Chapter 17: “Understanding Accounting and Financial Information”
Financial management is the heartbeat of competitive businesses, and accounting information helps keep the heartbeat stable.
To understand business operations it is important to read, understand, and analyze accounting reports and financial statements.
Accounting is recording, classifying, summarizing, and interpreting financial events and transactions (buying and selling products, having insurance, paying workers ad using supplies) in an organization to provide management and the financial information they need to make good decisions about its operation.
To record and summarize accounting data to records, we use the accounting system.
Accounting allows us to report financial information on any type of business.
The accounting profession is divided into five key working areas that are important, and all create career opportunities.
Managerial accounting provides information and analysis (about costs and controlling budgets) to managers inside the organization to help them make decisions (strategies to reduce costs). Financial accounting is like managerial accounting but financial/public/certified accountant provides information for individuals outside of organizations who want to know finances (annual report) to see if their organization is profitable. Auditing is reviewing and evaluating the information used to prepare a company’s financial statements to verify if an organization provides proper accounting procedures and financial reporting. Tax accountants are trained in tax law and are responsible for preparing tax returns or developing tax strategies. Government and not-for-profit accounting support organizations whose purpose is not generating a profit but serving ratepayers, taxpayers, and others according to a duly approved budget.
The accounting cycle is a six-step procedure that results in the preparation and analysis of the major financial statements that rely on the work of a bookkeeper (records business transactions) and an accountant.
Accountants classify and summarize financial data provided by bookkeepers, and then interpret the data and report the information to management, and suggest strategies for improving the firm’s financial condition and prepare financial analyses and income tax returns.
Bookkeepers divide the firm’s transactions into meaningful categories being very careful to keep the information organized and manageable, and then record financial data from the original transaction documents into a record book or computer program called a journal (day’s transactions).
Technology simplified the jobs of accounting by bringing computer programs and software that assist and ease accountants’ work but do not replace them due to their specified training and competences.
A financial statement is a summary of all the financial transactions that have occurred over a particular period that indicate the firm’s financial health and stability, and are key factors in management decision-making.
The financial statements of a business are the following: The balance sheet (the firm’s financial condition on a specific date), the income statement (summarizes revenues, cost of goods, and expenses and highlights the total profit or loss for a specific period), and the statement of cash flows (summary of money coming into and going out of the firm/company’s cash receipts and cash payments).
The fundamental accounting equation is Assets= Liabilities + Owners’ equity, and it must always be balanced; it is the basis of a balance sheet.
Assets are economic resources (things of value such as equipment, land, furniture, copyrights, goodwill, etc.) owned by a firm. Accountants list assets on the firm’s balance sheet in order of their liquidity, or the ease with which they can convert them to cash. The assets may be current (items converted into cash within 1 yr.), fixed (permanent such as land, buildings, and equipment) and intangible assets (copyrights, trademarks, goodwill).
Liabilities are what the business owes to others—its debts (current or long-term). Liabilities may be accounts payable (current expenses that are not yet paid), notes payable (things business promise to repay by a certain day), and bonds payable (money that the firm must repay back).
The revenue of a business monetary value of what a firm received for goods sold, services rendered, and other payments. The revenue depends on the production cost of goods sold that includes the operating expenses. When we subtract them by the revenue, we get the net profit or loss.
Ratio analysis is the assessment of a firm’s financial condition, using calculations and financial ratios developed from the firm’s financial statements and is especially useful in comparing the company’s performance to its financial objectives and to the performance of other firms in its industry.
There are four types of ratios that measure a business’s financial performance.
Liquidity ratios measure a company’s ability to turn assets into cash to pay its short-term debts and can be divided into the current ratio (current assets/current liabilities) and the acid-test ratio (cash+accounts receivable+marketable securities/current liabilities). Leverage (debt) ratios measure the degree to which a firm relies on borrowed funds in its operations (debts to owners’ equity ratio=total liabilities/owners’ equity). Profitability (performance) ratios measure how effectively a firm’s managers are using its various resources to achieve profits (Basic earnings per share=Net income after taxes/Number of common stock shares outstanding), (Return on sales=Net income/Net sales), (Return on equity=Net income after-tax/Total owners’ equity). Finally, the activity ratios tell us how effectively management is turning over inventory (Inventory turnover=Costs of goods sold/Average inventory)