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Understanding
Accounting and
Financial Statements
Edited by
Hector Martin

Explain the functions and importance

of accounting, and identify the three
basic activities involving accounting.

Describe the roles played by public,

management, government and not-forprofit accountants.

Identify the foundations of the

accounting system, including GAAP
and the role of the Financial
Accounting Standards Board (FASB).

Outline the steps in the accounting

cycle, and define double-entry
bookkeeping and the accounting
equation.

Explain the functions and major

components of the four principal financial
statements: the balance sheet, the
income statement, the statement of
owners equity, and the statement of
cash flows.

Outline accounting issues facing global

business and the move toward one set
of worldwide accounting rules.

Accounting is the process of measuring, interpreting, and

communicating
support
and it
Who
are somefinancial
of the information
Users andto what
dointernal
they use
external business decision making.
for?

 Open book management - sharing sensitive financial

information with employees and teaching them how to
understand and use financial statements.

Viewing financial information may help them better

understand how their work contributes to the
companys success.
Outsiders use financial data to evaluate investment
opportunities.

 Financing activities provide necessary funds to

start a business and expand it after it begins
operating.
Investing activities provide valuable assets
required to run a business.
Operating activities focus on selling goods and
services, but they also consider expenses as
important elements of sound financial
management.

 Public Accountants
Provide accounting services to
individuals or business firms for a fee

Management Accountants
Provide timely, relevant, accurate, and
concise information that executives
can use to operate their firms

Government and Not-for-Profit

Accountants

 Generally accepted accounting principles (GAAP) encompass the

conventions, rules, and procedures for determining acceptable
accounting practices at a particular time.
Financial Accounting Standards Board (FASB) is primarily
responsible for evaluating, setting, or modifying GAAP in the U.S.
Sarbanes-Oxley Act responded to cases of accounting fraud.
Created the Public Accounting Oversight Board, which sets audit
standards and investigates and sanctions accounting firms that certify the
books of publicly traded firms.
Senior executives must personally certify that the financial information
reported by the company is correct.
Resulted in increase in demand for accountants.

Accounting process - set of activities involved in

converting information about transactions
into financial statements.

 Assets - anything of value owned or leased by a business.

Liability - claim against a firms assets by a creditor.
Owners equity - all claims of the proprietor, partners, or
stockholders against the assets of a firm, equal to the excess of
assets over liabilities.
Basic accounting equation - relationship that states that
assets equal liabilities plus owners equity.

Double-entry bookkeeping - process by which accounting

transactions are entered; each individual transaction always has
an offsetting transaction.

 Simplifies the accounting process by automating data entry and

calculations.
Available products are customized for businesses of different sizes.
Entrepreneurs and small businesses use: QuickBooks, Peachtree,
and BusinessWorks.
Larger firms use larger scale software packages like: Computer
Associates, Oracle, and SAP.

Software that handles accounting information for international

businesses is another option. Offers different country
information/language.
Some systems offer web-based packages for small
medium businesses.

and

 Balance sheet - statement of a firms financial

positionwhat it owns and the claims against its
assetsat a particular point in time.
Photograph of firms assets together with its liabilities
and owners equity

Follows the accounting equation

Provide snapshot of
firms financial
position

Financial Interpolation of the consolidated balance sheet

2001-2002-2003

Assets = Liability +Equity

Net Income (NI) = Sales + Expenses

End RE = Begin RE+ NI- Dividends

Report the results

from operating the
business

Income Statement - financial record of a companys

revenues and expenses, and profits over a period of
time.
Firms financial performance in terms of revenues,
expenses, and profits over a given time period.
Reports profit or loss.
Focus on revenues and costs associated with
revenues.

 Statement of Owners Equity - is designed to show

the components of the change in equity from the end
of one fiscal year to the end of the next.
Begins with the amount of equity shown on the
balance sheet.
Net income is added, and cash dividends paid to
owners are subtracted.
revenue + gains-expenses-losses= income liabilities+
owners equity = asset

 Statement of cash flows - a firms cash receipts and

cash payments that presents information on its
sources and uses of cash.
Accrual accounting - method that records revenue
and expenses when they occur, not necessarily when
cash actually changes hands.

 The Cash Flow Statement is used by firms to

explain changes in their cash balances over a
period of time by identifying all of the sources
and uses of cash.
Source of cash is any activity that brings cash into the
firm. For example, sale of equipment.
Use of cash is any activity that causes cash to leave
the firm. For example, payment of taxes.

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 Why did the cash balance decline by $4.5 million from

2009 to 2010?
1. Accounts receivable increased by $22.5 million
representing an increase in uncollected cash from credit
sales. It represents $22.5m of use of cash to invest in
accounts receivable.
2. Inventory increased by $148.50 million indicating use of
cash to procure inventory.
3. Equipment increased by $175.50 million indicating use of
cash to invest in equipment.

In general,
an increase in an asset account = use of cash
a decrease in an asset account = source of cash

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4.

Accounts Payable, credit extended to the firm, increased by

$4.5million. Thus source of cash increased by $4.5million due to
accounts payable.
5. Long-term debt increased by $51.75 million indicating a source of
cash.
6. Short-term debt decreased by $9 million indicating use of cash to
pay off the debt.
7. Retained earnings increased by $159.75 million representing a
source of cash to the firm from the firms operations.
In general,
An increase in a liability account = source of cash
A decrease in a liability account = use of cash

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Change in cash balance = Sources of cash

Use of Cash = $216 - $220.50 = -$4.50
Sources of Cash

Uses of Cash

Increase in Accounts Payable

= $4.50

Increase in Accounts Receivable

$22.50

Increase in long-term debt

=$51.75

Increase in inventory =
$148.50

Increase in retained earnings =

$159.75

Increase in net plant and

equipment = $40.50
Decrease in short-term notes =
$9

Total Sources of cash =

$216.00

Total Uses of cash = $220.50

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 An analysis of H.J. Boswells operations reveals the

following for 2010:

The firm used more cash than it generated,

resulting in a deficit of $4.5 million
The primary source of cash flow was retained
earnings ($159.75 million) followed by longterm debt ($51.75 million)
The largest use of cash was for acquiring
inventory at $148.5 million.
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Sources of Cash

Decrease in an asset
account
Increase in a liability
account

Uses of Cash

Increase in an asset
account
Decrease in a liability
account

Increase in an owners Decrease in an owners

equity account
equity account

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 The format for a traditional cash flow statement is as follows:

Beginning Cash Balance
Plus: Cash Flow from Operating Activities
Plus: Cash Flow from Investing Activities
Plus: Cash Flow from Financing Activities
Equals: Ending Cash Balance

Operating activities represent the companys core business including sales and
expenses. Basically any activity that affects net income for the period.
Investing activities include the cash flows that arise out of the purchase and sale
of long-term assets such as plant and equipment.
Financing activities represent changes in the firms use of debt and equity such
as issue of new shares, payment of dividends.

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 International Accounting Standards Committee (IASC)

promotes worldwide consistency in financial reporting practices.
In 2001, became the International Accounting Standards
Board (IASB). International Financial Reporting Standards
(IFRS) are the standards.
Exchange Rates - ratio at which a countrys currency can be
exchanged for other currencies.
Consolidated financial statements must reflect gains and losses
due to changes in exchange rates.
Can have significant impact on financial statement.