Chapter 12: The Role ofAccounting in Business
12.1 The Role ofAccounting
Accounting. The process of measuring and summarizing business activities,
interpreting financial information, and communicating the result to
management and other decision makers
◦ Management accounting provides information and analysis to decision
makers inside the organization (such as owners and managers) to help them
operate the business.
◦ Financial accounting provides information not only to internal managers,
but also to people outside the organization (such as investors, creditors,
government agencies, suppliers, employees, and labor unions) to assist them
in assessing a firm’s financial performance.
Who uses financial accounting?
Owners and Managers: They look at financial statements as a report
card to see if the company did or did not make profit this helps them
take corrective decisions.
Investors and Creditors: Since they put on the money they want to
look at statements to see the financial health and performance of the
company to decide about continued investments
GovernmentAgencies: Business have to give financial information
to a number of government agencies such as taxing agencies etc.
-Preparing the organization’s financial statements including the income
statement, the statement of the owner’s equity, the balance sheets the
statement of cash flows (summarize a company’s past performance and
evaluate current financial situation) Financial accountants in U.S companies have to follow the GAAP (generally
accepted accounting principles) set of rules; this is done for accuracy
purposes and to compare one company to another. These are issued by FASB
(financial accounting standards board)
Companies outside the U.S follow other rules called IFRS (International
financial reporting standards)
12.2 Understanding Financial Statements
Income statement : shows revenues, or sales, and expenses
You divide your expenses into two categories:
◦ Cost of goods sold: the total cost of the goods that you’ve sold
◦ Operating expenses: the costs of operating your business except for the
costs of things that you’ve sold
Now you need to do a little subtracting:
1. The positive difference between sales and cost of goods sold is your
gross profit or gross margin.
The positive difference between gross profit and operating expenses is your
net income or profit, which is the proverbial “bottom line.” (If this
difference is negative, you took a loss instead of making a profit.)
To make more money?
◦ Reduce your cost of goods sold (say, package four toys instead of five)
◦ Increase the quantity of units sold
◦ Reduce your operating costs (salaries, advertising, table rental)
Increase the quantity of units sold To consider the possibilities above you have to make new income statements
for each option. Use “what if” technique likes a hypothetical income
statement to see what will work the best.
Break even. Have no profit or loss.
Total sales revenue=Expenses (variable and fixed)
To determine the level of sales at which this will occur, you need to do the
◦ Determine your total fixed costs
◦ Identify your variable costs (vary as the quantity of goods sold changes but
is constant on a per-unit basis)
◦ Determine your contribution margin per unit
Selling price per unit – variable cost per unit
◦ Calculate your breakeven point in units
Fixed costs ÷ contribution margin per unit
THE BALANCE SHEET
Balance sheet tells you what you have (and where it came from) at a
specific point in time.
-Assets: Resources from which it expects to gain some future benefit
-Liabilities: Debts that it owes to outside individual and organizations
-Owner’s Equity: investment in your own business
Most companies prepare financial statements on a twelve-month basis—that
is, for a fiscal year. Logical dates are picked. End date is usually at the end of the peak selling period.
The balance sheet is based on this equation.
Assets = liabilities + owner’s equity
Company’s assents come from▯ loans (liabilities) or investment made my
owners (owner’s equity)
STATEMENT OF OWNERS’S EQUITY
Statement of owner’s equity: reports changes in owner’s equity for the
How Do Financial Statements Relate to OneAnother?
When you prepare your financial statements, you should complete them in a
certain order as they are interrelated:
◦ Income statement
◦ Statement of owner’s equity
◦ Balance Sheet
If the interlinking numbers are carried forward correctly, and if assets and
liabilities are listed correctly, then the balance sheet will balance: Total
assets will equal the total of liabilities plus owner’s equity. 12.3Accrual accounting
Companies using cash-basis accounting recognize revenue as earned only
when cash is received and recognize expenses as incurred only when cash is
Companies using accrual accounting recognize revenues when they’re
earned (regardless of when the cash is received) and expenses when they’re
incurred (regardless of when the cash is paid out).
Cases: timing plays a role in making and receiving payments
Account receivable. When customers buy something and pay later the seller
is owed money.
Account payable. When companies don’t pay cash for materials and other
expenses the buyer has to pay later
Inventory. When companies manufacture or buy goods and hold them in an
inventory before selling them, in this case they don’t report payment for the
goods until they have been sold.
Long term assets/fixed assets: things they plan to use for an extended
period of time ( as a rule, for more than one year.) e.g. vehicle, building,
In such situations firms use accrual accounting-:
Accrual account:An accounting system that records transactions when they
occur, regardless of when cash is received or paid.
Basic Principles ofAccrual Accounting
. Sale is recognized on income statement when it takes place, regardless of
when cash is collected
. Expense is recognized on income statement when it takes place, regardless
of when payment is made .An item manufactured for later sale or bough for resale becomes part of
inventory and appears in the balance sheet until it is actually sold, at this
point it goes under income statement under cost of goods sold
.Along-term asset will appear on the balance sheet; its cost will be spread
over its useful life (number of years that it will be used). The annual cost
allocated will appear on the income statement as depreciation expense.
Beginning Balance Sheet
Classified balance sheet: classifies assets and liabilities into separate
categories, here assets are listed in order of liquidity (how easily they can be
converted into cash)
1. Current assets: assets that you intent to convert into cash within a year
2. Long-term assets: assets that you intent to hold for more than a year
Types of Liabilities
Liabilities are grouped in much the same manner as assets:
◦ Current liabilities—liabilities that you’ll pay off within one year
◦ Long-term liabilities- liabilities that don’t become due for more than one
year (due in 5years)
Merchandiser—a company that makes a profit by selling goods
Merchandising company: you must sell goods at a profit (called gross
profit=sales –cost of goods) that i