Why do we need accounting information?

Facilitate financial decision making,

Allocate scarce resources,

Stewardship,

Pay Dividends

Pay Bonuses

Pay Taxes

Control and evaluation

A process that classifies, summarizes and communicates financial information for decision making.

We start with a simple general definition to allow the flexibility to use accounting information to solve various problems.

I like to start from the individual transaction and work back to financial statements and reports. Eventually the goal is to take the reports and use them as tools for analysis.

The notes and the book will cover the same material, but not necessarily in the same order. The first five chapters of the Anthony book provide a review of the accounting process and all the note material in the next section correspond to these chapters.

Accounting is a classification/summarization process that transforms data into interpretable relationships.

The accounting process starts with transactions. Transactions are the records we make when an economic exchange of goods and services takes place. Examples include:

Examples of common transactions are: Borrowing money, Selling, Buying products, paying bills, etc.

The key to recording transactions is classifying the transaction correctly

Exchanges for items that have future economic benefit are classified as Assets.

Exchanges for which put us in debt are liabilities therefore if we buy a car and borrow money the net result is:

If we had borrowed money and then bought a car the transaction would look like:

So the journal entries explain the transaction conducted to borrow money and buy a car.

*If any of these items are unfamiliar you should get out your financial accounting text and review it, or consider purchasing one of the help books like "accounting for dummies." These books can provide a clear review of basic transactions and we assume this knowledge for A524.

In the example above the Car is a fixed asset or productive asset, (it will be assigned to the balance sheet and depreciated over its useful life). If we were a car dealer like Dan Young then the car would be classified as Inventory (not depreciated) and held for the purpose of resale.

Small Companies conduct dozens and even hundreds of transactions each day. Large companies quickly move to thousands and even million of transactions. Therefore data would quickly become meaningless without summarization. The art of accounting is to correctly summarize similar transactions so that the financial statements should an organized and interpretable picture of the Company.

Balance Sheets: keep all the permanent accounts: Cash, Receivables Inventory, Fixed Assets, Liabilities and Owners Equity.

Income Statements: Maintain the temporary transactions like Sales, purchases, salaries, travel, Interest income, etc. Temporary means that each period we will total all the transactions, summarize them on a statement and close them out which effectively starts the process over again. This is the periodicity principle of accounting.

At this stage you should be comfortable with the process of building basic financial statements, preparing them, adjusting them, creating reports and closing them at the end of the period. This is the accounting cycle.

Current Assets are relatively liquid (meaning they are close to cash) and should become cash with one year or the operating cycle of a business.

Operating Cycle refers to the period of time it takes to go from cash – into product – then to receivables – and back into cash. For jewelry store this could be months, for a grocery store if could be days. The shorter the operating cycle the faster a business is turning their product and collecting their cash. (Usually good)

Prepaid expenses: are items like paying for an insurance policy which will give us coverage into the future, so it's cost is spread over the useful life of the policy.

Property Plant and Equipment: are the productive assets of a company. They are put on the books at the original cost and then depreciated over their useful life.

Investments: Represents our firms' ownership of other companies.

Intangible assets are legal devices or accounting creations. Examples are patents, copyrights, goodwill.

This weakness points out that accounting is not a valuation process. Accounting statements (Balance Sheets) to not measure wealth rather they store costs. We use this information to figure out value.

Liabilities and Owners Equity; these are amounts we owe either to our creditors or our investors (stockholders). The two groups' desire returns on their money. Simply put, debtors expect to be paid interest and stockholders want dividends. Interest is a fixed payment for the use of money. Dividends are a distribution of the assets of a company to its shareholders.

If we look at the relationship between debt and equity of a firm, we are measuring its' leverage or capital structure. Leverage is also correlated with risk. The more debt a firm carries in proportion to its' equity the more risk the shareholders are taking and the more potential return they will require for their investment.

The Liability section also shows current and long-term debt. Again, current should be paid in the near future and long term is a structural commitment.

Analysis: If you examine the relationship between current assets and current liabilities you can observe an indication of the firms' liquidity. Liquidity is a company's short run ability to meet its' obligations. Lower liquidity generally means higher risk.

Measures the flow of resource in and out of a company. The Baron Coburg Case deals specifically with the issue of stocks versus flows. We will discuss this concept at length when we analyze the case. When reading financial statements you will note that large companies frequently combine many revenues and expenses so you have to go to the Notes at the end to gather more detail. There is also substantial detail provided in a Company's 10-K Report. See Edgar – Online at www.sec.gov for electronic 10-K filings.  (After clicking on the US Securities and Exchange Commission link, click on your Browser's back button to return to the notes.)

Information off the Income Statement:

There is a lot of information included in the Statement of Cash Flows; we will spend time on the Statement later in the semester.

Baron Coburg Case:

Review Questions and discussion

 
As we learned from the Coburg Case, some interesting questions arise regarding when a transaction should be classified as an asset or when expensing is appropriate. We start to see the need for a set of rules that govern the consistent and proper treatment for similar transactions. These rules are referred to as GAAP or Generally Accepted Accounting Principles.

Chapter 4 provides a brief review of bookkeeping. If you feel a more complete review is needed we suggest you review your basic financial accounting book, or borrow one from the library.

The reason to learn how to read financial reports is to make judgments. You may be considering buying the stock of a company. You may be an existing shareholder. Your IRA or pension may be buying stock in companies. How do we decide which company is doing better or worse. Ratio analysis is one tool that analysts' use to identify trends or factors which might effect the future. During the semester we will review a number of different ratios that can help us understand how well a company is doing.

I will mention a few ratios here, however, a more complete discussion will follow in Chapter 13.

Ratios can be classified into general categories.

Liquidity: These ratios measure a firm's short run ability to meet its obligations. Examples include:

Current Ratio Current Assets / Current Liabilities

Acid Ratio Liquid Assets (no inventory) / Current Liabilities

Leverage Ratios: These ratios measure a firm's capital structure or the reliance a firm places upon debt for it's capital needs.

Debt Ratio Total Debt / Assets

Debt to Equity Total Liabilities / Owner's Equity

Activity Ratios: These ratios measure how efficiently a firm manages is Inventory and Accounts receivables.

Accounts Receivable Turnover Cost of Goods Sold / Avg. Inventory bal.

Inventory Turnover Sales / Avg. Accounts Receivable bal.

Coverage Ratios: These ratios measure operating flow available to pay fixed commitments

Times Interest Earned Pre tax Income + interest / Interest

Cash flow coverage Operating cash flow / Interest

Other Ratios are listed in your book. Price Earnings, Dividend Yield and Payout, and Operating profit margins. All these ratios contribute to a story about the firm's financial strength or operating effectiveness. The key to ratio analysis is to use appropriate statistics to evaluate the characteristics of the firm you wish to question.