CyberSummary

INTRODUCTION

Accounting is the financial "language" organizations use to record, measure, and interpret all of their financial transactions and records. All organizations use accounting to ensure they use their money wisely and to plan for the future.

THE NATURE OF ACCOUNTING

Accounting is the recording, measurement, and interpretation of financial information. People and institutions, both within and outside businesses, use accounting tools to evaluate organizational operations.

Individuals and businesses can hire a public accountant, an independent professional, to provide accounting services ranging from the preparation and filing of individual tax returns to complex audits of corporate financial records. A certified public accountant (CPA) has been officially certified in the state in which he or she practices after meeting certain educational and professional requirements established by the state. Certification gives a public accountant the right to officially express an unbiased opinion regarding the accuracy of the client's financial statements. Large corporations, government agencies, and other organizations may employ their own private accountants to prepare and analyze their financial statements. Private accountants can be CPAs and may become certified management accountants (CMAs) by passing a rigorous examination.

Although the terms accounting and bookkeeping are often used interchangeably, they do not mean the same thing. Narrower and more mechanical than accounting, bookkeeping is typically limited to the routine, day-to-day recording of business transactions. Accountants not only record financial information, but also understand, interpret, and even develop sophisticated accounting systems necessary to classify and analyze complex financial information.

Accountants summarize the information they derive from a firm's business transactions in various financial statements. Many business failures may be linked directly to ignorance of the trends and other information "hidden" inside these financial statements. Managers and owners use financial statements (1) to aid in internal planning and control and (2) for external purposes such as reporting to the Internal Revenue Service, stockholders, creditors, customers, employees, and other interested parties.

Managerial accounting refers to the internal use of accounting statements by managers in planning and directing the organization's activities. Management's greatest concern is cash flow, the movement of money through an organization over a daily, weekly, monthly, or yearly basis. A common reason for a cash shortfall is poor managerial planning. Managerial accounting is the backbone of an organization's budget, an internal financial plan that forecasts expenses and income over a set period of time. While most companies prepare master budgets for the entire firm, many also prepare budgets for smaller segments of the organization such as divisions, departments, product lines, or projects. The major value of a budget lies in its breakdown of cash inflows and outflows.

Managers also use accounting statements to report the firm's financial performance to outsiders. They may become the basis for the information provided in the official corporate annual report, a summary of the firm's financial information, products, and growth plans for owners and potential investors. The most important component of an annual report is the CPA's signature attesting that the required financial statements accurately reflect the financial condition of the firm; financial statements meeting these conditions are termed audited. The primary external users of audited accounting information are government agencies, stockholders and potential investors, and lenders, suppliers, and employees. Government entities require organizations to file audited financial statements concerning taxes owed and paid, payroll deductions for employees and, for corporations, new issues of securities (stocks and bonds). A corporation's stockholders use financial statements to evaluate the return on their investment and the overall quality of the firm's management team; potential investors use them to determine whether the company meets their investment requirements and whether the returns from a given firm are likely to compare favorably with other similar companies. Banks and other lenders look at financial statements to determine a company's ability to meet current and future debt obligations if a loan or credit is granted. Labor unions and employees use financial statements to establish reasonable expectations for salary and other benefit requests.

THE ACCOUNTING PROCESS

Accountants carry out the accounting function by using the accounting equation and double-entry bookkeeping.

Accountants are concerned with an organization's assets, liabilities, and equity. A firm's economic resources, or items of value that it owns, represent its assets such as cash, inventory, land, equipment, buildings, and other tangible and intangible things. Liabilities are debts the firm owes to others. Owners' equity equals assets minus liabilities and reflects historical values. The relationship between assets, liabilities, and owners' equity is a fundamental concept in accounting and is known as the accounting equation: assets = liabilities + owners equity.

Double-entry bookkeeping is a system of recording and classifying business transactions in accounts that maintains the balance of the accounting equation. To keep the accounting equation in balance, each business transaction must be recorded in two separate accounts. All business transactions are classified as either assets, liabilities, or owners' equity; but most organizations break down these three accounts further to provide more specific information about a transaction.

In any accounting system, financial data pass through a four-step procedure called the accounting cycle because it collects, records, and analyzes raw data constantly throughout the business's life. Financial managers begin the accounting cycle by gathering and examining source documents concerning specific transactions. Each financial transaction is then recorded in a journal, a time-ordered list of account transactions. Next, the information is transferred, or posted, to a general ledger, a book or computer file with separate sections for each account. At the end of the accounting period, the manager or accountant prepares a trial balance of all the accounts in the general ledger. If the accounting equation is in balance, the information is used to prepare the firms' financial statements. In the case of public corporations and certain other organizations, a CPA must verify that the organization followed acceptable accounting practices in preparing the financial statements. When these statements have been completed, the organization's books are "closed," and the accounting cycle begins anew for the next accounting period.

FINANCIAL STATEMENTS

The end results of the accounting process are a series of financial statements, such as the income statement and the balance sheet. These statements are provided to stockholders and potential investors in a firm's annual report as well as to other relevant outsiders such as creditors and the Internal Revenue Service. Because different organizations generate income in different ways, they may use different formats and terminology in preparing accounting statements. Each type of business uses its own accounting principles, called generally accepted accounting principles (GAAP).

The income statement (also called a profit and loss statement or operating statement) is a financial report that shows an organization's profitability over a period of time. The income statement indicates the firm's profitability or income (the bottom line), which is derived by subtracting the firm's expenses from its revenues.

Revenue is the total amount of money received from the sale of goods or services as well as other business activities, such as the rental of property and investments. Nonbusiness entities typically obtain revenues through donations from individuals and/or grants from governments and private foundations. The next major item included in most income statements is the cost of goods sold, the amount of money the firm spent to buy and/or produce the products it sold during the accounting period. Gross income is revenues minus the costs of good sold required to generate the revenues.

Expenses are the costs incurred in the day-to-day operations of the organization. The number and type of expense accounts shown on income statements vary from organization to organization, but three common ones are selling, general, and administrative expenses; research, development, and engineering expenses; and interest expense. Included in the general and administrative category is a special type of expense known as depreciation, the process of spreading the costs of long-lived assets such as buildings and equipment over the total number of accounting periods in which they are expected to be used.

Net income (or net earnings) is the total profit (or loss) after all expenses, including taxes, have been deducted from revenue. Accountants often divide profits into individual sections such as operating income and earnings before interest and taxes. Income statements may also include previous years' income statements to permit comparison of performance from one period to another.

The second basic financial statement is the balance sheet, which presents a "snapshot" of an organization's financial position at a given moment. It indicates what the organization owns or controls and the various sources of the funds used to pay for these assets, such as bank debt or owners' equity. The balance sheet takes its name from its reliance on the accounting equation: Assets must equal liabilities plus owners' equity. The balance sheet is an accumulation of all financial transactions conducted by an organization since its founding. Balance sheets can be presented in a vertical format with assets at the top followed by liabilities and owners' equity, or with assets on the left side and liabilities and owners' equity on the right side.

All asset accounts are listed in descending order of liquidity--thatis, how quickly each could be turned into cash. Short-term, or current, assets are used or converted into cash within the course of a calendar year. Thus, cash is listed first followed by temporary investments, accounts receivable (money owed the company by its clients or customers), and inventory (in the form of raw materials, goods in process, and finished products ready for sale). Finally, long-term, or fixed, assets, which represent a commitment of organizational funds of at least one year, are listed.

Assets must be financed, either through borrowing (liabilities) or through owner investments (owners' equity). Current liabilities include a firm's financial obligations to short-term creditors that must be repaid within one year, while long-term liabilities have longer repayment terms. Accounts payable represents amounts owed to suppliers for goods and services purchased with credit. Other liabilities include wages owed to employees and taxes owed to the government. Occasionally, these accounts are consolidated into an accrued expenses account, representing all unpaid financial obligations incurred by the organization.

Owners' equity includes the owners' contributions to the organization along with income earned by the organization and retained to finance continued growth and development. The accounts listed in the owners' equity section of the balance sheet may vary from business to business. All equity accounts may be listed in one category or may be divided into the various classes of stock (common and preferred) outstanding.

RATIO ANALYSIS: ANALYZING FINANCIAL STATEMENTS

The income statement and balance sheet together provide the means to answer two critical questions: (1) How much did the firm make or lose? and (2) How much is the firm presently worth based on historical values found on the balance sheet? Ratio analysis, calculations that measure an organization's financial health, brings the information from the income statement and balance sheet into sharper focus so that managers, lenders, owners, and other interested parties can measure and compare the organization's productivity, profitability, and financing mix with other similar entities. It is the relationship of the calculated ratios to both prior organizational performance and the performance of the organization's "peers," as well as its stated goals that matters.

Profitability ratios measure how much operating income or net income an organization is able to generate relative to its assets, owners' equity, and sales. The profit margin, computed by dividing net income by sales, shows the overall percentage profits earned by the company. The higher the profit margin, the better the cost controls within the company and the higher the return on every dollar of revenue. Return on assets, net income divided by assets, shows how much income the firm produces for every dollar invested in assets. A low return on assets means the company is probably not using its assets very productively. Return on equity (also called return on investment (ROI)), calculated by dividing net income by owners' equity, shows how much income is generated by each $1 the owners have invested in the firm. A low return on equity means low stockholder returns.

Asset utilization ratios measure how well a firm uses its assets to generate each $1 of sales. Companies that use their assets more productively will have higher returns on assets than less efficient competitors. The receivables turnover, sales divided by accounts receivable, indicates how many times a firm collects its accounts receivable in one year, or how quickly it is able to collect payments on its credit sales. Inventory turnover, sales divided by total inventory, indicates how many times a firm sells and replaces its inventory over the course of a year. A high inventory turnover ratio may indicate great efficiency, but may also suggest the possibility of lost sales due to insufficient stock levels. Total asset turnover, sales divided by total assets, measures how well an organization uses all of its assets in creating sales. It indicates whether a company is using its assets productively.

Liquidity ratios compare current (short-term) assets to current liabilities to indicate the speed with which a company can turn its assets into cash to pay off debts. High liquidity ratios may satisfy a creditor's need for safety, but ratios that are too high may indicate that current assets are not being used efficiently. Liquidity ratios are best examined in conjunction with asset utilization ratios because high turnover ratios imply that cash is flowing through an organization very quickly--a situation that dramatically reduces the need for the type of reserves measured by liquidity ratios. The current ratio is calculated by dividing current assets by current liabilities. The quick ratio (or acid test) is a more stringent measure of liquidity because it eliminates inventory, the least liquid current asset.

Debt utilization ratios provide information about how much debt an organization is using relative to other sources of capital, such as owners' equity. Because the use of debt carries an interest charge that must be paid regularly regardless of profitability, debt financing is much riskier than equity. Consequently, the managers of most firms tend to keep debt-to-asset levels below 50 percent. The debt to total assets ratio indicates how much of the firm is financed by debt and how much by owners' equity. The times interest earned ratio, operating income divided by interest expenses, is a measure of the safety margin a company has with respect to the interest payments it must make to its creditors. A low times interest earned ratio indicates that even a small decrease in earnings may lead to financial difficulties.

Investors may use per share data to compare the performance of one company with another on an equal, or per share, basis. Earnings per share, net income or profit divided by the number of shares of stock outstanding, is important because it is yearly changes in earnings per share, in combination with other economic factors, that determine a company's overall stock price. Dividends per share, the actual before-tax cash payment received for each share owned, is another way to analyze the overall return resulting from a stockholder's investment.

While comparing a firm's performance to previous years is an excellent gauge of whether corporate operations are improving or deteriorating, another way to analyze a firm is to compare its performance with other firms in its industry.