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BUSN 70, Chapter 14

The recording, measurement and interpretation of financial information
Certified Public Accountant (CPA)
An individual who has been state certified to provide accounting services ranging from the preparation of financial records and the filing of tax returns to complex audits of corporate financial records
-Most CPAs are self-employed or members of large public accounting firms
Sarbanes-Oxley Act
required firms to be more rigorous in their accounting and reporting practices
-After the accounting scandals of Enron and Worldcom in the early 2000’s, Congress passed this
Dodd Frank Act
strengthens the oversight of financial institutions
-During the latest financial crisis, banks developed questionable lending practices, leading to this
Forensic accounting
-fit for legal review
-Involves analyzing financial documents in search of fraudulent entries or financial misconduct, in other words “cooked books”
Private Accountants
Employed by large corporations, government agencies, and other organizations to prepare and analyze their financial statements
-Deeply involved in most of the important financial decisions of the organization
Certified Management Accountants (CMAs)
Private accountants who, after rigorous examination, are certified by the National Association of Accountants and who have some managerial responsibility
-much narrower and more mechanical than accounting; limited to routine recording of business transactions
-obtain and record the information used by accountants; requires less training
have more training allowing them to understand, interpret and analyze financial information
Managerial Accounting
The internal use of accounting statements by managers in planning and directing the organization’s activities
Cash Flow
The movement of money through an organization over a daily, weekly, monthly or yearly basis
-Perhaps management’s single greatest concern is:
An internal financial plan that forecasts expenses and income over a set period of time
-Managerial accountants help prepare this
-The principal value of budgets lies in the breakdown of cash inflows and outflows
accounting statements
-Managers use accounting statements to report to outsiders
-Used for filing income taxes, obtaining credit and reporting results to stockholders
Audited financial statements
are those signed off on by a certified public accountant
The Accounting Equation
Assets = Liabilities + Owner’s Equity
A firm’s economic resources, or items of value that it owns, such as cash, inventory, land, equipment, buildings, and other tangible and intangible things
Short term assets
anything that can be turned into cash after a year, always at the top of financial statement, wall street pays attention to this
Long term assets
asset that will take longer than a year to liquidate it into cash, like land
Debts that a firm owes to others
Not all debt is bad to a company
-Interest you pay on a debt is a write off
Owners’ Equity
Equals assets minus liabilities and reflects historical values
Double-Entry Bookkeeping
A system of recording and classifying business transactions that maintains the balance of the accounting equation
To keep the accounting equation in balance, each transaction must be recorded in two separate accounts
All business transactions are classified as either assets, liabilities, or owner’s equity
Break Down
Most organizations further break down these accounts, such as assets may be broken down into cash, inventory and equipment
Accounting Cycle
The four-step procedure of an accounting system:
1)examining source documents, 2)recording transactions in an accounting journal,
3) posting recorded transactions
4) preparing financial statements
A time-ordered list of account transactions
A book or computer file with separate sections for each account
Income Statement
A financial report that shows an organization’s profitability over a period of time – month, quarter, or year
-Indicates a firm’s profitability or income (the bottom line), derived by subtracting expenses from revenues
-Other names include profit and loss (P&L) statement or operating statement
The total amount of money received from the sale of goods or services, as well as from related business activities
-Total dollar amount of products sold; includes rental-lease income and interest income
-Nonbusiness entities obtain revenues through donations and grants
Cost of Goods Sold
The amount of money a firm spent to buy or produce the products it sold during the period to which the income statement applies
-The cost of producing the goods and services, including labor, raw materials and other expenses associated with production
Cost of Goods Equation
Cost of Goods Sold = Beginning Inventory + Interim Purchases – Ending Inventory
Gross Income (or Profit)
Revenues minus the cost of goods sold required to generate the revenues
Always referred to as a percentage
-The costs incurred in the day-to-day operations of an organization
Common expense accounts
1) Selling, general, and administrative expenses (includes depreciation)
2) Research, development and engineering expenses
3) Interest expenses
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
The total profit (or loss) after all expenses, including taxes, have been deducted from revenue; also called net earnings
-Most companies present the current year’s results along with the previous two years’ income statements
-The portion of net income the business does not keep is what it pays out as dividends to shareholders
Shares outstanding
can be classified as either primary (primary EPS) or fully diluted (diluted EPS).
net income divided by the number of shares outstanding
Primary EPS
is calculated using the number of shares that have been issued and held by investors. These are the shares that are currently in the market and can be traded.
Diluted EPS
entails a complex calculation that determines how many shares would be outstanding if all exercisable warrants, options, etc. were converted into shares at a point in time, generally the end of a quarter.
Why we prefer diluted EPS
it is a more conservative number that calculates EPS as if all possible shares were issued and outstanding. The number of diluted shares can change as share prices fluctuate (as options fall into/out of the money), but generally the Street assumes the number is fixed as stated
Companies report both primary and diluted EPS
and the focus is generally on diluted EPS, but investors should not assume this is always the case. Sometimes, diluted and primary EPS are the same because the company does not have any “in-the-money” options, warrants or convertible bonds outstanding. Companies can discuss either, so investors need to be sure which is being used
Balance Sheet
A “snapshot” of an organization’s financial position at a given moment
-Shows assets and the funding used to pay for these assets, such as bank debt or owners’ equity
-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 since the company’s founding
how fast they can be turned into cash
Current Assets
Assets used or converted into cash within the course of a calendar year
Cash, temporary investments, accounts receivable and inventory
Accounts Receivable
Money owed a company by its clients or customers who have promised to pay for the products at a later date
Current Liabilities
A firm’s financial obligation to short-term creditors, which must be repaid within one year
Accounts Payable
The amount a company owes to suppliers for goods and services purchased with credit
Accrued Expenses
An account representing all unpaid financial obligations incurred by the organization
Owners’ Equity
-Owners’ equity includes the owners’ contributions along with income retained to finance growth and development

-Owners’ equity differs dramatically from company to company as some corporations sell stock to investors, who then become the owners

-Some companies have several kinds of stock, each with a different claim on the organization

-Each type of stock is represented by a separate owners’ equity account, called contributed capital

Statement of Cash Flows
Explains how the company’s cash changed from the beginning of the accounting period to the end
-flows takes the cash balance from one year’s balance sheet and compares it with the next while providing detail about how the firm used the cash
Cash From Operating Activities
Calculated by combining the changes in the revenue, expense, current assets and current liability accounts
Cash From Investing Activities
Calculated from changes in the long-term or fixed asset accounts
Cash From Financing Activities
Calculated from changes in the long-term liability accounts and the contributed capital accounts in owners’ equity
The excess of the purchase price over the fair market value of an asset. Accountants record this as a ‘write off’ in the financial report.
-The market sets the price of what a business is worth. In mergers and acquisitions, goodwill arises when more was paid for the business than you’d expect from just looking at the value of its assets and liabilities. This difference can have a number of reasons, including a happy workforce, customer loyalty, a good location, and so on.
Ratio Analysis
Calculations that measure an organization’s financial health
-Brings the complex information from the income statement and balance sheet into sharper focus
-A ratio is simply a number divided by another resulting in a number showing a relationship between the two
-Whether these numbers are good or bad depends on their relation to other numbers, such as ratios of prior performance or the performance of “peers”
Profitability Ratios
-Ratios measuring the amount of operating income or net income an organization is able to generate relative to its assets, owners’ equity, and sales
-Common profitability ratios include profit margin, return on assets and return on equity
Profit Margin
Net income divided by sales
Return on Assets
Net income divided by assets
Return on Equity
Net income divided by owners’ equity; also called return on investment (ROI)
Asset Utilization Ratios
Ratios that measure how well a firm uses its assets to generate each $1 of sales
-Managers use asset utilization ratios to pinpoint areas of inefficiency in their operations
-These ratios – receivables turnover, inventory turnover, and total asset turnover – relate balance sheet assets to sales, which are found on the income statement
Receivables Turnover
Sales divided by accounts receivable
Inventory Turnover
Sales divided by total inventory
Total Asset Turnover
Sales divided by total assets
Liquidity Ratios
Ratios that measure the speed with which a company can turn its assets into cash to meet short-term debt
-High liquidity ratios may satisfy a creditor’s need for safety, but may indicate the company is not using its current assets efficiently
-Liquidity ratios are best examined in conjunction with asset utilization ratios because high turnover ratios imply cash is flowing through very quickly
Current Ratio
Current assets divided by current liabilities
Quick Ratio (Acid Test)
A stringent measure of liquidity that eliminates inventory
Debt Utilization Ratios
Ratios that measure how much debt an organization is using relative to other sources of capital, such as owners’ equity
-Debt financing is riskier than equity as it demands a monthly payment regardless of profitability
-Recessions affect heavily indebted firms far more than those financed through equity
-Most companies tend to keep debt-to-asset levels below 50 percent
Debt to Total Assets Ratio
A ratio indicating how much of the firm is financed by debt and how much by owners’ equity
Times Interest Earned Ratio
Operating income divided by interest expense
Per Share Data
Data used by investors to compare the performance of one company with another on a equal, per share basis
Earnings Per Share
Net income or profit divided by the number of stock shares outstanding
Dividends Per Share
The actual cash received for each share owned

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