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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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
• 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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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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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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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