Business Foundations 3e

Hughes, Pride, &

Kapoor
 Using Accounting Information

Chapter

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 2
 Learning Objectives

1. Explain why accurate accounting information and

audited financial statements are important.
2. Identify the people who use accounting information
and possible careers in the accounting industry.
3. Discuss the accounting process.
4. Read and interpret a balance sheet.
5. Read and interpret an income statement.
6. Describe business activities that affect a firm’s
cash flow.

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 3
 Why Accounting Information
Is Important

 Accounting is the process of systematically

collecting, analyzing and reporting financial
information.
• How much profit did business earn last year
• How much tax does a business owe to SARS
• How much cash does a business have to pay its
lenders and suppliers.
 Recent accounting scandals
• Pressure on corporate executives to look good to
analysts and investors

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 4
 Why Audited Financial Statements are important

 Why audited financial statements

are important
• Bankers, creditors, investors, and government agencies rely on
an auditor’s opinion of the validity of a firm’s financial statements.
 What is an audit?
• An examination of a company’s financial statements and
accounting practices
• Generally accepted accounting principles (GAAPs)—an accepted
set of guidelines and practices for U.S. companies reporting
financial information and the accounting profession
• The FASB is developing a new set of standards combining those
of GAAP and the International Financial Reporting Standards.
• In South Africa, ASB(Accounting Standards Board) set standards
for GRAP(General Recognised Accounting Practice).

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 5
 Who Uses Accounting Information

 Managers are the primary users

• Proprietary: information that is not divulged to
anyone outside the firm
 Lenders, suppliers, stockholders, potential
investors, and government agencies are
other users

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 6
 Users of Accounting Information

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 7
 Different Types of Accounting

 Managerial accounting provides managers and

employees within the organization with information
needed to make decisions about a firm’s financing,
investing, marketing, and operating activities.
 Financial accounting generates financial
statements and reports for interested people
outside an organization.

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 8
 The Accounting Process

 The accounting equation:

assets = liabilities + owners’ equity
• Assets—the resources that a business owns
(e.g., cash, inventory, equipment, and real estate)
• Liabilities—the firm’s debts
• Owners’ equity—the difference between assets and
liabilities (what would be left for the owners if the firm’s
assets were sold and the money used to pay off its
liabilities)

Double-entry bookkeeping system: each financial transaction is

recorded as two separate accounting entries to maintain the balance
of the accounting equation

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 9
 The Accounting Process (cont.)

 The accounting cycle

• Done on a regular basis
– Analyze source documents
– Record transactions as they occur in the general
journal
– Post transactions to accounts in the general ledger

 Done at the end of the period

• Prepare the trial balance of all general ledger
accounts
• Prepare financial statements and close the books

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 10
 The Balance Sheet

 A summary of the amounts of a firm’s assets,

liabilities, and owners’ equity accounts
at the end of a specific accounting period.
 May be referred to as “Statement of Financial
Position”
 The balance sheet is a snapshot of the assets and
liabilities of a business.
 It shows the value of the resources within the
business, and how they were financed
 A balance sheet must “balance” since the
resources that have been obtained must have
been financed in some way

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 11
  Assets
• Listed in order of liquidity (ease with which an asset can be
converted into cash)
• Current assets—can quickly be converted into cash or that will
be used in one year or less
– Cash, accounts receivable, notes receivable, merchandise
inventory, and prepaid expenses
 Fixed assets—will be held or used for a period longer than one year
– Land, buildings, and equipment
– Depreciation—the process of apportioning the cost of a fixed asset
over the period during which it will be used

• Intangible assets—do not exist physically but have a value

based on the rights or privileges they confer on the firm
– Patents, copyrights, trademarks, and goodwill

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 12
 The Balance Sheet (cont.)

 Liabilities
• Current liabilities—debts to be repaid in one year
or less
– Accounts payable—short-term obligations that arise as a
result of making credit purchases
– Notes payable—obligations that have been secured with
promissory notes

• Long-term liabilities—debts that need not be repaid

for at least one year
– Mortgages, bonds, and long-term loans

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 13
 The Balance Sheet (cont.)

 Owners’ or shareholders equity

• For sole proprietorships—
Assets – liabilities = owners’ equity
• For partnerships—each partner’s share of ownership
is reported separately in each owner’s name
• For corporations—stockholders’ equity
• Retained earnings—profits not distributed to
stockholders

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 14
 Personal Balance Sheet

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 15
 An Example of a Balance Sheet

Fixed assets that the

business has
Items that the business obtained for long-term
has, but does not use, e.g. premises
intend to keep longer
than 12 months. E.g.
stock

The total value of things the business owns

Debts that the business intends to pay within the next

12 months

Long-term borrowing, e.g.

a bank loan The total value
of what a
business owes

The difference between total

assets and total liabilities The funds contributed
into the business by
the owners

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 16
 The Income Statement

 A summary of a firm’s revenues and expenses

during a specified accounting period
• Profit (cash surplus)
• Loss (cash deficit)
 Revenues
• The amounts earned by a firm from selling goods,
providing services, or performing business activities
• Gross sales—the total dollar amount of all goods and
services sold during the accounting period
• Net sales—the actual dollar amounts received by a firm
for the goods and services it has sold, after adjustment
for returns, allowances, discounts

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 17
 The Income Statement (cont.)

 Cost of goods sold

• The dollar amount equal to beginning inventory
plus net purchases less ending inventory

Cost of = Beginning + Net – Ending

goods sold inventory purchases inventory

Gross profit = a firm’s net sales less the cost of goods sold

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 18
 The Income Statement (cont.)

 Operating expenses
• All business costs other than the cost of goods sold
– Selling expenses—costs related to marketing activities
– General expenses—costs of managing the business
 Net income
• Revenues less expenses, when the difference
is positive
 Net loss
• Revenues less expenses, when the difference
is negative

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 19
 Personal Income Statement

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 20
 An Example of Income Statement

Money received
Money spent providing from selling
the goods and services goods and
sold (direct costs) services

Profit or loss made before

indirect costs are taken off

The indirect costs, or expenses that the

business has had to pay

The profit or loss from

trading
Costs or revenue from
financial dealings

Profit or loss made

before tax is taken off The corporation tax
the business must pay Profit or loss available to the business after tax

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 21
 Example

 Jack Sparrow owner of a small business called Gaming Computing buys and sells
computer and video games via online(his e-business) and well from his office. In the
month of May, Jack sold 50 games @ R 650 a game. 30 of these games were sold online
where his customers paid with their credit cards. In addition, the balance were sold at his
office. Jack operates mainly on a cash basis but allows 10 of his good customer a 30 day
credit term.
 He buys most of his games from his suppliers (ie from Microsoft and PC Games). He
purchase these games on demand as his suppliers are at close proximity to where he is
based. He, however, needs to purchase these games from Microsoft on a cash bases
only. PC games allows Jack 30 credit terms. In May, he purchased 30 games from
Microsoft @ R 300 each and 20 Games from PC games at @ R 350 each.
 Jack’s monthly expenses are as follows:
Rental- R 1200 ; Insurance R 2500 ; Web design- R 800
staff salaries – R 6000; Marketing – R 2500; Stationary - R1500

 He also recently purchased a new lap top valued at R 10 000. He needs to provide
depreciation to the value of R 350 pm
 Determine Jacks, Profit and loss for the month of May.

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 22
 The Statement of Cash Flows

 Illustrates how the operating, investing, and

financing activities of a company affect cash
during an accounting period
• Cash flows from operating activities
(providing goods and services)
• Cash flows from investing activities
(purchase and sale of land, equipment, and other assets
and investments)
• Cash flows from financing activities
(changes in debt obligation and owners’ equity accounts)

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 23
 An Example of Cash Flow

The net amount of

cash flowing into
or out of a
The net amount of business from its
cash flowing into or out trading activity
of a business from its
investment activity (i.e.
buying or selling fixed
assets)

The net amount of

cash flowing into or out
of a business from its
activity with banks or
shareholders

The total increase

or decrease in Figures in brackets
cash within the show cash outflows
business

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 24
 Evaluating Financial Statements

 Using accounting information to evaluate

a potential investment
• Use common sense to interpret the numbers.
• Financial statements should be audited by an
outside source and be current.
• Look for use of new strategies to reduce costs.
• Determine the firm’s ability to pay its debts and
borrow money in the future.
• Look at how the numbers relate to each other.
• Understand the financial ratios.

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 25
 Evaluating Financial Statements (cont.)

 Using accounting information to evaluate

a potential investment (cont.)
• Read letters from top executives.
• Examine the footnotes closely, look for red flags.
• Examine the comparative data to analyze trends.

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 26
 Comparing Data with Other Firms’ Data

 Comparisons are possible because of GAAP.

 Managers can get a general idea of a firm’s relative
effectiveness and its standing within the industry.
 Data are available from annual reports of public
corporations.
 Industry averages are available from Dun &
Bradstreet, Standard & Poor’s, and industry trade
associations.

© 2013 South-Western, a part of Cengage Learning. All rights reserved. Chapter 7 | Slide 27