Chapter 17

Understanding Accounting and

Financial Information

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 Chapter Contents
The Role of Accounting Information
The Accounting Cycle
Understanding Key Financial Statements
Analyzing Financial Performance Using Ratios
Accounting Disciplines

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 Learning Objectives
LO 17-1 Demonstrate the role that accounting and
financial information play for a business and its
stakeholders.
LO 17-2 List the steps in the accounting cycle, distinguish
between accounting and bookkeeping, and
explain how computers are used in accounting.
LO 17-3 Explain how the major financial statements differ.
LO 17-4 Demonstrate the application of ratio analysis in
reporting financial information.
LO 17-5 Identify the different disciplines within the
accounting profession.

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 The Role of Accounting Information
What Is Accounting?
• Accounting — The recording, classifying, summarizing, and
interpreting of financial events and transactions to provide
management and other interested the information they need to
make good decisions.
• Outside parties—such as employees, owners, creditors, unions,
investors, and the government—make use of a firm’s accounting
information.

LO 17-1
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 Figure 17.1 The Accounting System

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LO 17-1
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 Figure 17.2 Users of Accounting
Information and the Required Reports

Users Type of Report

Government taxing authorities (e.g.,
the Internal Revenue Service)
Government regulatory agencies
People interested in the
organization’s income and financial
position (e.g., owners, creditors,
financial analysts, suppliers)
Managers of the firm
Tax returns
Required reports
Financial statements found in annual
reports (e.g., income statement,
balance sheet, statement of cash
flows)
Financial statements and various
internally distributed financial
reports

LO 17-1
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 The Accounting Cycle
Accounting Cycle — A six-step procedure that results in
the preparation and analysis of the major financial
statements.
Bookkeeper’s Role
• Bookkeeping — The recording of business transactions.
• Bookkeepers divide a firm’s transactions into meaningful
categories and post them into a record book or computer
program called a journal.
• Double-entry bookkeeping — The practice of writing every
business transaction in two places; done so they can check one
list of transactions against the other for accuracy.

LO 17-2
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 Figure 17.3 Steps in the Accounting
Cycle

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LO 17-2
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 The Accounting Cycle
Bookkeeper’s Tools
• Ledger — A specialized accounting book or computer program
in which information from accounting journals is accumulated
into specific categories and posted so that managers can find all
the information about one account in the same place.
• Trial balance — A summary of all the financial data in the
account ledgers that ensures the figures are correct and
balanced.

LO 17-2
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 Understanding Key Financial
Statements
Financial statement — A summary of all the transactions
that have occurred over a particular period.
Key financial statements of business are:
• Balance sheet
• Income statement
• Statement of cash flows

LO 17-3
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 Understanding Key Financial
Statements
The Fundamental Accounting Equation
• Fundamental accounting equation — The basis for the
balance sheet.
• The equation must always be balanced and includes the
formula:
• Assets = Liabilities + Owners Equity

LO 17-3
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 Understanding Key Financial
Statements
The Balance Sheet
• Balance sheet — Financial statement that reports a firm’s
financial condition at a specific time and is composed of three
major accounts: assets, liabilities, and owners’ equity.

LO 17-3
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 Understanding Key Financial
Statements
Classifying Assets
• Assets — Economic resources (things of value) owned by a
firm; items can be tangible or intangible.
• Liquidity — The ease with which an asset can be converted into
cash.

LO 17-3
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 Understanding Key Financial
Statements
Classifying Assets continued
• Three categories:
1. Current assets — Items that can or will be converted into cash
within one year.
2. Fixed assets — Assets that are relatively permanent, such as
land, buildings, and equipment.
3. Intangible assets — Long-term assets (e.g., patents, trademarks,
copyrights) that have no physical form but do have value.

LO 17-3
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 Understanding Key Financial
Statements
Liabilities and Owners’ Equity Accounts
• Liabilities — What the business owes to others (debts).
• Common liability accounts:
1. Accounts payable — Current liabilities involving money owed to
others for merchandise or services purchased on credit but not yet
paid for.
2. Notes payable — Short-term or long-term liabilities that a
business promises to pay by a certain date.
3. Bonds payable — Long-term liabilities that represent money lent
to the firm that must be paid back.

LO 17-3
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 Understanding Key Financial
Statements
Liabilities and Owners’ Equity Accounts continued
• Owners’ equity — The amount of the business that belongs to
the owners minus any liabilities owed by the business.
• Retained earnings — The accumulated earnings from a firm’s
profitable operations that were reinvested in the business and
not paid out to stockholders in dividends.

LO 17-3
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 Understanding Key Financial
Statements
The Income Statement
• Income statement — The financial statement that shows a
firm’s profit after costs, expenses, and taxes; it summarizes all of
the resources that have come into the firm (revenue), all the
resources that have left the firm, expenses, and the resulting net
income or net loss.
• Net income or net loss — Revenue left over after all costs and
expenses, including taxes, are paid.

LO 17-3
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 Understanding Key Financial
Statements
The Income Statement continued
• The formula for the income statement:
Revenue
minus Cost of goods sold
Gross profit (gross margin)
minus Operating expenses
= Net income before taxes
minus Taxes
= Net income or loss

LO 17-3
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 Understanding Key Financial
Statements
Revenue
• Revenue is the monetary value a firm received for goods sold,
services rendered, or other payments.

Cost of Goods Sold

• Cost of goods sold (or manufactured) — A measures of the
cost of merchandise sold or cost of raw materials and supplies
used for producing items for resale.
• Gross profit (or gross margin) — How much a firm earned by
buying (or making) and selling merchandise.

LO 17-3
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 Understanding Key Financial
Statements
Operating Expenses
• Operating expenses — Costs involved in operating a business,
such as rent, utilities, and salaries.
• Depreciation — The systematic write-off of the cost of a
tangible asset over its estimated useful life.

LO 17-3
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 Understanding Key Financial
Statements
The Statement of Cash Flows
• Statement of cash flows — Financial statement that reports
cash receipts and disbursements related to a firm’s three major
activities
• Three major activities of a firm:
1. Operations
2. Investments
3. Financing

LO 17-3
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 Understanding Key Financial
Statements
The Need for Cash Flow Analysis
• Cash flow — The difference between cash coming in and cash
going out of a business.
• Managing cash flow is a key consideration of a business.

LO 17-3
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 Analyzing Financial Performance
Using Ratios
Ratio Analysis — The assessment of a firm’s financial
condition using calculations and interpretations of financial
ratios developed from the firm’s financial statements.
Key ratios include:
• Liquidity ratios
• Leverage (debt) ratios
• Profitability (performance) ratios

LO 17-4
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 Analyzing Financial Performance
Using Ratios
Liquidity Ratios
• Liquidity ratios measure a firm’s ability to turn assets into cash to
pay its short-term debts.
• Key ratios include:
• Current ratio
• Acid-test ratio
• This information is found on the firm’s balance sheet.

LO 17-4
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 Analyzing Financial Performance
Using Ratios
Leverage (Debt) Ratios
• Leverage ratios measure the degree to which a firm relies on
borrowed funds in its operations.
• Key ratios include:
• Debt to owner’s equity ratio
• Important to compare the ratios to those of other firms.

LO 17-4
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 Analyzing Financial Performance
Using Ratios 4 of 5
Profitability (Performance) Ratios
• Profitability ratios measure how effectively a firm’s managers are
using the firm’s various resources to achieve profits.
• Key ratios include:
• Earnings per share (EPS)
• Return on sales
• Return on equity
• Profitability ratios are very closely watched as measurements of
growth and management performance.

LO 17-4
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 Accounting Disciplines
Financial Accounting
• Financial accounting — Accounting information and analyses
prepared for people outside the organization.
• Outside users are interested in these questions:
• Is the organization profitable?
• Is it able to pay its bills?
• How much debt does it owe?
• Annual report — A yearly statement of the financial condition,
progress, and expectations of an organization.

LO 17-5
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 Accounting Disciplines
Financial Accounting continued
• Private accountant — An accountant who works for a single
firm, government agency, or nonprofit organization.
• Public accountant — An accountant who provides accounting
services to individuals or businesses on a fee basis.
• Certified public accountant (CPA) — An accountant who
passes a series of examinations established by the American
Institute of Certified Public Accountants (AICPA).

LO 17-5
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 Accounting Disciplines
Managerial Accounting
• Managerial accounting — Accounting used to provide
information and analyses to managers within the organization to
assist them in decision making.
• Managerial accounting is involved with:
• Costs of production
• Costs of marketing
• Preparation and control of budgets
• Minimizing tax liabilities

LO 17-5
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 Accounting Disciplines
Auditing
• Auditing — The job of reviewing and evaluating the information
used to prepare a company’s financial statements.
• Independent audit — An evaluation and unbiased opinion
about the accuracy of a company’s financial statements.

LO 17-5
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 Accounting Disciplines
Tax Accounting
• Tax accountants — An accountant trained in tax law and
responsible for preparing tax returns or developing tax
strategies.

Government and Not-for-Profit Accounting

• Government and not-for-profit accounting — Accounting
system for organizations whose purpose is not generating a
profit but serving ratepayers, taxpayers, and others according to
a duly approved budget.

LO 17-5
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