Introduction to Business

Accounting and Finance

Module Learning Outcomes

Recognize sound accounting practices, and use financial statements and

accounting principles to make informed judgements about an organization’s
financial health

16.1: Define accounting, and explain its role as a form of business communication
16.2: Identify key financial statements and their components, and explain the primar
y use of each type of payment
16.3: Calculate the break-even point, where profit will be equal to $0, using informati
on from financial statements
16.4: Use financial statements to calculate basic financial ratios to measure the profit
ability and health of a business
16.5: Discuss the importance of ethical practices in accounting and the implications o
f unethical behavior
Accounting in Business
Learning Outcomes: Accounting in Business

16.1: Define accounting, and explain its role as a form of business

communication
16.1.1: Explain the role of accounting as a form of business communication
16.1.2: Identify the users and uses of financial accounting
16.1.3: Identify the users and uses of managerial accounting
Class Discussion: Why Accounting?
Understanding Accounting in Business

Accounting is the measurement and communication process used to report

on the activities of profit-seeking business organizations. It is the language
of business.

Accounting represents all of

the financial transactions of
a business in a format that
can be interpreted and
understood by both internal
and external stakeholders.
Internal and External Users

Users of accounting information are separated into two groups, internal and
external.

Internal users are the people within a business organization who use
accounting information. For example, the human resource department
needs to have information about how profitable the business is in order to
set salaries and benefits. Likewise, production managers need to know if the
business is doing well enough to afford to replace worn-out machinery or
pay overtime to production workers.

External users are people outside the business entity that use accounting
information. These external users include potential investors, the Internal
Revenue Service, banks and finance companies, as well as local taxing
authorities.
Uses of Financial Accounting

Financial accounting information appears on financial statements that are

intended primarily for external use. Financial accounting relates to the
company as a whole.

Stockholders and creditors are two outside parties who need financial
accounting information. These two parties make decisions pertaining to the
entire company, such as whether to increase their investment in the
company or to extend credit to the company.
GAAP and Tax Accounting

Financial accountants adhere to set of rules called Generally Accepted

Accounting Principles (GAAP): a uniform set of accounting rules that
allow users to compare the financial statements issued by one company to
those of another company in the same industry.

Tax accounting information includes financial accounting information,

written and presented in the tax code of the government. Tax accounting
focuses on compliance with tax code and presenting the profit and loss story
of a business to minimize its tax liability.
Uses of Managerial Accounting

Managerial accounting information is for internal use and provides special

information for the managers of a company.

The information managers use may range from broad, long-range planning
data to detailed explanations of why actual costs varied from cost estimates.
Managerial accounting is more concerned with forward looking projections
and making decisions that will affect the future of the organization, than in
the historical recording and compliance aspects of the financial accountants.
Bookkeeping vs. Accounting

Accounting is often confused with bookkeeping.

Bookkeeping is a mechanical process that records the routine economic

activities of a business.

Accounting includes bookkeeping, but it goes further to analyze and

interpret financial information, prepare financial statements, conduct audits,
design accounting systems, prepare special business and financial studies,
prepare forecasts and budgets, and provide tax services.
Practice Question 1

Accounting is referred to as the language of business. In reality, accounting

information is communicated in multiple languages, including:
A. Financial, managerial, and tax
B. Financial and GAAP
C. Financial and forensic
D. Business and cost
Practice Question 2

Financial accounting information is used by both internal and external

audiences. Which of the following best describes external users and use?
A. A production manager evaluating whether to build or buy manufacturing
component
B. An IRS employee reviewing a business’s tax return
C. A bank officer considering a business’s loan application
D. A Human Resource team developing the next year’s compensation plan
Practice Question 3

Which of the following best describes users and uses of managerial

accounting information?
A. A bank officer considering a line of credit increase
B. A current stockholder evaluating whether to buy additional shares, sell her shares,
or hold
C. A prospective employee evaluating an offer of employment with a company
D. Department managers developing their budgets and business plans for the next
year
Key Financial Statements
Learning Outcomes: Key Financial Statements

16.2: Identify key financial statements and their components, and

explain the primary use of each type of statement
16.2.1: Define the accounting equation
16.2.2: Identify the use and components of the balance sheet
16.2.3: Identify the use and components of the income statement
16.2.4: Identify the use and components of the statement of owner’s equity
16.2.5: Identify the use and components of the statement of cash flows
16.2.6: Explain how the balance sheet, income statement, statement of
owner’s equity, and statement of cash flows are connected
Understanding Key Financial Statements

Financial statements are the means by which companies communicate

their story. Together these statements represent the profitability and
financial strength of a company.

Key Financial Statements include:

1. Income statement: reflects a company’s profitability
2. Statement of owner's equity: shows the change in retained earnings
between the beginning and end of a period
3. Balance sheet: reflects a company’s solvency and financial position
4. Statement of cash flows: shows the cash inflows and outflows for a company
during a period of time
The Accounting Equation

Three terms used in the accounting equation:

Asset: An asset is an economic resource that can be tangible or intangible.
Assets represent value that can be converted into cash. They can include
cash, vehicles, buildings, equipment, patents, and debts owed to the
company.
Liability: future sacrifices of economic benefits that the entity is obliged to
make to other entities as a result of past transactions or other past events.
Liability can include loans, monies owed to a supplier or creditor that the
business will use assets to settle.
Equity: the difference between the value of the assets and the amount of
the liabilities of something owned. Owner’s equity consists of the net assets
of an entity (net assets = total assets - total liability)

The Accounting Equation: Assets - Liability = Owner’s or

Shareholder’s Equity
Income Statement

• Also called “earnings statement” or “profit and loss statement”

• First financial statement prepared because it provides information for the
remaining 3 statements
• Provides information about the profitability of a stated period of time
• Made up of 3 types of accounts:
1. Revenue: inflows of cash resulting from the sale of products or
the rendering of services to customers
2. Expenses: costs incurred to produce revenues
3. Net Income (Revenues - Expenses = Net Income)
Example of an Income Statement
Metro Courier Inc.
Income Statement
Month Ended January 31, 20XX
Revenue:
Service Revenue $ 60,000
Total Revenues $ 60,000

Expenses:
Salary Expense 900
Utility Expense 1, 200
Total Expenses 2,100

Net Income ($60,000 – 2,100) $ 57,900

Statement of Owner’s Equity

• Explains the changes in retained earnings between two balance sheet

dates
• We start with beginning retained earnings (in our example, the business
began in January, so we start with a zero balance) and add any net
income (or subtract net loss) from the income statement. Next, we
subtract any dividends declared (or any owner withdrawals in a
partnership or sole-proprietor) to get the ending balance in retained
earnings (or capital for non-corporations)
Example: Statement of Retained Earnings
Metro Courier Inc.
Statement of Retained Earnings
Month Ended January 31, 20XX
Beginning Retained
$ 0
Earnings, Jan 1
Net income from month
57,900
(from income statement)
Total increase $ 57,900
Dividends (or withdrawals
– $0
for non-corporations)

Ending Retained
$ 57,900
Earnings, January 31
Balance Sheets

• Provides a snapshot of company’s financial position at a particular

moment in time. That specific moment is the close of business on the
date of the balance sheet.
• Lists a company’s:
1. Assets
2. Liabilities
3. Equity

The Accounting Equation

Assets – Liabilities = Owner’s or Shareholders’ Equity
Example of Balance Sheet
Metro Courier Inc.
Balance Sheet
January 31, 20XX
Assets Liabilities and Equity
Accounts
Cash $ 66,800 200
Payable
Accounts Total
5,000 200
Receivable Liabilities
Supplies 500
Prepaid Common
1,800 30,000
Rent Stock
Retained
Equipment 5,500 57,900
Earnings
Total
Truck 8,500 87,900
Equity
Total Total Liabilities +
$ 88,100 $ 88,100
Assets Equity
Statement of Cash Flow

• Reports the cash receipts and cash disbursements during an accounting

period
• Reports effects on cash of a company’s:
1. Operating activities
2. Investing activities
3. Financing activities
• Includes both cash and cash equivalents (ex. investments)
Operating Activities: Cash Inflows

Cash inflows from operating activities include:

1. Cash from sales of goods or services
2. Interest received from making loans
3. Dividends received from investments in equity securities
4. Cash received from the sale of trading securities
5. Other cash receipts that do not arise from transactions defined as investing or
financing activities
Operating Activities: Cash Outflows

Cash outflows for operating activities include payments to:

1. Acquire inventory
2. Suppliers and employees for other goods or services
3. Lenders and other creditors for interest
4. Purchase trading securities
5. All other cash payments that do not arise from transactions defined as investing
or financing activities
Investing Activities

Cash inflows from investing activities include:

1. Sale of property, plant, and equipment
2. Sale of available-for-sale and held-to-maturity securities
3. Collection of long-term loans made to others

Cash outflows for investing activities include:

4. Purchase of property, plant, and equipment
5. Purchase of available-for-sale and held-to-maturity securities
6. Long-term loans to others
Financing Activities

Cash inflows from financing activities include:

• Cash received from issuing capital stock and bonds, mortgages, and notes, and
from other short- or long-term borrowing

Cash outflows for financing activities include:

• Payments of cash dividends or other distributions to owners (including cash paid to
purchase treasury stock) and repayments of amounts borrowed
The Break-Even Point
Learning Outcomes: The Break-Even Point

16.3: Calculate the break-even point, where profit will be equal to

$0, using information from financial statements
16.3.1: Define the break-even point
16.3.2: Differentiate between fixed and variable costs
16.3.3: Calculate the break-even point
16.3.4: Calculate the contribution margin
16.3.5: Calculate the contribution margin ratio
16.3.6: Calculate the margin of safety
The Break Even Point
Businesses, both large
and small, are concerned
with determining the point
at which their revenues
exceed their expenses
and they begin to make a
profit.
The point at which
revenue equals expenses
(and profit is therefore $0)
is called the break-even
point.
Difference Between Fixed and Variable Costs

Fixed costs are expenses that are not dependent on the amount of goods
or services produced by the business.
• Examples: salaries or rents paid per month

Variable Costs are volume related and are paid per quantity or unit
produced.
• Examples: gas or tires for a car
Calculate the Contribution Margin

Contribution margin is the portion of revenue that is not consumed by

variable cost.

It is important to know the contribution margin in order to calculate what

portion of the revenue from a product is consumed by the variable costs
and what portion can be used to cover, or contribute to, fixed costs.

Inputs Cost Category

Lemons, sweetener, ice, and water 20 cents per glass Variable

Glasses 5 cents each Variable

Labor $100 per day per employee Fixed

Lemonade stand rental $2,000 per month Fixed

Break-Even in Units

Example: Video Productions produces videotapes selling for USD 20 per unit.
Fixed costs per period total USD 40,000, while variable costs is USD 12
per unit.

We find the break-even point in units by dividing the total fixed costs by the
contribution margin per unit. The contribution margin per unit is USD 8 (USD
20 selling price per unit - USD 12 variable cost per unit).
Break-Even in Sales Dollars

Companies frequently measure volume in terms of sales dollars instead of

units.

The formula to compute the break-even point in sales dollars looks a lot like
the formula to compute the break-even point in units, except we divide the
fixed cost by the contribution margin ratio instead of the contribution margin
per unit.

The contribution margin ratio expresses the contribution margin as a

percentage of sale:
Calculate the Contribution Margin Ratio

The Contribution Margin Ratio expresses the contribution margin as a

percentage of sales. To calculate this ratio, divide the contribution margin
per unit by the selling price per unit, or total contribution margin by total
revenues.

Example: Video Production’s contribution margin ratio would be USD 8

(contribution margin per unit) divided by USD 20 (the selling price per unit)
which would equal .40.
Margin of Safety

If a company’s current sales are more than its break-even point, it has a
margin of safety equal to current sales minus break-even sales.

The margin of safety is the amount by which sales can decrease before
the company incurs a loss.

Margin of safety = Current Sales - Break-even sales

Example: Margin of safety = USD 120,000 - USD 100,000 when Video

Productions has sales of USD 120,000 and its break-even sales are USE
100,000
Margin of Safety Rate

Sometimes people express the margin of safety as a percentage, called the

margin of safety rate.

When Video Productions has sales of USD 120,000 and its break-even sales
are USE 100,000, the margin of safety rate would be 16.67 percent. This
means that Sales volume could drop by 16.67 percent before the company
would incur a loss.
Financial Ratios
Learning Outcomes: Financial Ratios

16.4: Use financial statements to calculate basic financial ratios to

measure the profitability and health of a business
16.4.1: Explain how financial ratios are used
16.4.2: Calculate the current ratio using information from financial
statements
16.4.3: Calculate the acid-test (quick) ratio using information from financial
statements
16.4.4: Calculate inventory turnover using information form financial
statements
Financial Ratio Analysis

• Financial ratios allow us to look at profitability, use of assets,

inventories, and other assets, liabilities, and costs associated with the
finances of the business.
• Used to measure a firm’s financial health in four areas:
1. Liquidity
2. Long-term solvency
3. Profitability tests
4. The market

• These ratios can be used to compare the company’s performance across

periods (months, quarters, years) or to similar companies within the same
industry.
Financial Ratios Chart
Ratio Use Components
current (or working capital)
ratio; acid-test (quick) ratio; cash
indicate a company’s
flow liquidity ratio; accounts receivable
Liquidity ratio short-term debt-
turnover; number of day’s sales in
paying ability
accounts receivable; inventory
turnover; and total assets turnover
show the relationship
Equity (long-
between debt and equity (or stockholders’ equity) ratio; and
term solvency)
equity financing in a stockholders’ equity to debt ratio
ratio
company
rate of return on operating assets; net
income to net sales; net income to
an important
average common stockholders’ equity;
measure of a
Profitability test cash flow margin; earnings per share of
company’s operating
common stock; times interest earned
success
ratio; and times preferred dividends
earned ratio
help investors and
earnings yield on common stock; price-
potential investors
earnings ratio; dividend yield on common
assess the relative
Market test stock; payout ratio on common stock;
merits of the various
dividend yield on preferred stock; and
stocks in the
cash flow per share of common stock
marketplace
Calculate the Current Ratio

Working capital is the excess of current assets over current liabilities.

The ratio that relates current assets to current liabilities is the current (or
working capital) ratio. The current ratio indicates the ability of a company
to pay its current liabilities from current assets, and thus show the strength
of the company’s working capital position.

The current ratio is usually expressed in current assets to one dollar of

current liabilities.

Example: 1.25:1 means that the company has $1.25 for every $1 of
liabilities
Calculate the Acid-Test Ratio

The acid-test (quick) ratio is the ratio of quick assets (cash, marketable
securities, and net receivables) to current liabilities.

Short-term creditors are particularly interested in this ratio which relates to

the pool of cash and immediate cash inflows to immediate cash outflows.

In deciding whether the acid-test ratio is satisfactory, investors consider the

quality of marketable securities and receivables.
Calculate Inventory Turnover
A company’s inventory turnover ratio shows the number of times its
average inventory is sold during a period.

Other things being held equal, a manager who maintains the highest
inventory turnover ratio is the most efficient.

Other things are not always equal, for example, a company that achieves a
high inventory turnover ratio by keeping extremely small inventories on
hand may incur larger ordering costs, lost quantity discounts, and lose sales
due to lack of adequate inventory.
Summary of Liquidity Ratios
Liquidity
Formula Significance
Ratios

Current (or working Current assets / Current Test of debt-paying

capital) ratio liabilities ability

Quick assets (cash +

Acid-test (quick) marketable securities + Test of immediate
ratio net receivables) / debt-paying ability
Current liabilities

Test of whether or not

a sufficient volume of
Cost of goods sold /
Inventory turnover business is being
Average inventory
generated relative to
inventory
Interpretation and Use of Ratios

Standing alone, a single financial ratio may not be informative. Investors

gain a greater insight by computing and analyzing several related ratios for
a company.

Analysts must be sure their comparisons are valid, especially if those

comparisons are from different time periods.

Analysts must consider many items including:

• Business conditions
• Important events that may have a large impact on a ratio
• The seasonal nature of some businesses
Quick Reference Financial Ratio Calculations
Practice Question 5

Financial ratios allow a business, potential creditor, or investor to:

A. conduct a manager’s performance review
B. compare the performance of unrelated business
C. determine the health of a company individually and relate to
similar businesses or alternative investment options
D. evaluate market conditions
Practice Question 6

The current ratio is a liquidity ratio that serves as an indicator of a company’s

short-term debt-paying ability. Let’s assume your belt company’s month-end
balance sheet lists $2,000 in current assets, $5,000 in total assets, $500 in
current liabilities and $1,000 in total liabilities. What is your current ratio?
A. 4
B. 5
C. 4:1
D. $5:$1
Practice Question 7

The acid-test is another liquidity ratio that is of particular interest to those who
are considering a business’ request for a short-term loan or credit. Let’s say
your $2,000 current asset balance includes $200 in cash, $500 in accounts
receivable (net), $300 in a money market account, $700 in supplies and $300 in
prepaid insurance. Your current liabilities are $500. What is your current ratio?
A. 2:1
B. 3.4:1
C. 4:1
D. 2
Practice Question 8

A company’s inventory turnover ratio shows the number of times its average
inventory is sold during a period, where a higher inventory turnover is generally
considered to be better. Pulling a COGS of $5,000 from the income statement
and calculating average inventory of $300 based on January 1 and December 31
balance sheet data, what is the inventory turnover?
A. 6%
B. 6
C. 16.67
D. 17%
Class Discussion: Accounting and Life

Now we’ve learned and practiced some basic accounting principles and
calculations: the accounting equation, balance sheet, income statement.
owner’s equity, cash flows, break even, contribution margin, margin of
safety, and financial ratios.

Discuss as a large group how accounting practices could help you in your
personal life even if you are not a CPA.
Ethical Practices in Accounting
Learning Outcomes: Ethical Practices in
Accounting
16.5: Discuss the importance of ethical practices in accounting
and the implications of unethical behavior
16.5.1: Discuss the consequences of unethical practices in the accounting
profession
16.5.2: Discuss the impact of the Sarbanes-Oxley Act on accounting
practices
Consequences of Unethical Behavior in
Accounting
Unethical financial reporting has cost taxpayers billions of dollars,
employees their jobs, and the accounting profession its untarnished
reputation.

The American Institute of Public Accountants (AIPA) has its own Code of
Professional Conduct that prescribes the ethical conduct members
should strive to achieve which include the following guidance:
● Recognize and consider all relevant facts and circumstances, including applicable
rules, laws or regulations,
● Consider the ethical issues involved,
● Consider established internal procedures, and then
● Formulate alternative courses of action.
● After weighing the consequences of each course of action, you select the best
course of action based on your own judgment.
Sarbanes-Oxley (SOX)
In 2002 the Sarbanes-Oxley Act (SOX) went into effect. This law is one of
the most extensive pieces of business legislation passed by Congress.
• Attempts to foster ethical behavior in business accounting
• Top management must individually certify the accuracy of financial
information
• Increased severity of penalties for fraudulent financial activity and
altering or destroying key audit documents
• Increased the oversight role of boards of directors and the independence
of outside auditors
• Has improved investor confidence and made financial statements more
accurate and reliable
• Restricts the scope of non-auditing work and auditor may perform for a
client
Quick Review

• What is accounting? What is its role as a form of business

communication?
• What are key financial statements and their components, and what is the
primary use of each type of statement?
• How do you calculate the break-even point, where profit will be equal to
$0, using information from financial statements?
• How do you use financial statements to calculate basic financial ratios to
measure the profitability and health of a business?
• Why are ethical practices in accounting important? What are the
implications of unethical behavior?