3-6 ideas learn from Chapter 3 Accounting
1) Accounting Rules
Accounting rules set the standards so that financial reports of companies may be compared on an equal basis. Accounting’s governing rules are called ‘Generally Accepted Accounting Principles’ (GAAP). These rules have been developed over the years and are analogous to the precedents in the legal profession.
2) Accounting Concepts
There are seven concepts which is a guiding set of policies that underlie all accounting rules and reporting:
a. The Entity – A reporting entity can be a single grocery store, a production plant, an entire business, or a conglomerate.
b. Cash and Accrual Accounting
Using ‘cash basis’ accounting, transactions are recorded only when cash changes hands; but it doesn’t try to match the cost of conducting business with their related sales.
‘Accrual accounting’ recognizes the financial effect of an activity when the activity takes place without regard to the movement of cash. Accrual accounting raises two related issues, ‘allocation’ and ‘matching’, because activity and cash movement most often do not occur at the same time.
Without established policies for allocation and matching, accountant could easily manipulate financial report by choosing when to record sales or expenses in order to cover up or delay bad results.
c. Objectivity
Accounting records only contain transactions that have been “completed” and that have a “quantifiable” monetary value. Accountants also have an objectivity rule to guide them when in doubt. There must be reasonable and verifiable evidence to support the transaction, or else it does not get recorded.
d. Conservatism
Accounting conservatism governs the preparation of financial statements. Accounting records contain only measurable verifiable properties, debts, sales, and costs.
Conservatism also dictates that transactions be recorded at their ‘historical costs’.
e. Going Concern
Financial statements describe businesses as operating entities. The values assigned to items in the accounting records assume that the business is a going concern. Accountants presume that companies will continue to operate in the foreseeable future; they use historical costs.
f. Consistency
Accounting rules demand that an entity use the same accounting rules year after year. That enables an analyst to compare past with current results. Consistency requires that the same accounting method be used from year to year.
g. Materiality
Financial statements are only materially correct so that a reader can get a fairly stated view of where and entity stands; so that a reasonable person can make informed decisions based on the report.
3) The Financial Statements : Assets = Liabilities + Owner’s Equity
To know a company, you must be able to read and understand three major financial statements:
a) The Balance Sheet
b) The Income Statement
c) The Statement of Cash Flows
4) Ratio Analysis
Ratios are used to compare performances among companies within an industry and against a company’s own historical performance.
For major categories of ratios:
a) Liquidity ratios > 1 shows liquidity
It is to show whether a company is able to pay its bills
Current ratio = Current Assets / Current Liabilities
b) Capitalization measures
(i)Financial Leverage = (Total Liabilities + Owner’s Equity) / Owner’s Equity
Ratio > 2 show an extensive use of debt
(ii)Long-Term Debt to Capital = Long-Term Debt / (Liabilities + Owner’s Equity)
Ratio > 50% shows a high level of debt
c) Activity measures
Assets Turnover per Period = Sales / Total Assets
The ratio tells how actively the firm uses all of its assets. A firm generates more sales in a given set of assets is said have managed its assets efficiently. Ratios are industry-specific.
d) Profitability measures
Return on Equity (ROE) = Net Income / Owner’s Equity
If a company has a high level of debt and a small amount of equity, the return of ROE can be affected. That is called financial leverage. The choice of lower equity level can ‘leverage’ the ROE to extremely high levels.
5) Managerial Accounting
Managerial accounting focuses on operations. Instead of ratios, managerial accounting uses standards, budgets, and variances to run the business and explain operational results.
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