Chapter 3: Accounting Outline

Accounting is the language of business used by corporations to communicate their results to the world in a format that allows for comparisons to be made across very different types of business operations. Accounting also provides a means to control, evaluate and plan operations within the company. All corporate activities must eventually be measured in dollars.

Accounting answers three basic questions:

• What does the company own?
• How much does the company owe?
• How well did the company's operations perform?
• How does the company get the cash to fund itself?

Accounting overview:

• Common rules of accouting
• General Accepted Accounting Principles (GAAP Rules)
• Financial Accounting Standards Board (FASB) writes additional rules for new areas of business activity, about six per year.
• Fundamental Concepts of Accounting
• The Entity
• Reports communicate the activities of a specific entity so the parameters covered by a report must be clear.
• Cash and Accrual Accounting
• Using Cash Basis accounting, transactions are recorded only when cash changes hands.
• Tells you when and how much cash changed hands, but does not try to match the costs of conducting business with their related sales.
• Accrual accounting recognizes the financial effect of an activity when the activity takes place without regard to the movement of cash. Most businesses of any size use accrual accounting.
• As activity and cash movement do not occur at the same time, Allocation and Matching are important in accrual accounting
• Allocations to accounting periods
• Because profit and loss statements reflect activities over a specific time, the period of recognition is very important
• Matching
• Sales made in one period are matched with their related selling costs or COGS in the same accounting period.
• By matching sales and their related costs you can determine the actual profit
• Without policies for allocation and matching, financial reports could be easily manipulated by choosing when to record sales or expenses in order to cover up or delay bad results.
• Objectivity
• Accounting records only contain transactions that have been completed and that have a quantifiable monetary value.
• There must be reasonable and verifiable evidence to support the transaction, or else it does not get recorded.
• Conservatism
• When companies incur losses that a probably and that can be reasonably estimated, they are recorded even it they have not yet been realized.
• Gains are not recorded until they are actually realized.
• Dictates that transactions be recorded at their historical costs
• Going Concern
• Accountants presume that companies will continue to operate in the foreseeable future, so values assigned in the financial statements are not "fire sale" prices, but historical costs.
• Consistency
• An entity must use the same accounting rules year after year.
• This allows comparisons with the past to show performance trends.
• Inventory must be valued using the same system year after year.
• If a change of accounting method is necessary for a "substantial reason", the financial statements must state the reason in the footnotes and must also state how the change affected the profits and asset values that year.
• Materiality
• Financial statements are not exact to the penny, but are materially correct to provide the reader a fairly stated view of the entity.
• Big four accounting firms are:
• PricewaterhouseCoopers LLP
• KPMG LLP
• Deloitte & Touche LLP
• Ernst & Young LLP
• Financial Statements
• Balance Sheet
• Presents the assets owned by the company, the liabilities owed to others and the accumulated investment of its owners.
• Assets: resources the company possesses for the future benefit of the business
• Liabilities: dollar-specific obligations to repay borrowing, debts, and other obligations to provide goods or services to others.
• Owners equity: accumulated dollar measure of the owners' investment in the company.
• Can be shown as retained earnings or paid out as dividends
• Also known as net worth
• Show these balances as of a specific date.
• Snap shot of the company's holdings at a given time.
• Foundation for all accounting records.
• Fundamental accounting equation:
• Assets = Liabilities + Owners' Equity
• Current versus non-current
• Assets and liabilities are divided into current (easily transferred into cash within one year) and non-current (long-term)
• Working capital
• Gives an indication of a business's solvency
• Net Working Capital = Current Assets - Current Liabilities
• Double entry system
• All journal entries in the general ledger must have both a debit and a credit
• T accounts
• Income Statement
• Shows the flow of activity and transactions over a specific period
• Revenue from sales and expenses relating to those revenues
• When matched through accrual accounting, the difference is income
• Income = Revenue - Expenses
• Terminology
• Gross margin
• Gross margin = Sales - "The direct cost of good or services sold"
• Cost of Goods Sold (COGS) = Beginning inventory + new purchases - Ending inventory
• Operating Profit
• Earnings before interest and taxes (EBIT)
• Allocated cost of fixed assets (depreciation or amortization) must be charged to earnings.
• Divide the cost of equipment, tools, buildings and other fixed assets by their useful lives to estimate the cost of using up assets needed in the revenue-generating process
• Earnings before interest, taxes, depreciation and amortization (EBITDA) is one measure profitability.
• Net Income
• Items not directly linked to operations are deducted to calculate income
• Interest expense
• Deducted because companies may have used different proportions of bank borrowing and investors' money
• Investors' dividends are not deducted.
• Owners pay dividends out of the net income at the bottom of the statement.
• Segregating interest expenses allows operating income to reflect only the costs of operating the company, not those related to financing it.
• Tax expenses
• Segregated to leave operating income free of nonoperating expenses.
• Shows how the change in net assets occurred.
• Statement of Cash Flows
• Shows the net change in cash for the year.
• Mandated by FASB rule #95 for all financial statements.
• Knowing the sources and uses of cash is paramount for a business.
• Cash = Current liabilities + Noncurrent Liabilities + Owners' equity - Accounts receivable - Inventory - Noncurrent assets
• Answers the important questions:
• What is the relationship between cash flow and earnings?
• How are dividends financed?
• How are debts paid off?
• How is the cash generated by operations used?
• Are managements' stated financial policies reflected in the cash flow?
• Allows managers to plan and manage cash sources and needs from Operations, Investing and Financing activities.
• Operating activities
• Calculates the cash generated from the day-to-day operating activities of a business
• Converts accrual basis net income to a cash basis
• Must be adjusted in two ways to do this:
• Adjust net income for noncash expenses
• Operating items that did not use cash, but were deducted in the income statement as an expense must be added back.
• Add back depreciation (for example)
• Adjust net income for changes in working capital
• Adjust net income for changes in current assets and current liabilities that operational activities affected during the year.
• Increases in current assets use cash, while decreases in current assets produce cash
• Increases in current liabilities increase cash while decreases in current liabilities use it up
• To calculate the net changes for the year, subtract the beginning of the period's balances of current assets and liabilities from the ending balances items.
• The increases in current assets are uses of cash
• The increases in current liabilities are sources of cash
• Investing activities
• Deals with cash use and generation by long-term investments by the company
• Reflects the cash effects of transactions in long-term (noncurrent) assets on the balance sheet
• Financing activities
• Two ways for a company to finance itself: borrow money or raise money from investors.
• Borrowing would be reflected by changes in the long-term liabilities section of the balance sheet.
• When the company repays the debt, it will be reflected as a use of cash in the financing activities section.
• Participation by investors would be reflected in changes in the owners' equity accounts of the balance sheet.
• There are changes to the retained earnings when net income is added during the year and if dividends are paid out to investors.
• These three basic financial statements are inextricably tied together:
• Statement of cash flows demonstrates that the changes during the year in the cash balance had to result from changes in assets, liabilities and owners' equity.
• Assets and liabilities changes came from the balance sheet.
• Owners' equity changes were the result of changes in net income from the income statement.
• Using ratios to read financial statements
• Real information can be found in analyzing the relationship of one number to another or of one company to another in the same industry using ratios.
• Four main categories of ratios
• Liquidity measures
• Current ratio = current assets / current liabilities
• Can the company pay its bills comfortably? 
• A ratio greater than 1 shows liquidity.
• Capitalization measures
• Financial leverage = (total liabilities + owners' equity) / OE
• When a company assumes a larger portion of debt than the amount invested by its owners, it is said to be leveraged.
• Ratios larger than 2 show an extensive use of debt.
• Long-term debt to capital = long-term debt / (liabilities + OE)
• The level of debt is an important measure of a company's riskiness.
• Ratio of greater than 50% shows a high level of debt.
• Activity measures
• Assets turnover per period = sales / total assets
• Indicates how actively the firm uses all of its assets.
• Generating more sales with a given set of assets, a firm is said to have "managed its assets effectively"
• Ratios are industry-specific, but 36 is a high turnover of assets in most industries.
• Inventory turns per period = cost of goods sold / average inventory held during the period
• Average inventory = (beginning inventory + ending inventory) / 2
• Shows how actively a company's inventory is being deployed.
• Days sales in inventory = ending inventory / (cost of goods sold / 365)
• Shows how actively a company's inventory is being deployed.
• Profitability measures
• Return on Sales (ROS) = Net income / Sales
• Return ratios are easy to calculate and investment analysts use them frequently.
• Return on Equity (ROE) = Net income / Owners' equity
• Widely accepted yardstick to measure success.
• The mix of debt and equity can dramatically affect the ratios, as can the financial leverage used.
• The DuPont Chart
• Shows how several of the most important financial statement ratios are related to one another by displaying their components.
• Managerial Accounting
• Uses data to manage and analyze operations.
• Uses standards, budgets and variances to run the business and explain operational results.
• Two types of variances: price and volume
• Sales price variance
• Tells the manager how much of the difference between budgeted sales revenue and actual sales revenue is due to changes in sales price
• Sales Price Variance = (Actual Sales Price = Standard Sales Price) x (Actual Quantity Sold)
• Purchase Price Variance = (Standard Price - Actual Price) x (Actual Quantity Purchased or Used)
• Volume price variance
• Isolates the dollar effect of a different unit volume from what was budgeted assuming no price changes
• Sales Volume Variance = (Standard Sales Price) x (Actual quantity sold - Standard Quantity Sold)
• Material or Labor Efficiency Variance = (Standard Use Quantity - Actual Usage Quantity) x (Standard Cost of Material or Labor)
• Object is to budget a company's activities for a period of time, then explain why the actual results varied from the projections.
• Cost accounting
• Determines the cost of producing goods or services
• Allocating overhead is difficult as it must be allocated based on actual usage of the overhead expenses.
• Activity-based costing (ABC)
• Based on what it takes to create and deliver the product to the customer
• Ten Ways Accountants Can Misstate Earnings
1. Misclassify expenses as assets
2. Underestimate sales allowances for returns, discounts and markdowns
3. Underestimate bad-debt allowances on sales made on credit
4. Create off-balance-sheet liabilities
5. Recognize phantom revenues
6. Depreciate assets too slowly
7. Modify adjustments to inventory
8. Forecast unusual gains or losses
9. Create special reserves by overestimating future expenses and boost profits by revising those estimates downward later
10. Manipulate measures of performance that are tied to key executive bonus compensation.