Foundations of Accounting Thought When You Add You Subtract

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1 Foundations of Accounting Thought When You Add You Subtract Accounting: the recording, measurement, and interpretation of financial information

2 Accounting Accounting is the collection, analysis, and communication of financial information. Collection Analysis Communication Initial Records Intermediate Records Financial Records Financial Statements Sales invoices Cash Cash Balance sheet Cash receipts Purchases Credit sales Accounts / receivable Accounts / payable Accounts / receivable Accounts / payable Inventory Income statement Statement of cash Flow

3 The Accounting Cycle Financial statements for decision makers inside and outside the company are prepared (balance sheet, income statement, statement of cash flow) Transaction is recorded (a sale, salary earned, purchase goods) Transactions are posted to a journal as they occur Internal reports for decision makers are prepared (sales, debt, inventory) Journal entries are posted to ledger by type of account and balances are totaled

4 How Accounting Information is Used Current Investors Evaluate income and cash flow generated by the company; evaluate management's performance. Potential Investors Estimate the company s future growth potential and the risk of investing in the company. Creditors Evaluate prospective borrower s ability to repay principal and interest. Managers Determine allocation of resources; evaluate management s performance; compare actual results with budgeted plans. Unions Review company s financial condition in order to negotiate benefits and wages. Government Agencies Establish the company s tax liability.

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7 Who does nothing makes no mistakes; who makes no mistakes learns nothing. Pacioli, Summa De Arithmetica, Geometria, Proportioni et Proportionalita (1494)

8 Debit means an entry on the left side of an account. Credit means an entry on the right side of an account. A debit or charge indicates (1) an increase in an asset, (2) a decrease in a liability, or (3) a decrease in a shareholders equity item. A credit indicates (1) a decrease in an asset, (2) an increase in a liability, or (3) an increase in a shareholders equity item. Stickney, Weil, & Davidson, Financial Accounting

9 Income Statements Sportswear International, Inc. Income Statement For the Year Ended December 31, 1998 Revenues: Gross Revenue 1,480,000 Less: Sales returns and Allowance 35,000 Net Revenue 1,515,000 Cost of Sales: Beginning Inventory 150,000 Purchases 1,210,000 Cost of Goods Available for Sale 1,360,000 Less: Ending Inventory 145,000 Cost of Sales 1,215,000 Gross Profit 300,000 Operating Expenses: Selling Expense 65,000 Advertising 30,000 95,000 General and Administrative Expenses: Adminstrative Salaries 30,000 Rent 25,000 Utilities 10,000 Insurance 3,000 Depreciation 12,250 Total General Expense 80,250 Total Operating Expense 175,250 Income from Operations 124,750 Interest Expense 9,850 Income Before Taxes 114,900 Income Tax Expense ( 36% ) 41,364 Net Income $ 73,536

10 Balance Sheets Sportswear International, Inc. Balance Sheet At December 31, 1998 Assets Current Assets: Cash 332,000 Accounts Receivable 72,500 Less: Allowance for Doubtful Accounts 15,000 57,500 Inventory 42,000 Total Current Assets 431,500 Fixed Assets: Store Equipment 47,000 Less Accumulated Depreciation 13,500 33,500 Furniture and Fixtures 140,000 Less Accumulated Depreciation 55,000 85,000 Total Fixed Assets 118,500 Total Assets $550,000 Liabilities Current Liabilities: Accounts Payable 110,000 Long-term Liabilities: Notes Payable in ,000 Total Liabilities 460,000 Owner's Equity Capital Stock 65,000 Retained Earnings 25,000 Total Owner's Equity 90,000 Total Liabilities and Owner's Equity $ 550,000

11 The Accounting Equation Assets = Liabilities + Owner s equity Anything of value owned by the company Amounts owed by the company Claims of owners, partners, and shareholders against the firm s assets

12 Objectives of Financial Reporting Financial reporting should......provide information useful for making rational investment and credit decisions....provide information to help investors and creditors assess the amount, timing, and uncertainty of cash flows....provide information about the economic resources of a firm and the claims on those resources....provide information about a firm s operating performance during a period....provide information about how an enterprise obtains and uses cash....provide information about how management has discharged its stewardship responsibility to owners....include explanations and interpretations to help users understand the financial information provided. Stickney, Weil & Davidson, Financial Accounting

13 Financial Ratios Liquidity ratios - ability to pay short-term debts Current ratio Quick ratio Current assets Current liabilities Cash + Accounts receivable Current liabilities 2:1 ratio considered favorable 1:1 ratio considered adequate Activity ratios - how efficiently assets are used Accounts receivable turnover Inventory turnover Net sales Average net A/R Cost of goods sold Average inventory per period Varies with payment terms Varies by industry

14 Financial Ratios Continued Profitability ratios - overall operating success Return on sales Return on Equity Net income Net sales Net income Equity Varies by industry Varies by industry Debt ratios - ability to pay long-term debts Debt to total assets Times interest earned Total liabilities Total Assets Income before interest & taxes Interest + Expense The lower the better for lenders The higher the better for lenders

15 Financial Accounting A firm s financial accounting system is concerned with EXTERNAL users of information - consumer groups, unions, stockholders, and government. Managerial Accounting Managerial accounting serves INTERNAL users of a company s financial information. Ronald Ebert & Ricky Griffin, Business Essentials 2nd Edition (1998)

16 Business Benefits of Budgeting Budgets provide standards from which performance can be measured. inform and often motivate employees. can force managers to be future oriented. allow top managers to get a better overall perspective. allow managers to recognize and anticipate problems. facilitate communication among departments. Source: UNDERSTANDING BUSINESS, 3/e by Nickels, McHugh, and McHugh

17 Management Information Systems MIS Transactions Procedures Processes Computers Decision Making

18 Accounting Information Model Management Process Goal Accounting Process Information Needs Strategy Inputs Tactics Storage / Processing (Models) Activities Information Needs Evaluate Reports Evaluate Improve Improve

19 Manufacturing and Information Systems Input Processing Output Raw Materials Manufacturing Process Finished Goods Data Input Process Data into Information with Information Systems Information

20 Data versus Information Input Processing Output Data Input Process Data into Information Information alphanumeric audio video text calculating updating adding sorting reports displays documents

21 Trends in M.I.S. + _ Increased access to information Increased reliance on technology Increased speed Decreased size Increased portability Increase in computer crime Increased pace Decrease in privacy

22 Poet s Point/Counterpoint about Accounting Point Double-entry bookkeeping is one of the most beautiful discoveries of the human spirit It came from the same spirit which produced the systems of Galileo and Newton and the subject matter of modern physics and chemistry. By the same means, it organizes perceptions into a system, and one can characterize it as the first Cosmos constructed purely on the basis of mechanistic thought Without too much difficulty, we can recognize in double-entry bookkeeping the ideas of gravitation, or the circulation of the blood and the conservations of matter. Juann Wolfgagn von Goethe, Reprinted in the Wall Street Journal, 3/17/93 (Editorial Page) Counterpoint The Hardship of Accounting Never ask of money spent Where the spender thinks it went. Nobody was ever meant To remember or invent What he did with every cent Robert Frost, 1936 A Further Range