Chapter 17 – Understanding Accounting and Financial Information
17-31
tion, and superior products.
d. Intangibles⎯such as brand names, trade-
marks, and copyrights⎯can be among the
firm’s most valuable assets.
2. LIQUIDITY refers to how fast an asset can be
converted into cash.
a. Speedier conversion means higher liquidity.
b. An ACCOUNT RECEIVABLE is the amount
of money owed to the firm that it expects to
receive within one year—it is considered a
LIQUID ASSET.
c. LAND is considered a FIXED or LONG-
TERM ASSET, because it takes time, effort,
and paperwork to sell.
3. ASSETS ARE CHARACTERIZED BASED ON
LIQUIDITY.
a. CURRENT ASSETS are items that can or
will be converted to cash within one year
(examples: cash, accounts receivable, and
inventory).
b. FIXED ASSETS are assets that are relative-
ly permanent, such as land, buildings, and
equipment.
c. INTANGIBLE ASSETS are long-term assets
(e.g., patents, trademarks, copyrights) that
have no real physical form but do have val-
ue.
Chapter 17 – Understanding Accounting and Financial Information
17-32
PPT 17-29
Classifying Assets
CLASSIFYING ASSETS
17-29
LO 17-4
• Current Assets — Items that can or will be
converted to cash within one year.
• Fixed Assets — Long-term assets that are relatively
permanent such as land, buildings, or equipment.
• Intangible Assets — Long-term assets that have no
physical form but do have value such as patents,
trademarks, and goodwill.
Chapter 17 – Understanding Accounting and Financial Information
17-33
E. LIABILITIES AND OWNERS’ EQUITY ACCOUNTS
1. LIABILITIES are what the business owes to
others (DEBTS).
a. CURRENT LIABILITIES are debts due in
one year or less.
b. LONG-TERM LIABILITIES are debts not
due for one year or longer.
c. Common liabilities:
i. ACCOUNTS PAYABLE are current lia-
bilities or bills the company owes to oth-
ers for merchandise or services pur-
chased on credit but not yet paid for.
ii. NOTES PAYABLE are short-term or
long-term liabilities that a business prom-
ises to repay by a certain date.
iii. BONDS PAYABLE are long-term liabili-
ties that represent money lent to the firm
that must be paid back.
2. EQUITY is the value of things you OWN (assets)
minus the amount of money you OWE others (li-
abilities).
a. The value of what stockholders own in a firm
(minus liabilities) is called STOCKHOLD-
ERS’ (or SHAREHOLDERS’) EQUITY.
b. OWNERS’ EQUITY is the amount of the
business that belongs to the owners minus
Chapter 17 – Understanding Accounting and Financial Information
17-34
PPT 17-30
Classifying Liabilities
CLASSIFYING LIABILITIES
17-30
LO 17-4
• Liabilities — What the business owes to others – its
debts.
• Accounts Payable — Current liabilities a firm owes
for merchandise or services purchased on credit.
• Notes Payable — Short or long-term liabilities a
business promises to pay by a certain date.
• Bonds Payable — Long-term liabilities that the firm
must pay back.
Chapter 17 – Understanding Accounting and Financial Information
17-35
any liabilities owned by the business.
c. The formula for OWNERS’ EQUITY:
Owners’ equity = Assets − Liabilities
d. Businesses that are not incorporated identify
this as a CAPITAL ACCOUNT.
e. For corporations, the OWNERS’ EQUITY ac-
count records the owners’ claims to funds
they have invested in the firm plus retained
earnings.
f. RETAINED EARNINGS are the accumulat-
ed earnings from a firm’s profitable opera-
tions that were reinvested in the business
and not paid out to stockholders in divi-
dends.
F. THE INCOME STATEMENT
1. The INCOME STATEMENT is 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 (reve-
nue), all the resources that have left the firm,
and the resulting net income.
2. NET INCOME OR NET LOSS is revenue left
over after all costs and expenses, including tax-
es, are paid.
3. The income statement reports the results of op-
erations over a particular period of time.
4. This statement includes valuable financial infor-
mation for stockholders, lenders, investors, and
employees.
Chapter 17 – Understanding Accounting and Financial Information
17-36
PPT 17-31
Owners’ Equity Accounts
OWNERS’ EQUITY ACCOUNTS
17-31
LO 17-4
• Owners’ Equity — The
amount of the business that
belongs to the owners minus
any liabilities of the owners.
• Retained Earnings —
Accumulated earnings from the
firm
’
s profitable operations that
are reinvested in the business.
TEXT FIGURE 17.6
You, Incorporated
This text figure helps students develop a personal balance
sheet.
test
prep
PPT 17-32
Test Prep
TEST PREP
17-32
• What do we call the formula for the balance
sheet? What three accounts does it include?
• What does it mean to list assets according to
liquidity?
• What is the difference between long-term and
short-term liabilities on the balance sheet?
• What is owners’ equity and how is it determined?
PPT 17-33
The Income Statement
The INCOME STATEMENT
17-33
LO 17-4
• Income Statement — The
financial statement that
shows a firm
’
s bottom line –
that is, its profit after costs,
expenses, and taxes.
• Net Income/Net Loss —
The revenue left over after
costs and expenses.
TEXT FIGURE 17.7
Sample Very Vegetarian Income
Statement
This text figure shows the calculations involved in creating
Very Vegetarian’s income statement.
Chapter 17 – Understanding Accounting and Financial Information
17-37
5. The income statement is arranged according to
GENERALLY ACCEPTED ACCOUNTING
PRINCIPLES (GAAP):
Revenue
– Cost of goods sold
= Gross profit (gross margin)
– Operating expenses
= Net income before taxes
– Taxes
= Net income or loss
G. REVENUE is the value of what is received for goods
sold, services rendered, and other financial sources.
1. There is a difference between revenue and
sales.
2. Most revenue comes from SALES, but other
sources of revenue include rents earned, inter-
est earned, and so forth.
3. GROSS SALES are the total of all sales the firm
completed.
4. NET SALES are gross sales minus returns, dis-
counts, and allowances.
H. COST OF GOODS SOLD
1. COST OF GOODS SOLD (or COST OF
GOODS MANUFACTURED) is a measure of
the cost of merchandise sold or cost of raw ma-
terials and supplies used for producing items for
resale.
a. The cost of goods sold includes the pur-
Chapter 17 – Understanding Accounting and Financial Information
17-38
PPT 17-34
The Income Statement
The INCOME STATEMENT
17-34
LO 17-4
• The formula for the income statement:
Revenue
– Cost of Goods Sold
= Gross Profit
– Operating Expenses
= Net Income before Taxes
– Taxes
= Net Income or Net Loss
PPT 17-35
Accounts of the Income Statement
ACCOUNTS of the INCOME
STATEMENT
17-35
LO 17-4
• Revenue is the monetary value a firm received for
goods sold, services rendered or other payments.
• Cost of Goods Sold (or Manufactured) —
Measures the cost of merchandise the firm sells or the
cost of raw materials and supplies it used in producing
items for resale.
• Gross Profit (or Gross Margin) — How much a
firm earned by buying (or making) and selling
merchandise.
Chapter 17 – Understanding Accounting and Financial Information
17-39
chase price plus any costs associated with
obtaining and storing the goods.
b. Valuing a firm’s INVENTORY is complicat-
ed—it doesn’t matter when an item was
placed in inventory; what matters is how an
accountant records the cost of the item
when it was sold.
2. GROSS PROFIT (GROSS MARGIN) is how
much a firm earned by buying (or making) and
selling merchandise.
3. A service firm may have no cost of goods sold—
gross profit would equal net revenue.
4. The gross profit doesn’t tell you everything—you
must SUBTRACT EXPENSES to determine net
profit or loss.
I. OPERATING EXPENSES
1. OPERATING EXPENSES are costs involved in
operating a business, such as rent, utilities, and
salaries.
2. DEPRECIATION is the systemic write-off of the
cost of a tangible asset over its estimated useful
life.
a. Assets such as equipment and machinery
are considered depreciable subject to ac-
counting rules.
b. Companies are permitted to recapture the
cost of assets using DEPRECIATION as a
business operation expense.
Chapter 17 – Understanding Accounting and Financial Information
17-40
SPOTLIGHT ON
small
business
PPT 17-36
The In’s and Out’s of Valuing In-
ventory
THE IN’S and OUTS of
VALUING INVENTORY
17-36
• Generally Accepted Accounting
Principles (GAAP) sometimes
permits accountants to use different
method of accounting for inventory.
• FIFO: First-In, First-Out
• LIFO: Last-In, First-Out
• Each valuation can affect income
and ending inventory valuation.
PPT 17-37
Accounts of the Income Statement
ACCOUNTS of the INCOME
STATEMENT
17-37
LO 17-4
• Operating Expenses – Cost
involved in operating a business,
such as rent, salaries and
supplies.
• Depreciation — The systematic
write-off of the cost of a tangible
asset over its estimated useful
life.
critical thinking
exercise 17-2
THE PIZZA STAND
A student organization plans to operate a pizza stand during
homecoming weekend. This exercise asks students to prepare
a budget and calculate expected profit. (See the complete ex-
ercise on page 17.85 of this manual.)
Chapter 17 – Understanding Accounting and Financial Information
17-41
3. OPERATING EXPENSES can be classified into
two categories:
a. SELLING EXPENSES are expenses related
to the marketing and distribution of the firm’s
goods or services.
b. GENERAL EXPENSES are administrative
expenses of the firm, such as depreciation
and rent.
J. NET PROFIT OR LOSS
1. After all expenses are deducted, the firm’s NET
INCOME BEFORE TAXES is determined.
a. Net income can also be referred to as NET
EARNINGS or NET PROFIT.
b. After allocating for taxes, you get to the bot-
tom line, the NET INCOME (or perhaps NET
LOSS) the firm incurred from revenue minus
sales returns, costs, expenses, and taxes.
2. Businesses need to keep track of how much
money they earn, spend, how much cash they
have on hand, and so on.
3. Users of financial information are very interested
in the FLOW OF CASH into and the flow of cash
out of a business.
K. THE STATEMENT OF CASH FLOWS
1. The STATEMENT OF CASH FLOWS is the fi-
nancial statement that reports cash receipts and
disbursement related to the firm’s three major
activities: operations, investment, and financing.
Chapter 17 – Understanding Accounting and Financial Information
17-42
critical thinking
exercise 17-3
PREPARING FINANCIAL
STATEMENTS
This exercise directs students to use a given list of accounts to
create a balance sheet and income statement. (See the com-
plete exercise on page 17.89 of this manual.)
PPT 17-38
The Statement of Cash Flows
The STATEMENT of CASH FLOWS
17-38
LO 17-4
• Statement of Cash Flows — Reports cash
receipts and cash disbursements related to the three
major activities of a firm:
1. Operations
2. Investments
3. Financing
Chapter 17 – Understanding Accounting and Financial Information
17-43
a. OPERATIONS: Cash transactions associat-
ed with running the business
b. INVESTMENTS: Cash used in or provided
by the firm’s investment activities
c. FINANCING: Cash raised from the issuance
of new debt or equity capital or cash used to
pay business expenses, past debts, or com-
pany dividends
2. Accountants analyze all of the CASH CHANG-
ES that have occurred from operating, investing,
and financing to determine the firm’s net cash
position.
3. Cash flow analysis answers questions such as:
a. How much cash came into the business from
current operations?
b. Was cash used to buy stocks, bonds, or oth-
er investments?
c. Were investments sold that brought in cash?
d. How much money came in from issuing
stock?
4. Managing cash flow can mean the success or
failure of a business.
L. THE NEED FOR CASH FLOW ANALYSIS
1. A business can increase sales and increase
profit and still suffer cash flow problems.
2. CASH FLOW is the difference between cash
coming in and cash going out of a business.
Chapter 17 – Understanding Accounting and Financial Information
17-44
lecture enhancer 17-7
USING THE STATEMENT OF CASH
FLOWS
Companies do not go out of business because they report net
losses—they fail because they run out of cash. (See the com-
plete lecture enhancer on page 17.81 of this manual.)
TEXT FIGURE 17.8
Sample Very Vegetarian Statement
of Cash Flows
This text figure shows a statement of cash flows, again using
the example of Very Vegetarian.
bonus case 17-1
THE BEST-LAID PLANS OFTEN GO
AWRY
This case discusses how offering credit to customers affected
the finances of a pottery import firm. (See the complete case,
discussion questions, and suggested answers beginning on
page 17.100 of this manual.)
Chapter 17 – Understanding Accounting and Financial Information
17-45
3. Poor cash flow is a major problem for business
and is particularly difficult for small business.
a. In order to meet the demands of customers,
a business buys more and more goods on
credit.
b. It is selling its goods and services, but isn’t
getting paid in time to turn around and pay
its own bills.
c. When the firm’s credit limit is reached, the
bank may refuse further loans.
d. Too often, the company goes into BANK-
RUPTCY because there is no cash available
when it is most needed.
4. Accountants can advise the firm whether it
needs cash and, if so, how much.
learning objective 5
Demonstrate the application of ratio analysis in reporting financial information.
V. ANALYZING FINANCIAL PERFORMANCE US-
ING RATIOS
A. Accountants use accurate financial information to
prepare a financial analysis.
1. RATIO ANALYSIS is the assessment of a firm’s
financial condition using calculations and inter-
pretations of financial ratios developed from the
firm’s financial statements.
2. FINANCIAL RATIOS are helpful in analyzing
the actual performance of the company com-