Chapter 13

Understanding Principles of Accounting

Chapter Overview

Accountants provide business managers and investors with an accurate picture of a firm’s financial health by collecting, analyzing, and communicating financial information.  Certified public accountants (CPAs) are licensed professionals who provide auditing, tax, and management advisory services for other firms and individuals.  Public accountants, who have not yet been certified, perform similar tasks.  Private accountants provide diverse specialized services for the specific firms that employ them.

The CPA Vision Project is a self-assessment of the CPA profession to determine the future of accounting.  Participants in the project have identified key forces that are affecting the profession and have developed recommendations for change, including a set of core services that CPAs should offer clients and a set of core competencies that CPAs should possess.

The accounting equation and double-entry accounting are two basic accounting concepts.  The accounting equation (assets=liabilities + owners’ equity) is used to balance the data in accounting documents.  Double-entry accounting acknowledges the dual effects of financial transactions and helps ensure that the accounting equation always balances.  These tools enable accountants to enter and track transactions, and to uncover accounting errors.

The three basic financial statements reflect the activity and financial condition of a business.  The balance sheet summarizes assets, liabilities, and owners’ equity at a given point in time.  The income statement details revenues and expenses for a given period of time and identifies profit and loss.  The statement of cash flows reports cash receipts and payments from operating, investing, and financing activities.

Drawing on data from financial statements, the key financial ratios can help analyze the financial strength of a business.  The liquidity ratios – current and debt to equity – measure solvency in both the short and long run.  Return on equity and earnings per share measure profitability.  Inventory turnover ratios show how efficiently a firm is using its funds.

Firms that do international business face special issues, particularly regarding exchange rates, which fluctuate continually.  U.S. accountants must always translate foreign currencies into the value of the U.S. dollar, and subsequently, they must make adjustments to reflect shifting exchange rates over time.

 

Chapter Objectives

1. Explain the role of accountants and distinguish between the kinds of work done by public and private accountants.
2. Discuss the CPA Vision Project and explain how the CPA profession is changing.
3. Explain how the following concepts are used in accounting:  The accounting equation and double-entry accounting.
4. Describe the three basic financial statements, show how they reflect the activity and financial condition of a business, and explain the key standards and principles for reporting them.
5. Show how computing key financial ratios can help in analyzing the financial strengths of a business.
6. Explain some of the special issues facing accountants at firms that do international business.

 

REFERENCE OUTLINE

Opening Case:  Humpty-Dumpty Time at Arthur Andersen

1. What is Accounting and Who Uses Accounting Information?

 

1. Who Are Accountants and What Do They Do?
1. Financial vs. Managerial Accounting
1. Financial Accounting
2. Managerial Accounting
2. Certified Public Accountants (CPAs)
1. Professional Practice
2. CPA Services
3. Non-certified Accountants
3. Private Accountants
4. The CPA Vision Project
1. Identifying Issues for the Future
2. Global Forces as Drivers of Change
3. Recommendations for Change
4. A New Direction

1. Tools of the Accounting Trade
1. The Accounting Equation
1. Assets and Liabilities
2. Owners’ Equity
2. Double-Entry Accounting

 

1. Financial Statements
1. Balance Sheets
1. Assets
1. Current Assets
2. Fixed Assets
3. Intangible Assets
2. Liabilities
3. Owners’ Equity
2. Income Statements
1. Revenues
2. Cost of Goods Sold
3. Operating Expenses
3. Statements of Cash Flows
4. The Budget:  An Internal Financial Statement
5. Reporting Standards and Practices
1. Revenue Recognition
2. Matching
3. Full Disclosure

1. Analyzing Financial Statements
1. Short-Term Solvency Ratios
1. Current Ratio
2. Working Capital
2. Long-Term Solvency Ratios—Debt to Owners’ Equity
3. Profitability Ratios
1. Return on Equity
2. Earning Per Share
4. Activities Ratios—Inventory Turnover Ratio

 

1. International Accounting
1. Foreign Currency Exchange
2. International Transactions
3. International Accounting Standards

LECTURE OUTLINE

1. What Is Accounting and Who Uses Accounting?  (Use PowerPoint 13.3.)

 

Accounting is a comprehensive system for collecting, analyzing, and communicating financial information which is used to prepare financial statements and management reports.

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

1. Who Are Accountants and What Do They Do?  (Use PowerPoint 13.4, 13.5.)

 

1. Financial vs. Managerial Accounting

1. Financial Accounting.  Financial accounting is concerned with external uses of information.

 

1. Managerial Accounting.  Managerial accounting is concerned with internal uses of information.

1. Certified Public Accountants (CPAs)

 

CPAs are members of firms that offer accounting services to the public.

1. Professional Practice.  CPAs work as individual practitioners or join other CPA firms.

 

1. CPA Services.  Most CPA firms provide auditing services, which examine the fairness of a company’s accounting system, tax services, and management services.

1. Noncertified Public Accountants.  This category includes accountants who do not take the CPA exam, who are preparing for it, or who are waiting for state certification.

 

1. Private Accountants

Private accountants are hired as salaried employees of a firm.

1. The CPA Vision Project  (Use PowerPoint 13.6.)

 

The CPA Vision Project is a profession-wide program that was established to assess the future of accounting; a prime reason for the project is the disturbing decline in the number of young people who entered the profession in the last decade.

1. Identifying Issues for the Future.  Domestic and global forces affect the profession:  Change in perceived value of accounting, technology changes, global business requiring new accounting skills, and changes in the code of standards are catalysts for change in the profession.
2. Global Forces as Drivers of Change.  Global forces include:  technical, economical, political, social, human resource, and regulatory.

 

1. Recommendations for Change.  These include:  (a) a broader, strategic focus; (b) expansion of knowledge and experience; (c) revitalization of CPA education; and, (d) opportunities for advancement.

1. A New Direction.  Changes in core services, referring to the work that the CPA performs, and in core competencies, are two change categories revealed by the Vision Project.

 

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

1. Tools of the Accounting Trade  (Use PowerPoint 13.7.)

 

1. The Accounting Equation

Assets = Liabilities + Owners’ Equity

1. Assets and Liabilities.  An asset is any economic resource that is expected to benefit a firm or an individual who owns it; a liability is a debt that the firm owes to an outside organization.

 

1. Owners’ Equity.  Owners’ equity refers to the amount of money that owners would receive if they sold all assets and paid all debts.

1. Double-Entry Accounting

 

Accountants use double-entry accounting to record the dual effects of financial transactions.
Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

 

1. Financial Statements  (Use PowerPoint 13.8, 13.9, 13.10.)

 

1. Balance Sheets

Balance sheets display a firm’s financial condition at one point in time.  They supply information about assets, liabilities, and owners’ equity.

1. Assets.  The following assets are listed in order of liquidity.

 

1. Current Assets.  These assets include cash and assets that can or will be converted to cash with a year.  Accounts receivable represent amounts due from customers who have made credit purchases.  Merchandise inventory is the cost of merchandise purchased for sale to customers and still on hand.  Prepaid expenses include on-hand supplies and rent paid for the period to come.

1. Fixed Assets.  Fixed assets, including land, buildings, and equipment, have long-term use or value.

 

1. Intangible Assets.  This asset category includes the cost of obtaining rights, such as patents, trademarks, and copyrights.

1. Liabilities.  Current liabilities are debts that must be paid within one year.  Accounts payable are amounts owed to creditors for supplies, materials, and wages.  Long-term liabilities include debts that are not due for more than one year.

 

1. Owners’ Equity.  Common stock is calculated by multiplying the number of common shares outstanding by the legal value per share.  Paid-in capital is additional money invested in the firm by its owners.  Retained earnings are net profits minus dividend payments to stockholders.

 

 

1. Income Statements  (Use PowerPoint 13.11.)

The income statement reflects a firm’s annual profit or loss.

1. Revenues.  Revenues are funds that flow into a business from the sale of goods or services.

 

1. Cost of Goods Sold.  This figure represents the cost of obtaining materials to make the products that were sold during the year.

1. Operating Expenses.  These expenses are necessary for a firm to earn revenues.

 

1. Statements of Cash Flows  (Use PowerPoint 13.12.)

Required of all firms whose stock is publicly traded, the statement of cash flows shows a company’s yearly cash receipts and cash payments.  This statement shows cash flows from operating, investing, and financing.

1. The Budget:  An Internal Financial Statement  (Use PowerPoint 13.13.)

 

A budget is a detailed statement of estimated receipts and expenditures for a period of time in the future.

1. Reporting Standards and Practices  (Use PowerPoint 13.14.)

 

Spelled out in GAAP, these practices and principles cover a range of issues.

1. Revenue Recognition.  This is the formal recording and reporting of revenues in financial statements, which takes place after the earnings cycle is completed.

 

1. Matching.  The matching principle states that expenses will be matched with revenues to determine net income for an accounting period.

1. Full Disclosure.  This indicates that financial statements should not include just numbers; they should include management’s interpretation and explanation of those numbers.

 

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

1. Analyzing Financial Statements  (Use PowerPoint 13.15.)

 

1. Short-Term Solvency Ratios  (Use PowerPoint 13.16.)

1. Current Ratio.  This ratio measures a firm’s ability to meet current obligations out of current assets.

 

1. Working Capital.  Working capital is the difference between a firm’s current assets and its current liabilities.

1. Long-Term Solvency Ratios  (Use PowerPoint 13.17.)

 

1. The Debt-to-Owners’ Equity Ratio.  This ratio illustrates the extent to which a firm is financed through borrowed money.

1. Profitability Ratios  (Use PowerPoint 13.18.)

 

1. Return on Equity.  This measures the percentage of equity that is profit to the firm.

1. Earnings per Share.  This ratio is calculated by dividing net income by the number of shares outstanding.

 

1. Activity Ratios

1. Inventory Turnover Ratio.  This ratio measures the average number of times that inventory is sold and restocked during the year.

 

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

 

 

1. International Accounting  (Use PowerPoint 13.19.)

 

1. Foreign Currency Exchange

The amount that a firm pays for foreign purchases and the amount that it gains in sales to foreign buyers are impacted by currency exchange rates.

1. International Transactions

 

Accounting for international transactions involves translating from one currency to another and reflecting gains or losses due to exchange-rate fluctuations.

1. International Accounting Standards

 

The International Accounting Standards Board (IASB), professional accounting groups from about 80 nations, is trying to eliminate national differences in financial reporting procedures; IASB financial statements include an income statement, balance sheet, and statement of cash flows similar to those in the U.S., but international standards do not yet require a standard format.

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

Answers to Questions and Exercises

Questions for Review

1. Identify the three types of services performed by CPAs.

 

Those services are:  auditing services, tax services, and management services.

2. How does the double-entry system reduce the chances of mistakes or fraud in accounting?

 

Every transaction affects two accounts.  Recording dual effects ensures that the accounting equation always balances.

3. What are the three basic financial statements and what major information does each contain?

 

The balance sheet reflects a firm’s financial condition at one point in time by supplying detailed information about the firm’s assets, liabilities, and owners’ equity.  The income statement reflects a firm’s profit or loss by comparing the firm’s revenues with its expenses.  The statement of cash flows describes a company’s yearly cash receipts and cash payments.

4. Identify the three major classifications of financial statement ratios and give an example of one ratio in each category.

 

Solvency ratios express a firm’s ability to pay obligations; profitability ratios measure potential earnings; and activity ratios reflect how efficiently management uses its assets.  Examples will vary.

5. Explain how financial ratios allow managers to monitor their own efficiency and effectiveness.

 

Financial ratios allow managers to compare their performance against both their own past history, and against comparable companies in their industry.

Questions for Analysis

6. Explain the ways in which financial accounting differs from managerial accounting.

 

Financial accounting is concerned with external users of information; managerial accounting is concerned with internal users of information.

7. If you were planning to invest in a company, which of the three types of financial statements would you most want to see?  Why?

 

Balance sheets provide the most complete information, while income statements illustrate the relationship between the company’s revenues and expenses and the resulting profit or loss.  Some companies, unless publicly traded, do not prepare a statement of cash flows.

8. Dasar Co. reports the following data in its September 30, 2002 financial statements:

 

Gross sales                 $225,000
Current sales                 40,000
Long-term assets        100,000
Current liabilities          16,000
Long-term liabilities     44,000
Owners’ equity             80,000
Net income                      7,200
Compute the following ratios:  current ratio, debt-to-equity ratio, and return on owners’ equity.

*  Current ratio:          40,000/16,000=2.5
*  Debt-to-Equity:      60,000/80,000=.75
*  Return on Owners’
Equity:                        7,200/80,000=.09

Application Exercises

9. Interview an accountant at a local manufacturing firm.  Trace the process by which budgets are developed in that company.  How does the firm use budgets?  How does budgeting help managers plan business activities?  How does budgeting help them control business activities?  Give examples.

 

Answers will vary.  Students will probably recognize that firms sometimes develop budgets from scratch, but more often by using previous years’ data.  Budgets usually provide control for company spending or resource allocation.

10. Interview the manager of a local retail or wholesale business about taking inventory.  What is the firm’s primary purpose in taking inventory?  How often is it done?

 

Answers will vary, but students may note that businesses often take inventory for the purpose of tax reporting.

Answers to Building Your Business Skills

1. What cost savings are inherent in the electronic system for both your company and its customers?  In your answer, consider such costs as handling, postage, and paper.

 

An electronic system could eliminate much of the handling required by a paper system.  It would also virtually eliminate postage and paper, and it would reduce human error.

2. What consequences would your decision to adopt an electronic system have on others with whom you do business, including manufacturers of check-sorting equipment, the U.S. Postal Service, and banks?

 

Most businesses that you deal with would benefit from increased speed and accuracy, but those that provide goods and services that require manual processing would experience reduced demand for their products.

3. Switching to an electronic bill-paying system would require a large capital expenditure for new computers and computer software.  How could analyzing the company’s income statement help you justify this expenditure?

 

The high costs are short term, while savings from the elimination of paper, postage, handling, and error will accumulate over time.  Large capital expenditures reflected in the long-term liabilities on the income statement will not affect the current ratio.

4. How are consumers likely to respond to paying bills electronically?  Are you likely to get a different response from individuals than you get from business customers?

 

Answers will vary.  However, students should note that they would likely receive at least a handful of complaints from each customer group during the transition process.  Long-run business customers would be more likely than individual customers to convert completely to the new system.

Answers to Exercising Your Ethics

1. What are the roles of financial accounting, managerial accounting, and accounting services in this scenario?

 

Financial accounting:  preparation of financial statements
Managerial accounting:  internal financial budgets
Accounting services:  working with CPA consultants

2. What are the chief ethical issues in this situation?

 

The underling issue in this situation is confidentiality.  How much information from your old position could you ethically use in your new position?  Would it be reasonable to draw the line at information that is publicly available?  How can you separate information that you actually knew from information that you might have deduced without insider knowledge?

3. As the central figure in this scenario, how would you handle this situation?

 

Answers will vary.

Classroom Activities

1. Divide students into three-member groups.  Announce that each group has $10,000 to distribute among various fund-seeking organizations.  It is up to each group to decide to which organizations they will donate and how much.  Each group can come up with their own charity options, but each group needs to provide an explanation regarding how they chose which charity and how they arrived at the dollar amount to be donated.  Most group members will select those organizations with which they are familiar or those whose budgets have been cut, etc.   

 

2. Ask students to bring the financial statements of a selected organization.  During class, ask the students to figure any number of financial ratios based on the information in the financial statements.  How do the firms compare financially?  Are there any explanations in any of the firm’s ratios?