Intermediate Accounting: Accounting Theories - Essay Example

Intermediate accounting Intermediate accounting Intermediate accounting familiarizes with the broader level of accounting theory. Topics included in intermediate accounting are financial ratio analysis, the conceptual outline of Generally Accepted Accounting Principles (GAAP), equity accounting and financial statement preparation. Stockholders, customers, and potential investors will often use financial data to assess the performance and financial health of a business model. Financial ratios are used to analyze an organization’s financial performance. Financial ratios are used by creditors, bankers, accountants and shareholders to evaluate information presented in an organization’s financial statement. Houston and Brigham (2009) state that, the outcome of the evaluation determines whether investors and other external users of financial information decide to retract or extend financing to the organization. The shareholders level of commitment to the organization may also fluctuate based on the outcome of the evaluations. There are several categories of ratio, each designed to assess a different aspect of an organization’s performance. The five categories are; liquidity ratios, profitability ratios, asset activity ratios and debt ratios. Liquidity ratios Liquidity ratios assess the ability of a business to convert its current resources into cash and payoff the company’s current obligations (Houston and Brigham, 2009). They include the quick ratio, also known as the acid test, the current ratio, cash coverage ratio and liquidity index. Quick ratio evaluates the ability of a company to fulfill any short-term obligations with assets that can be converted into cash quickly (Houston and Brigham, 2009). A quick ratio greater than 1 is an indication that the firm is able to liquidate all of its accounts. Current ratio examines the ability of a company to pay off its financial obligations in one year (Houston and Brigham, 2009). Current ratio accounts for current assets like account receivables and the company’s liabilities like account payables to help the manager understand the solvency of the company. A ratio lying within 1.5 and 3 indicates strong financial performance (Houston and Brigham, 2009). A current ratio of less than one is an indication that the firm might not be able to meet all of its financial liabilities if they are needed to be paid at the same time (Houston and Brigham, 2009). Current ratio that is relatively high and may indicate that the company is resting on a huge amount of money, rather than spending it in the company. Current ratio provides financial analysts and investors with an indication of the stability and efficiency of an organization’s operating cycle and its financial health. Cash coverage ratio shows the amount available to pay interest and liquidity index evaluates the amount of time needed to convert assets into cash (Houston and Brigham, 2009). Profitability ratios Profitability ratios measure how well a business performs regarding generation of profit on sales and investments. Most common profitability ratios used include the operating profit margin, the gross profit margin, the net profit margin, the return on equity ratio (ROE), and the return on asset’s ratio (ROM) (Bodie, Kane and Marcus, 2004).The operating profit margin is computed by dividing the earnings before interests and taxes by sales. The resulting ratio determines how effective the organization is at keeping production costs minimum (Bodie, Kane and Marcus, 2004). The gross profit margin is evaluated by dividing the amount of gross profit of the company’s sales. The resulting ratio is used to establish the amount of profit that remains from each sale after the cost of good’s sales has been subtracted (Bodie, Kane and Marcus, 2004). The net profit margin is evaluated by dividing the net salary available to stockholders by sales. The ratio is used to determine how effective an organization is at making profit on each dollar of revenue it generates. The return on equity ratio is computed by dividing the net income for the fiscal year by the shareholders’ equity (Bodie, Kane and Marcus, 2004). The ratio is useful for comparing the profit generating ability of a company to that of other companies in the same industry. The returns on assets’ ratio are computed by dividing an organization’s yearly earnings by the organizations total assets. The ratio reveals the amount of earnings that were generated from the capital that was invested (Bodie, Kane and Marcus, 2004). Asset activity ratio Asset activity ratio evaluates the quality of management since they reveal how the management is utilizing organizational resources (Bodie, Kane and Marcus, 2004). Examples of asset activity ratio are the accounts payable turnover ratio, the accounts receivable turnover ratio, inventory turnover ratio, sales to working capital ratio and working capital turnover ratio. The accounts payable turnover ratio is determined by dividing the total purchases generated from suppliers by the average accounts payable in the same period (Bodie, Kane and Marcus, 2004). The ratio reveals to the investors the number of times per period an organization pays its average payable amount. The accounts receivable turnover ratio is computed by dividing net credit sales by the average accounts receivable within the same period. A high ratio indicates that a business functions on cash criteria or that the business collection of accounts and extension of credit receivable is efficient (Bodie, Kane and Marcus, 2004). A low ratio suggests that the company should re-evaluate its credit policies to ensure the timely collection of disclosed credit that is not yielding interest for the company (Bodie, Kane and Marcus, 2004). Inventory turnover ratio is estimated by taking the cost of goods sold by a business and dividing it by the business’ average inventory within any accounting period (Bodie, Kane and Marcus, 2004). The ratio is used to determine the inventory management effectiveness of business. The sales to working capital ratio are computed by taking the annualized net sales and dividing it by the average working capital. The ratio is used to analyze the relationship between the amount used to fund processes and the sales made from these processes. The working capital turnover ratio is evaluated by dividing net sales by the working capital within a period of 12 months (Bodie, Kane and Marcus, 2004). The ratio determines how well the company is using its working capital to support a specific number of sales. A high turnover ratio is an indication that the organization is efficient in using a business’ short-term liabilities and assets to support sales. A small ratio suggests that the firm is investing in several accounts to support its sales, which could cause many debts (Bodie, Kane and Marcus, 2004). Debt ratios Debt ratios show the level to which a firm is depends on debts to finance its activities, and its capability to pay off the debts (Bodie, Kane and Marcus, 2004). Commonly used debt ratios include the debt to equity ratio, a fixed charge coverage ratio, and the debt service coverage ratio. Debt to equity ratio is calculated by taking the total liabilities of the company and dividing it by the stockholders’ equity (Bodie, Kane and Marcus, 2004). The ratio indicates the quantity of debt and equity the firm is using to fund its assets. The fixed charge coverage ratio is estimated by taking the earnings before interests and taxes (EBIT) together with fixed charges before taxes and dividing by a fixed charge(before taxes) with interest (Bodie, Kane and Marcus, 2004). The ratio is used to determine a firm’s ability to achieve fixed financing expenditures such as leases and interests. The debt-service coverage ratio (DSCR) is evaluated by dividing the business’ net operating income by its total debt service (Bodie, Kane and Marcus, 2004). The DSCR has different interpretations. In finance, the ratio is used to determine income property loans. The ratio is considered ideal if it is greater than one. This means the company is making enough income to pay off its obligations. The most fundamental metric to managers, investors, and markets are the liquidity set of ratios because these ratios measure the ability of an organization to stay in business (Bodie, Kane and Marcus, 2004). Accountancy professionals in organizations help with corporate strategy and help businesses to minimize costs, improve the business, and reduce risks. For this intention, there is a big demand for professional accountants in any organization in order to ensure quality financial accounting. Bodie, Kane and Marcus (2004) defined financial accounting as the procedure that controls the formulation of financial reports on the business for the exhaustion by participants in and out of the association. Financial accounting faces some challenges including timeliness, soft assets, forward-looking information and non-financial statements. Financial accounting has the objective to provide information that is useful to investors and other external users of financial data in making rational investment and other similar decisions (Bodie, Kane and Marcus, 2004). The accounting profession established a set of ethics known as the GAAP meaning Generally Accepted Accounting Principles. The principles serve as a guide to the accounting profession in collecting and reporting the financial information of an organization (Bodie, Kane and Marcus, 2004). American Institute of Certified Public Accountants (AICPA), the state professional firm of practicing Certified Public Accountants (CPA) have aided in the establishment of GAAP in the United States of America. SEC is an organization of the federal government that oversees the activities of corporate bodies whose stock is held publicly. SEC designated FASB as the agency in charge with establishing accounting standards for public enterprises in the Unites States (Bodie, Kane and Marcus, 2004). AICPA appointed and recognized other sources for providing substantial authoritative support for accounting practices. The major functions of these groups were to advance the written statement of accounting principles, to establish appropriate practices and to minimize the areas of inconsistency in a business (Bodie, Kane and Marcus, 2004). FASB is instrumental in establishing and improving the standards of financial accounting and reporting for the education of the public, which includes issuers and other users of financial information (Bodie, Kane and Marcus, 2004). There are other agencies and groups that have influenced accounting theory and the establishment of accounting standards. These agencies include the Institute of Management Accountants (IMA), the American Accounting Association (AAA), the Internal Revenue Service (IRS), and the Financial Executives Institute (FEI). These agencies influence the process of standard setting because of their interest in the accounting process, broad use of the reports produced by the accounting procedure, or both (Bodie, Kane and Marcus, 2004). Example Christi’s mom loaned her $30 to start her business. Christie bought 2 quarter packs of lemonade mix each costing $1.00 per pack, 100 plastic cups for $5.00, a magic marker, and poster board for $3.00, working table and chair for $8.00 and a small safety box for keeping her money for $2.00. Her mom agreed to lend her a two-quarter pitcher and mixing spoon for $1.00 per day and sell her water and ice from the kitchen for $0.50 per pitcher. Christi negotiated terms of net 5 on these items. The cost of ice, water, and rent had to be repaid within 5 days of starting a business. She priced her lemonade at $0.50 per cup. By evening, Christi had sold 60 cups of lemonade. She used six packs of the mix since each pitcher produced 10 cups of lemonade. All sales were for cash except 2 cups that she sold to her mom and 6 cups to her dad who agreed to her later. She agreed to sell them the lemonade on credit terms of 2 days. (Adapted from: Mukherjee & Hanif. (2003). Financial Accounting. Boston: McGraw Hill Higher Education) Christie’s Lemonade Stand Balance Sheet For the end of first day operations Cash $29 Accounts receivable 3 Inventories 6 Fixed assets 13 @$ 8.00 + Total assets $51 Accounts payable $4 Loan $ 30 Retained earnings 17 Total claims $51 plug figure important for balancing total assets and liabilities 6 cups to mom and dad @ $0.50 for each cup 4 packs of lemonade mix @ $1.00 for every cup Pack + 40 cups @ $0.05 magic marker and poster board @ $ 3.00 + chair and table @ $8.00 + money box @ $2.00 operating finances negotiated at net 5 days capital from mom net incomes for day 1 of operation Christie’s Lemonade Stand Statement of cash flows For day one of operations Cash inflows: Cash collected from customers Loan from mom Total cash inflows Cash outflows: Purchase of lemonade mixture Payment for board, marker, chair, table, and money box purchase of plastic cups Total cash outflows NET CASH FLOW $27 $30 $57 $10 $13 $5 $28 $29 (Adapted from: Mukherjee & Hanif. 2003). Financial Accounting. Boston: McGraw Hill Higher Education) References Bodie, Z., Kane A., and Marcus, A., J. (2004). Essentials of Investments, 5th ed. Boston: McGraw-Hill Irwin. Houston, J., F, and Brigham, E. F. (2009). Fundamentals of Financial Management. Cincinnati, Ohio: South-Western College Pub. Mukherjee & Hanif. (2003). Financial Accounting. Boston: McGraw Hill Higher Education. Read More