CHAPTER 18 – Understanding Financial Information And Accounting
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CHAPTER 17 – UNDERSTANDING ACCOUNTING AND FINANCIAL INFORMATION
LEARNING GOALS
After you have read and studied this chapter, you should be able to:
1. Demonstrate the role that accounting and financial information play for a business and for its stakeholders. 2. Identify the different disciplines within the accounting profession. 3. List the steps in the accounting cycle, distinguish between accounting and bookkeeping, and explain how computers are used in accounting. 4. Explain how the major financial statements differ. 5. Demonstrate the application of ratio analysis in reporting financial information.
LEARNING THE LANGUAGE
Listed below are important terms found in the chapter. Choose the correct term for the definition and write it in the space provided.
Accounting Depreciation Liquidity Accounting cycle Double-entry bookkeeping Managerial accounting Accounts payable Financial accounting Net income or net loss Annual report Financial statement Notes payable Assets Fixed assets Operating expenses Auditing Fundamental accounting equation Owner’s equity Balance sheet Government and not-for-profit Private accountant accounting Bonds payable Gross profit (gross margin) Public accountant Bookkeeping Income statement Ratio analysis Cash flow Independent audit Retained earnings Certified internal auditor (CIA) Intangible assets Revenue Certified management accountant Journal Statement of cash flows (CMA) Certified public accountant (CPA) Ledger Tax accountant Cost of goods sold (cost of goods Liabilities Trial balance manufactured) Current assets
1. A yearly statement called the ______states the financial condition, progress, and expectations of an organization.
2. A company’s ______is the difference between cash coming in and cash going out of a business.
1 3. Items known as ______can or will be converted into cash within one year.
4. An accounting system called ______is used for organizations whose purpose is not generating a profit but serving ratepayers, taxpayers, and others according to a duly approved budget.
5. Assets that are relatively permanent, or ______include items such as land, buildings and equipment.
6. A______is the record book or computer programwhere accounting data are first entered.
7. Long term liabilities that represent money lent to the firm that must be paid back are ______.
8. The amount of the business that belongs to the owners minus any liabilities owed by the business is the formula for ______.
9. A ______is a summary of all the data in the account ledgers to show whether the figures are correct and balanced.
10. An accountant known as a(n) ______is trained in tax law and is responsible for preparing tax returns or developing tax strategies.
11. The ease with which an asset can be converted into cash is its ______.
12. A(n) ______is an evaluation and unbiased opinion about the accuracy of a company ‘s financial statements.
13. Accounting used to provide information and analyses to managers inside the organization to assist them in decision-making is called ______.
14. A concept called ______is a system of writing every business transaction in two places.
15. An accountant called a ______passes a series of examinations established by the American Institute of Certified Public Accountants
16. The economic resources, or things of value, owned by the firm are called ______.
17. ______are current liabilities or bills the company owes to others for merchandise or services purchased on credit but not yet paid for.
18. A firm’s ______is how much the firm earned by buying, or making, and selling merchandise.
19. Accounting information and analyses prepared for people outside the organization is ______.
2 20. ______is revenue left over after all costs and expenses, including taxes, are paid.
21. The financial statement called a ______reports the financial condition of a firm at a specific time and is composed of three major accounts: assets, liabilities and owner’s equity.
22. An accountant who works for a single firm, government agency, or nonprofit organization is called a(n) ______, 23. The recording, classifying, summarizing and interpreting of financial events and transactions, called ______provides management and other interested parties the information they need to make good decisions.
24. A company’s ______is the value of what is received from goods sold, services rendered and other financial sources.
25. The job of reviewing and evaluating the records used to prepare the company's financial statements is called ______.
26. A ______is the summary of all transactions that have occurred over a particular period.
27. The six-step procedure called the ______results in the preparation and analysis of the major financial statements.
28. A type of expense called the ______is a measure of the cost of merchandise sold or cost of raw materials and supplies used for producing items for resale.
29. A ______is one who provides accounting services to individuals or businesses on a fee basis.
30. Accounts known as ______indicate what the business owes to others (debts).
31. A specialized accounting book known as a______is one in which information from accounting journals is accumulated into specific categories and posted so managers can find all the information about one account in the same place.
32. A ______is a professional accountant who has met certain educational and experience requirements, passed a qualifying exam in the field, and been certified by the Institute of Certified Management Accountants.
33. The recording of business transactions is called ______
34. The ______shows a firm’s profit after costs, expenses and taxes; it summarizes all of the resources that have come into the firm, all the resources that have left the firm and the resulting net income.
35. ______is the systematic write-off of the cost of a tangible asset over its estimated useful life.
3 36. Long-term assets that are relatively permanent are known as ______and include patents, and copyrights that have no real physical form but do have value.
37. The financial statement called a ______reports cash receipts and disbursements related to a firm’s three major activities: operations, investment, and financing.
38. A ______is an accountant who has a bachelor's degree 2 years of internal auditing experience, and has passed an exam administered by the Institute of Internal Auditors.
39. Assets equal liabilities plus owner's equity is the ______and is the basis for the balance sheet.
40. Costs involved in operating a business, such as rent, utilities, and salaries are called ______.
41. The assessment of a firm’s financial condition and performance, or ______is done through calculations and interpretations of financial ratios developed from the firm’s financial statements.
42. The accumulated earnings from a firm’s profitable operations that were kept in the business and not paid out to stockholders in dividends are ______.
43. Short-term or long-term liabilities, or ______, are those that a business promises to repay by a certain date.
ASSESSMENT CHECK
Learning Goal 1 The Role of Accounting Information
1. Why is it important to know something about accounting?
2. Financial transactions include:
a. ______
b. ______
c. ______
d. ______
3. What are two purposes of accounting?
4 a. ______
b. ______
4. Who are the users of accounting information?
a. ______
b. ______
c. ______
d. ______
5 Learning Goal 2 Accounting Disciplines
5. List the five key working areas of accounting.
a. ______
b. ______
c. ______
d. ______
e. ______
6. Identify the areas with which managerial accounting is concerned.
a. ______
b. ______
c. ______
d. ______
7. How does financial accounting differ from managerial accounting?
8. Answers to financial questions such as profitability, and about debt and liabilities are answered in the company’s ______
9. What are some accounting services public accountants may provide for their clients ?
a. ______
b. ______
c. ______
10. What does it indicate when financial reports are prepared in accordance with GAAP?
11. Describe the Sarbanes-Oxley Act.
6 12. Internal audits are conducted to guarantee______
______
13. A Tax accountant is responsible for:
a. ______
b. ______
14. Who are the primary users of government and not-for-profit accounting information? What do the users of this information want to ensure?
Learning Goal 3 The Accounting Cycle
15. How do accountants differ from bookkeepers?
16. List the six steps in the accounting cycle
a. ______
b. ______
c. ______
d. ______
e. ______
f. ______
17. What is the benefit of double-entry bookkeeping?
7 18. What is the difference between a journal and a ledger?
8 19. How have computers helped in the accounting process?
a. ______
b. ______
c. ______
d. ______
e. ______
Learning Goal 4 Understanding Key Financial Statements
20. Describe the three key financial statements
a. ______
b. ______
c. ______
21. The difference between the financial statements can be summarized this way:
22. The fundamental accounting equation is:
______= ______+ ______
23. How do you calculate your net worth, or equity?
24. Assets include ______
______
25. Describe “goodwill” as an asset.
9 26. In what order are assets listed on a balance sheet?
27. Describe the three categories of assets on a balance sheet.
a. ______
b. ______
c. ______
28. What is the difference between current liabilities and long-term liabilities?
29. Describe:
a. Accounts payable:
b. Notes payable
c. Bonds payable
30. How is “equity” calculated? What is shareholder’s equity?
31. What is a capital account?
32. An income statement
a. summarizes: ______
10 ______
b. reports the firm’s operations over ______
______
33. What is the formula for developing an income statement, according to GAAP?
34. What is the difference between:
a. revenue and sales?
b. between gross sales and net sales?
35. Costs that make up cost of goods sold include:
36. How does gross margin differ between a service firm and a manufacturing firm?
37. Describe the two categories of operating expenses.
38. What is the “bottom line”?
39. Describe the three major activities for which cash receipts and disbursements are reported on a statement of cash flows.
a. ______
b. ______
c. ______
11 40. What questions may be answered by a statement of cash flows?
a. ______
b. ______
c. ______
d. ______
41. How would you describe a poor, or negative, cash flow?
42. How do cash flow problems start?
Learning Goal 5 Analyzing Financial Performance using Ratios
43. Financial ratios provide key insights into how a firm compares to other firms in the same industry in what key areas?
a. ______b. ______
b. ______c. ______
44. What do liquidity ratios measure?
45. Two key liquidity ratios are:
a. ______
b. ______
46. The formula for the current ratio is as follows:
12 47. The current ratio is compared to:
a. ______
b. ______
48. The formula for the acid test ratio is:
49. To what kinds of firms is the acid test ratio important?
50. What do leverage ratios measure?
51. What is the formula for the debt to equity ratio, and what does it measure?
52. What does it mean if a firm has a debt to equity ratio above 100%?
53. What do profitability ratios measure?
54. What are three profitability ratios?
a. ______
b. ______
c. ______
55. What is the difference between Basic EPS and diluted EPS?
13 56. What is the formula for determining Basic Earnings Per Share?
57. What is the formula for return on sales and for what do firms use this ratio?
58. What is the formula for return on equity? What does it measure?
59. What do activity ratios measure?
60. What is the formula for inventory turnover? What does it measure?
61. What is meant by inventory turnover ratios that are:
a. lower than average?
b. higher than average?
CRITICAL THINKING EXERCISES
Learning Goals 1,2 1. Match the following terms with the descriptions below. Some of these terms are describing general areas of accounting, others are similar but more specific, so use your text to help you to differentiate the terms!
Annual report Tax accountant Auditing Independent audit Certified internal auditor Managerial accounting Certified management accountant (CMA) Private accountant Certified public accountant (CPA) Public accountant Financial accounting
14 a. ______Markus Larsen works for a mid-sized, publicly held company. He is responsible for the preparation and analysis of financial information for people and organizations outside the firm.
b. ______Jim Hopson has his own small accounting firm. He provides business assistance to his clients in a number of ways. Most recently he helped a small business by designing an accounting system for the firm, and helped them select the correct software to use to get them started.
c. ______Bob Glenn is majoring in accounting, but plans to specialize in this area, as he enjoys preparing budgets and checking to determine if costs for departments are within the budget. Bob also feels that with growing emphasis on global competition, outsourcing , and organizational cost cutting the job market for this area of accounting may be very strong.
d. ______Harry Winston prepares tax returns for his company, and develops strategies to minimize the company’s tax burden.
e. ______Nancy Hoffman works for Monsanto on a full time basis to help the company keep accurate financial information.
f. ______Hector Perez‘s job is to guarantee that proper accounting procedures and financial reporting are being carried on within the company. For this job Hector not only examines the financial health of a company but looks into organizational efficiencies and effectiveness.
g. ______Kimberly Chung recently passed a series of examinations to meet the state’s requirement for education and experience, and she can now work as a private or public accountant in this type of position in accounting.
h. ______Irena Manovich is involved with this type of accounting, which is concerned with measuring and reporting costs of production, marketing and other functions, preparing budgets, checking to see that units are staying within budgets and designing strategies to minimize taxes.
i. ______In his job as a public accountant for a major accounting firm, Ryan Deiker performs this job, which is to determine if a firm has prepared its financial statements according to accepted accounting principles.
j. ______As a stockholder in Microsoft, Gary Ford receives this document each year. Gary has noticed that more information is going into this yearly report, as pressure builds from stakeholders.
k. ______Because internal financial controls are very important for firms, Eric Minette, who is a private accountant, ensures that proper accounting procedures and financial reporting are being carried out within the company for which he works.
Learning Goal 3
15 2. Sun-2-Shade is a new company that manufactures self-darkening windshields for automobiles. The company is doing very well! They need a bookkeeper to help them with their paperwork, and an accountant. You have been given the task of writing a brief job description for each job. How would you write the job description for each?
Bookkeeper –
Accountant –
3. The Accounting Cycle is as follows:
1) analyze documents 2) record transactions in journals 3) post to ledgers 4) trial balance 5) prepare financial statements 6) analyze financial statements
Identify which of the following activity is being described in each statement.
a. ______Joan Perez has finished analyzing and categorizing original documents, and is getting ready for the next step in the accounting cycle, which will be this activity.
b. ______Joan is summarizing all the data, to check that all the information is correct
c. ______The accountant for Joan’s company is getting ready to evaluate the financial condition of the firm from the financial statements.
d. ______Joan is just beginning the bookkeeping process, and is in the process of dividing the firms transactions onto categories such as sales documents, purchasing receipts and shipping documents.
e. ______While Joan has prepared the journals, this step is often done by computer.
f. ______Once the summary statements show that all the information is correct, then the accountant will do this, in accordance with generally accepted accounting principals, so that she can analyze them.
Learning Goal 4
16 4. a. Two key financial statements are the balance sheet and the income statement. Indicate whether each of the following accounts would be found on a balance sheet or an income statement.
1. ______Cash 11. ______Notes payable
2. ______Retained earnings 12. ______Accounts receivable
3. ______Accounts payable 13. ______Equipment
4. ______Interest expense 14. ______Advertising expense
5. ______Rent expense 15. ______Wages expense
6. ______Property 16. ______Supplies expense
7. ______Commission revenue 17. ______Utilities expense
8. ______Gross sales 18. ______Cost of goods sold
9. ______Common stock 19. ______Inventories
10. ______Supplies expense 20. ______Gross Profit
b. Identify the current assets and list them in order of their liquidity.
1. ______
2. ______
3. ______
5. The balance sheet reports the financial condition of a firm at a specific time. The basic formula for a balance sheet is:
Assets = Liabilities + Owner's Equity
Total assets consist of current, fixed and intangible assets
Total liabilities consist of current and long-term liabilities
Owner's Equity consists of various types of stock and retained earnings
17 Using the following list of accounts, construct an accurate balance sheet for Sun-2-Shade, Inc.
BE CAREFUL! Not all of the accounts listed will be used for the balance sheet.
SUN-2-SHADE, INC. List of accounts
Accounts payable $25,000 Utilities $12,000 Net sales $600,000 Supplies $3700 Accounts receivable $110,000 Investments $45,000 Depreciation expense $4000 Rent $35,000 Inventories $62,000 Advertising $28,000 Wages and salaries $125,000 Notes payable (current) $15,000 Rental revenue $3000 Cost of goods sold $313,000 Property, plant, equipment $200,000 Cash $18,000 Retained earnings $165,000 Accrued taxes $40,000 Long-term debt $60,000 Common stock $130,000
SUN-2-SHADE, INC. BALANCE SHEET Year ending December 31, 20__
18 6. The income statement reports all the revenues and expenses of a firm for a specific period of time. The basic formula for an income statement is:
Revenue - Cost of goods sold = Gross profit (gross margin) Gross profit - operating expenses = Net income (loss) before taxes Net income before taxes - taxes = Net income (loss)
Using the previous list of accounts construct an accurate income statement for Sun-2-Shade. For purposes of illustration, assume a 28% tax rate on income. Be careful! Not all the accounts listed will appear on an Income Statement!
SUN-2-SHADE, INC. INCOME STATEMENT Year ending December 31, 20__
19 7. Cash flow problems arise when a firm has debt obligations that must be met before cash from sales is received.
Prepare a personal cash flow statement for two weeks. Include all projected income and all projected cash disbursements (payments) How’s your cash flow?
Cash flow forecast Week one Week two
Projected income ______(Include all sources of income) Projected "outgo" ______(Include all expenses)
Surplus (Deficit) ______
Learning Goal 5 8. Liquidity ratios measure a firm's ability to pay short-term debt. Using the balance sheet and income statement you calculated earlier :
a. Calculate the current ratio for Sun-2-Shade
b. Calculate the acid-test ratio for Sun-2-Shade
c. What shape does Sun-2-Shade appear to be in?
9. Leverage ratios refer to the degree to which a firm relies on borrowed money for its operations.
a. Calculate the Debt to owner's equity ratio for Sun-2-Shade
b. If the industry average is .75, how does Sun-2-Shade compare?
10. Profitability ratios measure how effectively the firm is using its resources.
a. If Sun-2-Shade has approximately 30,000 shares of common stock outstanding, what is their Basic Earnings per share?
b. Calculate their Return on sales.
c. What is Return on Equity?
20 11. Activity ratios measure the effectiveness of the firm in using the available assets.
a. If the average inventory for Sun-2-Shade is 70,000, what is the inventory turnover rate?
b. If the industry average is 3.5, what does that indicate for Sun-2-Shade? PRACTICE TEST
MULTIPLE CHOICE – Circle the best answer
Learning Goal 1 1. Which of the following describes an activity associated with accounting? a. establishing a channel of distribution and supply chain b. forecasting demand for a new product c . developing strategies for entering new markets d. summarizing and interpreting company financial information
2. The purpose of accounting is to: a. allow for government tracking of business activities. b. make sure a business is paying its taxes. c. help managers evaluate the financial condition of the firm . d. provide a method of spending money wisely.
Learning Goal 2 3. The type of accounting that is concerned with providing information and analyses to managers within the organization is called: a. financial accounting. b. managerial accounting. c. auditing. d. tax accounting.
4. Jim Hopson is an accountant who works for a number of businesses as a “consultant.” He has helped to design an accounting system, provides accounting services, and has analyzed the financial strength of many of his clients. Jim is working as a: a. private accountant. b. certified management accountant. c. certified internal auditor. d. public accountant.
5. This legislation created new government reporting standards for publicly traded companies. a. The Public Company Oversight Act b. The Robinson-Patman Act c. The Sarbanes-Oxley Act d. The Clayton Act
Learning Goal 3 6. If you were working as a bookkeeper, the first action you would take is: a. record transactions into a ledger.
21 b. develop a trial balance sheet. c. prepare an income statement. d. divide transactions into meaningful categories.
7. A specialized accounting book in which information is accumulated into specific categories and posted so managers can find all information about one account in the same place is a: a. ledger. b. journal. c. trial balance sheet. d. double entry book. 8. Which of the following is true of the use of computers in accounting? a. Computerized accounting systems are primarily used only in large corporations. b. Computers have been programmed to make financial decisions on their own. c. Computers can free up accountants to do important tasks, such as financial analysis. d. Computerized accounting systems have actually made the accounting process slightly more complicated because of the need to understand the software.
Learning Goal 4 9. The ______reports the firm’s financial condition at a specific time. a. income statement b. cash flow statement c. statement of stockholder’s equity d. balance sheet
10. Which of the following would be considered a current asset? a. accounts payable b. accounts receivable c. copyrights d. buildings
Use the information below to answer questions 11 and 12: Net sales $30,000 Total Assets 16,000 Taxes 2,300 Cost of goods sold 12,500 Total Liabilities 8,000 Operating expenses 3,200
11. Net income is: a. 14,000. b. 17,500. c. 14,300. d. 12,000.
12. Equity is: a. 16,000. b. 24,000. c. 8,000.
22 d. can’t determine from information given.
13. Which of the following assets would be considered to be the most liquid assets? a. current assets b. fixed assets c. intangible assets d. long-term assets
14. Gross profit (gross margin) is equal to: a. Gross sales minus net sales. b. Operating expenses minus taxes. c. Revenue minus cost of goods sold. d. Cost of goods sold minus operating expenses.
23 15. Mary Jane Ashton is in accounting for the small manufacturing firm by which she has been employed for several years. She is currently in the process of preparing the company’s statement of cash flow. When she is done, this statement will show: a. net income after taxes. b. gross profit. c. total owner’s equity. d. cash inflow and cash outgo from operations.
Learning Goal 5 16. Financial ratios a. are used to calculate profits from one year to the next b. are a poor indicator of a company’s financial condition c. are only used by independent auditors d. are helpful to use in analyzing the actual performance of a company
17. The calculation for the current ratio is: a. net income divided by net sales. b. net income after taxes divided by number of common shares outstanding. c. cost of goods sold divided by average inventory. d. current assets divided by current liabilities.
18. Which kind of ratio is used to determine the ability of a firm to pay its short-term debts? a. activity ratios b. profitability c. debt d. liquidity
19. A debt to equity ratio of over 100% would mean: a. the company has more debt than equity. b. the company has more equity than debt. c. by comparison with other firms, the company is probably in good shape. d. the company is in too much debt, and should restructure.
20. Earnings per share, return on sales and return on equity are all : a. activity ratios. b. profitability ratios. c. liquidity ratios. d. debt ratios.
TRUE-FALSE
Learning Goal 1 1. _____ Understanding accounting is primarily important only if you are planning on working in the field.
2. _____ Financial transactions include buying and selling goods, acquiring insurance and using supplies.
24 Learning Goal 2 3. _____ Financial accounting is used to provide information and analyses to managers within the firm to assist in decision making.
4. _____ Dave Daschle works for Lawson Allen, an accounting firm that provides accounting services to individuals or businesses on a fee basis. Dave would be considered a private accountant
5. _____ An annual report is a yearly statement of the financial condition, progress and expectations of the firm.
6. _____ A tax accountant will perform the internal audits for a firm in order to determine what a firm’s tax liability will be.
7. _____ The primary users of government accounting information are individuals and groups that want to ensure that the government is fulfilling its obligations.
Learning Goal 3 8. _____ The practice of writing every transaction in two places is known as double entry bookkeeping
9. _____ Trial balances are derived from information contained in ledgers.
10. ____ Computerized accounting systems assist in making financial information readily available whenever the organization needs it.
Learning Goal 4 11. ____ The fundamental accounting equation is assets = liabilities - owner’s equity
12. ____ The “bottom line” is shown in the balance sheet.
13. ____ Cash flow is generally not a problem for companies that are growing quickly.
14. ____ Revenue can be generated from activities other than sales.
15. ____ Retained earnings are accumulated earnings from the firms profitable operations that were kept in the business.
Learning Goal 5 16. ____ The four types of financial ratios include liquidity, debt, profitability and activity ratios.
17. ____ The higher the risk involved in an industry, the lower the return investors expect on their investment.
25 18. ____ There are two forms of earnings per share, basic and diluted.
You Can Find It on the Net
Do you know what your personal balance sheet looks like? For a way to find out, visit the web site at http://financialplan.about.com/ Click on the Personal finance link, then budgets and follow to the budgeting worksheets. Use this worksheet to develop your own personal financial statements. Any surprises? What’s your net worth? Would you be a good risk for a business loan, or to get involved in franchising, as the web site describes? Why or why not?
26 ANSWERS
LEARNING THE LANGUAGE
1. Annual report 16. Assets 30. Liabilities 2. Cash flow 17. Accounts payable 31. Ledger 3. Current assets 18. Gross margin (gross profit) 32. Certified Management Accountant (CMA) 4. Government and not-for- 19. Financial accounting 33. Bookkeeping profit accounting 5. Fixed assets 20. Net income or net loss 34. Income statement 6. Journal 21. Balance sheet 35. Depreciation 7. Bonds payable 22. Private accountant 36. Intangible assets 8. Owner’s equity 23. Accounting 37. Statement of cash flows 9. Trial balance 24. Revenue 38. Certified Internal Auditor (CIA) 10. Tax accountant 25. Auditing 39. Fundamental accounting equation 11. Liquidity 26. Financial statement 40. Operating expenses 12. Independent audit 27. Accounting cycle 41. Ratio analysis 13. Managerial accounting 28. Cost of goods sold (cost of 42. Retained earnings goods manufactured) 14. Double entry bookkeeping 29. Public accountant 43. Notes payable 15. Certified Public Accountant (CPA)
ASSESSMENT CHECK
Learning Goal 1 The Role of Accounting Information
1. You have to know something about accounting if you want to succeed in business. It’s almost impossible to run a business without being able to read, understand, and analyze accounting reports and financial statements.
2. Financial transactions include a. buying and selling goods and services b acquiring insurance c. paying employees d. using supplies.
3. Two purposes of accounting are: a. to help managers evaluate the financial condition and operating performance of the firm b. to report financial information to people outside the firm such as owners, creditors, suppliers, employees, investors, and the government.
27 4. Users of accounting information include: a. government agencies, such as the IRS b. other regulatory agencies c. stockholders, creditors, financial analysts and suppliers d. managers of the firm.
28 Learning Goal 2 Accounting Disciplines
5. The five key working areas of accounting are: a. Managerial accounting b. Financial accounting c. Auditing d. Tax accounting e. Government and not-for-profit accounting
6. Managerial accounting is concerned with: a. measuring and reporting costs of production, marketing, and other functions b. preparing budgets( planning) c. checking whether or not units are staying within their budgets (controlling) d. designing strategies to minimize taxes.
7. Financial accounting differs from managerial accounting because the information and analyses are for people outside the organization.
8. Answers to financial questions such as profitability, and about debt and liabilities are answered in the company’s annual report.
9. Some accounting services public accountants may provide for their clients include: a. providing business assistance by designing an accounting system for a firm b. helping to select the correct computer and software to run the system c. analyzing the financial strength of an organization .
10. The independent Financial Accounting Standards Board defines what are generally accepted accounting principles that accountants must follow. If financial reports are prepared “in accordance with GAAP” , users know the information is reported according to standards agreed on by accounting professionals.
11. The Sarbanes-Oxley Act created new government reporting standards for publicly traded companies, following the scandals involving companies such as WorldCom, Enron and Tyco. The act also created the Public Company Accounting Oversight Board (PCAOB) which is charged with overseeing the American Institute of Certified Public Accountants.
12. Internal audits are conducted to guarantee that the company is carrying out proper accounting procedures and financial reporting.
13. A tax accountant is responsible for: a. preparing tax returns b. developing tax strategies.
14. The primary users of government accounting information are citizens, special interest groups, legislative bodies, and creditors. These users want to ensure that government is fulfilling its obligations and making the proper use of taxpayers’ money.
29 Learning Goal 3 The Accounting Cycle
15. Accountants classify and summarize the data provided by bookkeepers. They interpret the data and report them to management. They also suggest strategies for improving the financial condition and progress of the firm.
16. The steps in the accounting cycle are: a. Analyze source documents, such as sales documents, purchasing receipts and shipping documents. b. Record transactions into journals c. Post journal entries into ledgers d. Prepare a trial balance e. Prepare financial statements: income statement, balance sheet, and statement of cash flows f. Analyze financial statements
17. It is possible that a bookkeeper could make a mistake when recording financial transactions. In double entry bookkeeping, two entries in the journal and the ledgers are required for each company transaction. The entries can be double checked to make sure that there have been no mistakes.
18. A ledger is a specialized accounting book in which information from accounting journals is accumulated into specific categories and posted so managers can find all the information about one account in the same place.
19. Computers a. have simplified the accounting process b. have made financial information available whenever the organization needs it c. can free up accountants to do more important tasks such as financial analysis. d. can address the specific needs of small businesses. e. can help make accounting work less monotonous.
Understanding Key Financial Statements
20. a. Balance sheets report the firm’s financial condition on a specific date. b. Income statements summarizes revenues, cost of goods, and expenses, for a specific period of time, and highlights the total profit or loss the firm experienced during that period. c. The Statement of cash flows provides a summary of money coming into and out of the firm that tracks a company’s cash receipts and cash payments.
21. The difference between the financial statements can be summarized this way: The balance sheet details what the company owns and owes on a certain day. The income statement indicates what a firm sells its products for and what its selling costs are over a specific period of time. The statement of cash flows highlights the difference between cash coming in and cash going out of a business.
22. The fundamental accounting equation is: Assets = Liabilities + Owner's equity
30 23. To calculate your net worth, you would add up everything you own – cash, property, money owed to you; in other words, all your assets. From that you would subtract the money you owe to others, your liabilities, such as credit card debt, IOUs, current car loan, and student loans, for example. That figure tells you your net worth, or equity.
24. Assets include productive, tangible items such as equipment, buildings, land, furniture, fixtures, and motor vehicles that help generate income, as well as intangibles of value such as patents or copyrights.
25. Goodwill represents the value attached to factors such as a firm’s reputation, location, and superior products. It is included on a balance sheet when one firm acquires another and pays more for it than the value of its tangible assets.
26. Assets on a balance sheet are listed in order of their liquidity, which refers to how fast an asset can be converted into cash.
27 a. Current assets are items that can or will be converted into cash within one year. Current assets include cash, accounts receivable, and inventory. b. Fixed assets are long-term assets that are relatively permanent such as land buildings and equipment. They are often referred to as property, plant and equipment on a balance sheet. c. Intangible assets are long-term assets that have no physical form but have value. Examples include patents, trademarks, copyrights, and goodwill.
28. Liabilities are what the business owes to others. Current liabilities are payments due in one year or less; long-term liabilities are payments not due for one year or longer.
29. a. Accounts payable is money owed to others for merchandise and/or services purchased on credit but yet not paid. If you have a bill you haven’t paid, you have an account payable. b. Notes payable are short-term or long-term loans that have a promise for future payment c. Bonds payable are money loaned to the firm that it must pay back.
30. The value of things you own, assets, minus the amount of money you owe others, liabilities, is called equity. The value of what stockholders own in a firm minus liabilities is called stockholders equity.
31. Businesses that are not incorporated identify the investment of the sole proprietor or partner(s) through a capital account. For them, owner’s equity means the value of everything owned by the business less any liabilities of the owners, such as bank loans.
32. The income statement a. summarizes all of the resources, called revenue, that have come into the firm from operating activities, money resources used, expenses incurred, and resources left after covering expenses. b. reports the firm’s financial operations over a particular period of time, usually a year, a quarter of a year or a month.
33. The formula for an income statement is: Revenue
31 - Cost of Goods Sold Gross Margin -Operating Expenses Net Income before Taxes -Taxes = Net income (or loss)
34. a. Revenue is the value of what is received for goods sold, services rendered, and other financial sources. Most revenue comes from sales, but there could be other sources of revenue such as rents received, money paid to the firm for use of its patents, interest earned, and so forth.
b. Gross sales are the total of all sales the firm completed. Net sales refer to sales minus returns, discounts, and allowances.
35. The cost of goods sold includes the purchase price plus any freight charges paid to transport goods plus any costs associated with storing the goods. In other words, all the costs of buying and keeping merchandise for sale are included in the cost of goods sold.
36. It’s possible in a service firm that there may be no cost of goods sold; therefore, net revenue could equal gross margin. In a manufacturing firm, it is necessary to estimate the cost of goods manufactured.
37. Two categories of operating expenses are selling and general expenses. Selling expenses are related to the marketing and distribution of the firm’s goods or services, such as salaries for salespeople, advertising and supplies. General expenses are administrative expenses of the firm, such as office salaries, depreciation, insurance and rent.
38. The “bottom line” is the net income or net loss the firm incurred from operations.
39. The three major activities for which cash receipts and disbursements are reported on a statement of cash flows include: a. Operations – cash transactions associated with running the business b. Investments – cash used in or provided by the firm’s investment activities c. Financing – cash raised from new debt or new equity capital, or cash used to pay expenses, debts or dividends
40. Questions answered by a statement of cash flows may be: a. how much cash came into the business from current operations, in other words, from buying and selling goods and services? b. Was cash used to buy stocks, bonds or other investments? c. Were some investments sold that brought in cash? d. How much money came into the firm from issuing stock?
41. A poor, or negative, cash flow indicates that more money is going out of the business than is coming in from sales or other sources of revenue.
32 42. Cash flow problems start when, in order to meet the demands of customers, more and more goods are bought on credit. Similarly, more and more goods are sold on credit. This can go on until the firm uses up all the credit it has with banks that lend it money. When the firm requests money from the bank to pay a crucial bill the bank refuses the loan because the credit limit has been reached. All other credit sources may refuse a loan as well. The company needs to pay its bills or else its creditors could force it into bankruptcy.
33 Learning Goal 5 Analyzing Financial Performance using Ratios
43. Firms provide key insights into how a firm compares to other firms in the same industry in the key areas of: a. liquidity c. profitability b. debt d. overall business activity
44. Liquidity ratios measure the company’s ability to pay its short-term debts. Short-term debts are expected to be repaid within one year and are of importance to the firm’s creditors who expect to be paid on time.
45. Two key liquidity ratios are: a. current ratio b. quick ratio
46. Current ratio = Current assets Current liabilities
47. The current ratio is compared to a. competing firms within the industry to measure how the company sizes up to its main competitors. b. the previous year to note any significant changes.
48. Acid test ratio = Cash + marketable securities + receivables Current liabilities
49. This ratio is important to firms with difficulty converting inventory into quick cash.
50. Leverage ratios measure the degree to which a firm relies on borrowed funds in its operations.
51. Debt to equity ratio = Total liabilities Owner’s equity
This ratio measures the degree to which the company is financed by borrowed funds that must be repaid.
52. A debt to equity ratio of above 100% would show that a firm actually has more debt than equity. It’s possible that this firm could be perceived as a risk to both lenders and investors. It’s always important to compare ratios to other firms in the same industry because debt financing is more acceptable in some industries.
53. Profitability ratios measure how effectively the firm is using its various resources to achieve profits.
54. Three profitability ratios are: a. Earnings per share b. Return on sales
34 c. Return on equity
35 55. Basic earnings per share measures the amount of profit earned by a company for each share of outstanding common stock. Diluted EPS measures the amount of profit earned by a company for each share of outstanding common stock, but takes into consideration stock options, warrants, preferred stock and convertible debt securities that can be converted into common stock.
56. Basic earnings per share= Net Income Number of Common shares outstanding
57. Return on sales = Net Income Net Sales
Firms use this ratio to see if they are doing as well as the companies they compete against in generating income on sales they achieve.
58. Return on equity = Net Income Total Owner’s Equity Return on equity measures how much was earned for each dollar invested by owners.
59. Activity ratios measure how effectively management is turning over inventory.
60. Inventory turnover = Cost of Goods Sold Average Inventory The inventory turnover ratio measures the speed of inventory moving through the firm and its conversion into sales. Inventory sitting by idly in a business costs money.
61. a. A lower than average inventory turnover ratio often indicates obsolete merchandise on hand or poor buying practices. b. A higher than average ratio may signal lost sales because of inadequate stock. An acceptable turnover ratio is generally determined on an industry-by-industry basis.
CRITICAL THINKING EXERCISES
Learning Goals 1,2 1. a. Financial accounting g. Certified public accountant (CPA) b. Public accountant h. Managerial accounting c. Certified management accountant (CMA) i. Independent audit d. Tax accountant j. Annual report e. Private accountant k. Certified internal auditor (CIA) f. Auditing
Learning Goal 3 2. BOOKKEEPING JOB DESCRIPTION - The bookkeeper for Sun-2-Shade will be responsible for collecting all original transaction documents, and dividing them into meaningful categories (sales, purchasing, shipping, and so on). The information will be recorded into journals on a daily basis, using the double-entry method. The bookkeeper will also be responsible for
36 recording the information from the journals into ledgers. Must be familiar with computer accounting applications.
ACCOUNTANT JOB DESCRIPTION - The accountant for Sun-2-Shade will be responsible for classifying and summarizing the data provided by the bookkeeper. He/she will interpret the data, report to management, and suggest strategies for improving the financial condition and progress of the firm. Must be able to suggest tax strategies and be skilled in financial analysis. Must be a Certified Management Accountant.
3. a. Record in journals d. Analyze source documents b. Take a trial balance e. Post to ledgers c. Analyze financial statements f. Prepare financial statements
Learning Goal 4 4. a 1. Balance sheet 11. Balance sheet 2. Balance sheet 12. Balance sheet 3. Balance sheet 13. Balance sheet 4. Income statement 14. Income statement 5. Income statement 15. Income statement 6. Balance sheet 16. Income statement 7. Income statement 17. Income statement 8. Income statement 18. Income statement 9. Balance sheet 19. Balance sheet 10. Income statement 20. Income statement
b. 1. Cash 2. Accounts receivable 3. Inventories
37 5. BALANCE SHEET SUN-2-SHADE Year ending December 31, 20 _
Assets Current assets Cash $ 18,000 Investments 45,000 Accounts receivable 110,000 Inventory 62,000 Total current assets $235,000 Property, plant and equipment (Less accumulated depreciation) 200,000 Total Assets $435,000
Liabilities and Stockholder's equity Liabilities Current liabilities Accounts payable $25,000 Notes payable (current) 15,000 Accrued taxes 40,000 Total current liabilities $80,000 Long-term Debt 60,000 Total liabilities $140,000
Stockholder's equity Common stock $130,000 Retained earnings 165,000 Total stockholders equity $295,000
Total liabilities and stockholder's equity $435,000
38 6. SUN-2-SHADE, INC. INCOME STATEMENT Year ending December 31, 20__
Revenues Net sales $600,000 Rental revenue 3,000 Total revenues $603,000 Cost of goods sold 313,000 Gross profit $290,000 Operating Expenses Wages and salaries $125,000 Rent 35,000 Advertising 28,000 Depreciation 4,000 Utilities 12,000 Supplies 3,700 Total Operating Expenses $207,700 Net Income Before Taxes $ 82,300 Less Income Taxes 23,044 Net Income After Taxes $ 59,256
7. Everyone's answer will vary, obviously. The things to look at include your wages for the next two weeks, and any other income you will be receiving within the next two weeks (not including that $10 your friend owes you unless you know they're going to pay you!), and any expenses that will be due within the next two weeks, such as car payments, insurance, rent, groceries, utility bills, cell phone bills, credit card payments, tuition, books, and so on.....
Learning Goal 5 8. a. Current ratio: $235,000 = 2.9 $80,000
b. Acid-test ratio: $173,000 = 2.16 $80,000
c. It seems that Sun-2-Shade is financially sound from the liquidity perspective, as their ratios are above the benchmark of the 2:1 ratio.
9. a. Debt/Owner's equity ratio: $140,000 = .47 $295,000 b. Sun-2-Shade seems to be in very good shape, and could actually afford to take on slightly more debt, according to the industry average.
10. a. Earnings per share: $59,256 = $1.98 share 30,000
b. Return on sales: $59,256 = 10% approximately
39 $600,000
c. Return on equity: $59,256 = 20.1% $295,000
11. a. Inventory turnover: 313,000 = 4.47 times 70,000 b. Sun-2-Shade’s turnover is high, compared to the industry average. This could indicate that they are running the risk of lost sales from inadequate stock.
PRACTICE TEST
MULTIPLE CHOICE TRUE-FALSE
1. d 11. d 1. F 10. T 2. c 12. c 2. T 11. F 3. b 13. a 3. F 12. F 4. d 14. c 4. F 13. F 5. c 15. d 5. T 14. T 6. d 16. d 6. F 15. T 7. a 17. d 7. T 16. T 8. c 18. d 8. T 17. F 9. d 19. a 9. T 18. T 10. b 20. b
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