Chapter 16

Understanding Accounting and Financial

Statements
ls oa
ng G
r n i 5 Explain the three principal
Lea financial statements.
Explain the functions and
1 6 Discuss how financial ratios are
importance of accounting. used to analyze a firm’s financial
strengths and weaknesses.
2 Identify the three basic activities
involving accounting.
7 Describe the role of budgets in a
Describe the roles played by business.
3
public, management, government
8 Explain uniform financial
and not-for-profit accountants. statements and how
exchange rates influence
4 Outline the steps in the accounting international accounting
process.
practices.
Accounting Process of measuring, interpreting, and communicating financial 
information to support internal and external business decision making.

USERS OF ACCOUNTING
INFORMATION
• 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 company’s success.
• Outsiders use financial data to evaluate investment opportunities.
• Accountants serve public good.
• Example: Volunteer programs that provide free help for low­ and middle­
income senior citizens file their taxes.  AARP’s Tax Aide
BUSINESS ACTIVITIES INVOLVING
ACCOUNTING
• Accounting plays a key role in each of a businesses three key areas:
• Financing activities Provide necessary funds to start and expand a business.
• 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.
ACCOUNTING PROFESSIONALS
Public Accountants
Public accountant Accountant who works for an independent accounting firm.
Certified public accountant (CPA) Accountant who meets specified 
educational and experiential requirements and has passed a 
comprehensive examination on accounting theory and practice.
Management Accountants
• Management accountant Accountant employed by a business other than a 
public accounting firm.
Government and Not-for-Profit Accountants
• Perform professional services similar to those of management 
accountants.
THE ACCOUNTING PROCESS
Accounting process Set of activities involved in converting 
information about transactions into financial statements.
The Impact of Computers and the Internet
on the Accounting Process
• Simplifies the accounting process by automating data entry and calculations.
• Software that handles accounting information for international businesses is also 
available.
The Foundation of the Accounting System
• Generally accepted accounting principles (GAAP) Principles that encompass 
the conventions, rules, and procedures for determining acceptable accounting 
practices at a particular time. 
• Financial Accounting Standards Board (FASB) Organization primarily 
responsible for evaluating, setting, or modifying GAAP in the U.S.
Sarbanes­Oxley Act A response to cases of accounting fraud.
• Created the Public Accounting Oversight Board. 
• Added to the reporting requirements for publicly traded companies. 
The Accounting Equation
Assets Anything of value owned or leased by a business.
• Tangible: Equipment, buildings, inventory.
• Intangible: Patents, trademarks
Liability Claim against a firm’s assets by a creditor.
Owner’s 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.
FINANCIAL STATEMENTS
• Provide managers with information for evaluating organization’s ability to meet 
current obligations and needs, its profitability, and its overall financial health.
The Balance Sheet
Balance sheet Statement of a firm’s financial position—what it owns and the 
claims against its assets—at a particular point in time.
The Income Statement
Income statement Financial record of a company’s revenues, expenses, and 
profits over a period of time.
• Helps decision makers focus on overall revenues and the costs involved in 
generating these revenues.
• Sometimes called a profit­and­loss, or P&L, statement.
The Statement of Cash Flows
Statement of cash flows Statement of a firm’s cash receipts and cash payments 
that presents information on its sources and uses of cash. 
Accrual accounting Accounting method that records revenue and expenses when 
they occur, not necessarily when cash actually changes hands. 
• Inadequate cash flow is a reason for many business failures.
FINANCIAL RATIO ANALYSIS
• Ratio analysis Tool for measuring a firm’s liquidity, profitability, and reliance 
on debt financing, as well as the effectiveness of management’s resource 
utilization.
BUDGETS
Budget Planning and control tool that reflects a firm’s 
expected sales revenues, operating expenses, and cash 
receipts and outlays.
• Cash budget Tracks the firm’s cash inflows and outflows.
INTERNATIONAL ACCOUNTING
• Global firms must translate financial statements of the firm’s international 
affiliates, branches, and subsidiaries and convert data about foreign currency 
transactions to dollars.
Exchange Rates
• Ratio at which a country’s currency can be exchanged for other currencies.
• Consolidated financial statements must reflect gains and losses due to changes in 
exchange rates.
International Accounting Standards
• International Accounting Standards Committee (IASC) promotes worldwide 
consistency in financial reporting practices.