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Chap14 Accounting Instrnotes
Chap14 Accounting Instrnotes
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.
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.
1. Recording and managing cash inflows from products sold and cash outflows for
resources purchased, including payroll and payment of gross wages or earnings and the
taxes associated with them. .
2. Measuring and recording cost-of-goods sold through purchase orders for the materials
and parts used to add value to a company’s products, measure the costs of various units,
functions, and departments in the company. Depreciation is the expense method used to
reduce the value of a company’s assets used in production over time.
3. Preparing tax returns and other financial reports for local, state, and federal
governments.
4. Preparing reports on whether a company is meeting goals and objectives on costs,
inventory control, and cash balances.
5. Preparing information and reports of a company’s financial statements that show a
company’s profitability over time, the success of its business model, and its current
financial situation.
D. Types of Accountants
Accountants can be divided into two groups: inside or outside (independent)
accountants. Most of them have passed the stringent professional exams developed by the
American Institute of Certified Public Accountants required to become a certified public
accountant (CPA).
1. External accountants work in the Big Four accounting firms such as Ernst & Young or
KPMG, LLP that specialize in auditing large companies or in small independent public
companies or partnerships to provide services to medium or small companies and
individuals.
2. The Sarbanes-Oxley Act, passed in 2002, requires a company’s CEO and CFO, as well
as its external auditors, to sign off that their company’s financial statements accurately
reflect its situation.
A. Liquidity Ratios
Liquidity ratios measure a company’s ability to pay its bills when they are due.
1. Current ratio is a test of solvency that tests ability to pay liabilities due within one
year.
Current assets/Current liabilities = Current Ratio
2. Quick ratio is a more stringent test, excluding inventory.
Cash + Receivables/ Current Liabilities = Quick Ratio
2. Asset turnover measures how well a company’s assets are used to generate sales.
Sales/Total Assets = Asset Turnover
C. Profitability Ratios
Many different profitability ratios are used to relate a company’s performance to
different pieces of financial information such as sales, equity, or total capital to measure
how effectively a company’s business model is generating profit and cash.
1. Gross margin indicates how much of each sales dollar is left after paying the cost of
goods sold.
Gross profit (or COGS)/ Sales X 100 = Gross Margin
Relatively small improvements in gross margin can lead to major increases in the bottom
line.
2. Profit margin or return on sales measures how much profit is generated from sales.
Net Income/Sales X 100 = Return on Sales
3. Return on Equity (ROE or ROI) and Earnings Per Share measure tells managers
how much profit has been earned on each $100 of stockholders’ equity invested in the
business. The higher the Return on Equity, the more a company’s managers are adding to
the value of its owners’ investment, so it is sometimes called Return on Investment.
Net Income/ Owner’s Equity X 100 = Return on Equity
Earning’s per share is another measure used to examine how much profit has been
earned for each share of its stock.
Net Income/ Total Number of Shares = Earnings Per Share
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.
The balance sheet is the summary of the financial condition of a business on the
day at the end of the specific reporting period, such as December 31, 2003. It reports the
main assets, what it owns, and liabilities, what it owes, and its stockholder’s equity, or
what it’s worth. Its purpose is to track the relationship between capital and assets to see
how well a company is using them. The basic equation of accounting is what a company
owns minus what it owes is what it is worth., or Assets – Liabilities = Owners’ Equity
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.
The income statement, or profit and loss statement, summarizes and reports the
results of a company’s profit-making activities in a specific time period. The “bottom
line” on this statement shows profit or loss for the period. To calculate net income,
companies deduct the cost of goods sold (COGS) from sales revenue. Gross profit or
gross margin is left after cost of goods sold is deducted. Net profit, the bottom line, is the
total profit or earnings that reflect adjustments for cost of goods sold, all other expenses,
interest, and taxes. The income statement shows
Sales revenue-Expenses= Profit (or loss)
4. Explain 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.
A company’s business model requires both profit and cash flow objectives to
ensure its long-term and short-term survival. It needs cash to pay its bills and invest in
new materials, labor, and other resources on a regular basis. The statement of cash flows
shows how much a company generates during a specific period, where it came from, and
how it was used.