Economics /Management 4 Financial Accounting

Accounting Fundamentals, Terminology, and Conceptual

Foundations

Accounting Firms Globals 1. Ernst & Young (E&Y). 2. Deloitte & Touche (D&T). 3. KPMG. 4. Price-Coopers (PwC). 5. Arthur Anderson Regionals 1. Moss Adams. 2. BDO Siedman 3. H&R Block-McGladry (Pullen). 4. Century

The Big Four

Accounting – recording & processing commercial transactions to report business financial performance & financial position. a) Control (bookkeeping & internal controls); b) Financial reporting; c) Auditing; d) Tax-planning; e) Management & Information systems

consulting; f) Forensic accounting & litigation support.

Credentials: CPA, CIA, EA, CFE, CMA

Accounting Terminology

• Terms of Art

– New words; Old words w/ new meanings

– Use online glossaries

• In order to

Expedite conversations

Avoid ambiguity

• Abbreviations [SG&A, EBITDA, AR’s, CAPEX]

Get used to it

Financial Accounting

A highly-stylized Information System

Formulated as a system of Simultaneous Equations

Organized around the fundamental Accounting Equation

Assets = Liabilities + Equity

The Fundamental Equation of Accounting

Assets = Liabilities + Equity

What we OWN “Assets” must have a Source =

Liabilities are what we owe to others Equity is what we owe to ourselves

Firms Need Cash (to acquire Assets),

so they create Financial Capital

• Financial Capital represents the Cash raised when firms sell Financial Securities

1. Stocks – shares of the Firm sold to investors, also called Share-holders – Equity Capital

2. Bonds – loans from creditors, bond-holders – Debt

Capital

Designed to provide Useful information to

Direct Providers of Financial Capital 1. Owners/Investors (who buy Stock) 2. Creditors / Lenders (who buy bonds) Indirect Providers of Financial Capital 3. Suppliers/Vendors 4. Customers 5. Government Tax & Regulatory Agencies

What are the Characteristics of Useful?

a) Relevant – for decision-making

b) Reliable – consistent & comparable

c) Independent

d) Timely – result of recent activities How timely is publicly-reported financial accounting?

Two Methods of Accounting

Cash-basis • Rules-oriented method. Only cash

receipts or disbursements matter. And there is only one bottom-line.

Accrual • Principles-based method. GAAP

accounting. More useful but opens the way for judgment, thus manipulation. There are many possible bottom-lines.

Accounting Assumptions • One Entity. You are separate from your

company for accounting purposes.

• Record-keeping for a “Period” of time. Fiscal “FY” year comprised of 4 interim quarters of roughly 13 weeks each.

• In Dollar$.

• On-going concern. Change accounting methods for bankrupt companies or for discontinued operations w/in a company.

Most companies Retailers 1st Quarter Jan-Mar Feb-Apr 2nd Quarter Apr-June May-July 3rd Quarter Jul-Sep Aug-Oct 4th Quarter Oct-Dec Nov-Jan

The Accounting Period is a 12 month fiscal year “FY”

With 4 Interim Periods, Quarters.

What is Nordstrom’s fiscal year? How about Starbucks?

Accrual Accounting is a highly-stylized Information System

Basic Functions (all info systems):

1. Collection transactions’ data

2. Measurement in dollars $

3. Classification into 7-11 Elements

4. Presentation in 4 Reports

Collection

Collect the quantitative information from commercial transactions with outsiders. No transaction, no record, no seat at the table..

Measurement

Transactions are recorded in $’s, or a local currency. Not always easy. Think of trade-in’s. Often “estimates” are required.

Classification

Transaction numbers are given a name, actually two names … and recorded twice. This preserves the fundamental equation. The fun begins with classification.

Let’s be Candid

No one knows the truth. Facts are in dispute. But we need to communicate. So the issue is really, “what lies should we tolerate?”

Classification is a Decision that starts a Process

• Amounts are recorded in two journals.

• Called double-entry book-keeping.

• Journals are individual accounts.

• Accounts are grouped by elements.

• There are five basic and two adjunct elements.

Classification into the Elements of Accounting

1. Asset

2. Liability

3. Equity

4. Revenue

5. Expense

6. Gain

7. Loss

Types of Assets

1. Cash

2. Inventory

3. FF&E

4. PP&E

5. Trademarks

6. Goodwill

Are all of the assets owned or controlled by a firm listed on its Balance Sheet?

Types of Liabilities

1. Customer Advances

2. Payables

3. Accrued Expenses

4. Loans

5. Employee Pensions

Name the fundamental difference between Assets and Liabilities.

Types of Expenses

1. Cost of Goods Sold

2. Wages & Salaries

3. Advertising

4. Parking

5. Depreciation

6. Interest

Name the three “generic’ types of Expenses and any other categorizations of Expenses..

Generic Types of Expenses

1. Direct (COGS) 2. Indirect (Wages, Advertising,

Parking) 3. Periodic (Rent, Interest) Other categorizations of Expenses.

1. Operating & non-Operating 2. Financing 3. Recurring & non-Recurring

Presentation

Into Financial Reports

1. Balance Sheet

2. Income Statement

3. Statement of Cash Flows

4. Statement of Shareholder’s Equity

Simultaneous Equations To be explained & illustrated later

Cash0 + Inventory0 = Liabilities + PinK + RE0

Revenue + (COGS) = Earnings

Inventory0 + Purchases + (COGS) = Inventory1

Cash1 = Cash0 + Revenue - (Inventory1 - Inventory0)

Cash1 + Inv1 = Liabilities + PinK + RE0 + Earnings

Cash1 + Inventory1 = Liabilities + PinK + RE1

Terminology is Critical

• (Earned) Revenue v. Unearned Revenue.

• Pre-paid Expense v. Expense.

• Expense v. Accrued Expense.

• Goods Sold v. Inventory on Hand.

• Wholesale COSTS v. Retail PRICES

ADJECTIVES MATTER

Symmetry and Semantics

• Current vs. Non-Current

• Direct vs. Indirect

• Operating v. non-Operating

• Monetary vs. non-Monetary

• Right vs. Obligation

• Inflow vs. Outflow

• Primary vs. Adjunct

TIMING

• Accrual is all about Time. The accounting period

matters ! It establishes when activities, and

subsequent results, stop.

• COSTS – what the firm pays for something.

• EXPENSES – what COSTS will become at some point in time.

• PRICES – what the firm receives for something.

Turning Costs into Expenses

We purchase T-shirts @ $10 each - “wholesale” Cost.

We sell T-shirts @ $20 each - “retail” Price. Thus, we expect $10 per T-shirt sold as Profit.

Cash

Receivables

Inventory

Pre Paid Expenses

Customer Advances

Payables

Accrued expenses

Paid in Capital

Retained earnings

The Balance Sheet

The Income Statement Revenue COGS Profit

TEMPLATES

$ 100

$ 0

$ 0

$ 0

$ 0

$ 0

$ 0

$ 100

$ 0

Balance Sheet

We invest $100 cash in our T-shirt business.

$ 0

$ 0

$ 100 $ 0

$ 0

$ 0

$ 0

$ 100

$ 0

Balance Sheet

We purchase ten T-shirts @ $10 each for a total of $100 in inventory consisting of 10 items.

Income Statement $ 100 Revenue ($50) COGS $ 50 Profit

1. We sell five T-shirts @ $20 price each in-cash for a total of $100 in Revenue recognized. 2. We “expense” five T-shirt’s costs of $10 each for total expenses of $50 recognized. 3. Matching costs with revenues is called expense recognition. The net result is $ 50 in Profits.

$ 100

$ 0

$ 50 $ 0

$ 0

$ 0

$ 0

$ 100

$ 50

Balance Sheet

We now have $ 50 cash and $ 50 in inventory . We have $ 50 in retained earnings.

• Accrual concepts lead to Guidelines called GAAP.

• Fiction is permitted in accounting; it’s just not called fiction, it’s called interpretation.

• Occasionally, the line between truth and fiction is not a very bright one.

• Sometimes, a white lie gets a desired effect w/ little risk of harm.

Principle’s-Based Reporting

The subjective meets the objective

• Opinion meets Evidence

• Quantitative meets Qualitative

• Romance meets Reality

• Form meets with Substance

Profits ?

Profits are a construct, not a fact The “fact” is … a good accountant can make profits almost anything that he/she is directed that they be … Profits = Revenue & Gains less Expenses & Losses Thus, we will look very closely at what is meant by Revenue, Expenses, Gains, Losses.

Accounting Principles

1. Cost

2. Realization

3. Matching

4. Disclosure

5. Objectivity

6. Materiality

7. Consistency

8. Conservatism

Accounting Principles

1. Costs become expenses

2. Realization of Revenue

3. Matching Expenses to revenue

4. Disclosure qualitative reporting

5. Objectivity unrelated parties

6. Materiality significant

7. Consistency no flip-flopping

8. Conservatism no exaggerations

What is the Goal of Financial Accounting (?)

USEFULNESS

… for what purpose?

COMPARABILITY