratio
D. Profit margin

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 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
Strong compliance to accounting principles creates
trust among stakeholders
• Transparency and accuracy in reporting revenue,
income, and assets develops trust from investors and
other stakeholders

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 Solve the Dilemma
Exploring the Secrets of Accounting 1

You have been promoted from vice president of marketing

of BrainDrain Corp. 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 the 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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 Solve the Dilemma
Exploring the Secrets of Accounting 2

Searching for Answers

• With the firm’s trusted senior financial analyst by your
side, you delve into the accounting statements
• Resolved to “get to the bottom” of the firm’s financial
problems
• Set a new course that will take the firm from
insolvency and failure to financial recovery and
perpetual prosperity

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 Solve the Dilemma
Exploring the Secrets of Accounting 3

Critical Thinking Questions

1. Describe the three basic accounting statements. What
types of information does each provide that can help
you evaluate the situation?
2. 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?
3. What are the limitations of ratio analysis?

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