Chapter Fourteen

Accounting: Measuring how Efficiently and Effectively

Resources Are Creating Value and Profit

© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/IrwinIntroduction to Business

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Learning Objectives

1. Explain how the success of a company’s business model can be measured by financial accounts and describe the various kinds of activities that accountants perform.

2. Analyze a company’s balance sheet and describe how it balances the assets a company owns against the capital owed to its creditors and stockholders.

3. Explain how the income statement is used to measure a company’s bottom line profit and the various costs and expenses that must be deducted to arrive at this total.

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Learning Objectives

4. Understand why the need for cash, as well as profit, affects a company’s business model and how the cash flow statement measures the cash that flows into and out of a company.

5. Appreciate how financial ratios can be used to analyze the information in a company’s financial statements and how they help both managers and investors evaluate a company’s current and future profitability.

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The Nature of Accounting

• Accounting - the process of collecting financial data,

organizing and analyzing it using agreed-upon accounting rules, and reporting the results in financial statements

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The Nature of Accounting

• Accounting system - the financial information system a company

uses to measure, record, analyze, and report all the transactions involved in its value-creation process

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Question?

What is the record-keeping activities needed to monitor and track all of the financial transactions related to making and selling goods and services?

A. BookkeepingB. AccountingC. Accounting systemsD. Double-entry journals

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Types of Accounting Activities

• Bookkeeping - the record-keeping activities needed to

monitor and track all of the financial transactions related to making and selling goods and services

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Types of Accounting Activities

• Depreciate - the act of calculating the reduced value of

the assets a company uses to make and sell its products

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Accounting Activities

Figure 14.1

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The Rules of Accounting: GAAP

• Generally accepted accounting principles

- a set of accounting rules and procedures U.S. companies must follow to ensure their financial standing is being reported accurately and honestly

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Types of Accountants

• Certified public accountants (CPAs) - people who have taken 150 semester

hours of accounting courses and have passed the CPA exam administered by the American Institute of Certified Public Accountants

Steps to become a CPA can be found at cpa-exam.org

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Types of Accountants

• Audit - the formal evaluation of the fairness and reliability of a company’s financial statements

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Types of Accountants

• Managerial accountants - accountants who specialize in preparing

and analyzing the financial data used by managers

• Financial accountants - accountants who specialize in preparing

financial data, following GAAP rules, for use by outside stakeholders

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Accounting Concepts and Financial Statements

• The Balance Sheet• The Income Statement• The Statement of Cash Flows

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The Balance Sheet

• Balance sheet - a summary of the financial condition of a

business at the end of a day of a specific reporting period

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The Balance Sheet

• Assets - the productive resources a company owns

as well as all of its financial investments

• Liabilities - the financial obligations a company incurs

by borrowing money or buying productive resources on credit

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The Balance Sheet

• Stockholders’ equity - the total capital invested in a company over

a time as well as the past profits it has retained in its business

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The Basic Accounting Equation

Assets - Liabilities = Owners’ Equity

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The Basic Accounting Equation

• Double entry bookkeeping - a method of recording the dual effects of a

business’s financial transaction so that the company’s assets, liabilities, and owners’ equity are always in balance

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Assets

• Liquidity - assets listed in the firm’s balance sheet in

order of how fast they can be converted into cash

• Current assets - the total value of a company’s cash,

accounts receivable, inventory, and prepaid expenses

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Liabilities

• Current liabilities - debts that are payable within one year’s time, including accounts payable and accrued expenses

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Stockholders’ Equity

• Total equity - the sum of the capital stock invested in a

business in addition to its retained earnings

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The Income Statement

• Income statement - the financial report that summarizes the

results of a company’s profit-making activities in a specific time period

• Bottom-line profit - the amount of net income, profit, or

earnings a company reports on the bottom line of its income statement

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Sales, Expenses, and Profit

Figure 14.3

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The Income Statement

• Accrual basis of accounting - the principle that a company’s income

statement should reflect the revenue received when the company makes a sale, not when payment is actually received

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Question?

What is a company’s total profit after deducting the cost of the goods it has sold as well as all of its other expenses?

A. Gross profitB. Gross marginC. Net incomeD. Cash flow

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The Income Statement

• Gross profit - the amount of money left over after a firm

deducts the cost of the goods it has sold from the revenues earned from them

• Net income - a company’s total profit after deducting the

cost of the goods it has sold as well as all of its other expenses

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The Statement of Cash Flows

• Cash flow statement - a financial report showing how much cash

a company generated during a specific time period, including where the cash came from and how it was used

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The Statement of Cash Flows

• Cash flows from operating activities• Cash flows from investing• Cash flows from financing

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The Statement of Cash Flows

• Working capital - the amount of cash left over after a

company subtracts its current assets from its current liabilities

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Using Financial Ratios to Analyze a Company’s Performance

• Financial ratios - ratios that measure different aspects of a

company’s performance

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Using Financial Ratios to Analyze a Company’s Performance

• Liquidity Ratios• Asset Management Ratios• Profitability Ratios

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Liquidity Ratios

•Current ratio•Quick ratio

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Asset Management Ratios

• Inventory turnover ratio - a measure of how quickly a firm’s inventory

is being sold

• Asset turnover ratio - a measure of how well a company’s assets

are being put to use to generate sales

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Profitability Ratios

• Gross margin - a measure of how much of each sales

dollar is left over after a firm pays for the cost of goods sold

• Profit margin - a measure of how much profit a company

generates from its sales

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A Look at Gross Margin

Figure 14.4

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Dick’s Gross Margin

Figure 14.5

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Sales and Net Income of Four Major Sports Retailers, 2002

($ in millions)

Figure 14.6

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Return on Equity and Earnings Per Share

• Return on equity - a measure of how much profit a company

has earned on each $100 of stockholders’ equity invested in the business

• Earnings per share - a measure of how much profit a company

has earned for each share of stock issued

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Return on Invested Capital

• Return on invested capital - a measure of how much profit a company

generates for each dollar invested in its business

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Return on Capital Income, 2002

Figure 14.7

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ROIC Best-in-Class Retailers, 2002

Figure 14.8

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Video: Aon Company

• Aon Company is a financial services company that provides accounting and other financial services. This video discusses managerial, financial, and tax accounting and the roles that each play at Aon.

• Identify the steps in the accounting cycle