AccountingProf: Jim WallaceTA: Charles Yeh

Overview of Week 1Administrative stuffWhat is financial accounting?Financial statementsGAAPWhat number do you want?

Administrative StuffWho am IWho is your T.A.Teaching philosophySyllabusHomeworkCalculator

Web Access to Class Info

The site should contain:SyllabusPowerPoint slidesHandoutsHomework solutions

http://www.cgu.edu/pages/3471.asp

What is Financial Accounting?A method to communicate financial information to interested external parties.Users include capital providers, regulators, customers, suppliers, employees, etcCapital suppliers include debt and equity providersFinancial accounting is used for both prediction and control

Some Preconceptions- Misconceptions?Accounting yields the truth.Accounting is rigid.Accounting is useless.Accounting is hard!Accountants are boring.

Other Types of AccountingManagerialNon-profitTax

The Financial StatementsThe accounting equationBalance SheetIncome StatementStatement of Cash FlowsStatement of Owners Equity Statement of retained earnings

Balance SheetMirrors the Accounting Equation Assets = Liabilities + EquityUses of funds = Sources of fundsAssets are listed in order of liquidityCurrent and non-current Liabilities are listed in order of maturityEquity consists of Contributed Capital and Retained Earnings

AssetsTo be reported on a balance sheet, an asset must:

Be owned or controlled by the companyMust possess expected future benefits

Most Assets are Reported at Historical CostHistorical Cost isObjectiveVerifiableTherefore, not subject to biasHowever, historical cost is not particularly relevant to most readers of the balance sheetRelevance vs. Reliability is an important issue with accountants.

Disneys Assets

LiabilitiesLiabilities are listed in order of maturityCurrent Liabilities come due in less than a year.Noncurrent liabilities come due after a year.Companies desire more current assets than current liabilities this difference is called net working capital

Disneys Liabilities and Equity

Equity Equity consists of:

Contributed Capital (cash raised from the issuance of shares)

Earned Capital (retained earnings). Retained Earnings is updated each period as follows:

Market Value vs. Book Value

Stockholders equity = Company book value

Book value is determined using GAAP. Book value is not the same as Market Value.Market Value = # of Shares x Price per shareOn average, US company book value is roughly two-thirds of market value.

Income Statement

Walt Disneys Income Statement

Accrual AccountingAccrual accounting refers to the recognition of revenue when earned (even if not received in cash) and the matching of expenses when incurred (even if not paid in cash).

Accrual AccountingAccrual accounting rests on two guiding principles:Revenue Recognition Principle record revenue whenEarnedRealized or RealizableMatching Principle record expenses whenIncurredNeither the recognition of revenue nor the recording of expense necessarily involves the receipt or payment of cash

Statement of Stockholders EquityStatement of Equity is a reconciliation of the beginning and ending balances of stockholders equity accounts.Main equity categories are:Contributed capitalRetained earnings (including Other Comprehensive Income or OCI)Treasury stock

Disneys Statement of Stockholders Equity

Statement of Cash FlowsStatement of cash flows (SCF) reports cash inflows and outflowsCash flows are reported based on the three business activities of a company:Operating activities: transactions related to the operations of the business.Investing activities: acquisitions and divestitures of long-term assetsFinancing activities: issuances and payments toward equity, borrowings, and long-term liabilities.

Walt Disney Companys Statement of Cash Flows

Articulation of Financial StatementsFinancial statements are linked within and across time they articulate.Balance sheet and income statement are linked via retained earnings.Absent of equity transactions such as stock issuances and purchases and dividend payments, the change in stockholders equity equals the income or loss for the period.

In Class Example

Baron Coburg

Oversight of Financial AccountingGAAPOversight of Financial AccountingSEC oversees all publicly traded companiesFinancial Accounting Standards Board (FASB) Generally Accepted Accounting Principles (GAAP)

Basic Assumptions and PrinciplesMonetary UnitFiscal periodGoing concernObjectivity (Reliability)ConsistencyVersus comparability

Question?Financial statements must contain objective and verifiable numbers if they are to be useful. Yet, many estimates and subjective assumptions are required for the preparation of these reports. Please reconcile these apparently inconsistent statements.

Exception to the Basic PrinciplesMaterialityOnly transactions with amounts large enough to make a difference are considered materialNon-material transactions can be treated in the easiest manner

Information Beyond Financial StatementsManagement Discussion and Analysis (MD&A)Independent Auditor ReportFinancial Statement Footnotes

Audit ReportFinancial statements present fairly and in all material respects company financial condition. Financial statements are prepared in conformity with GAAPFinancial statements are managements responsibility. Auditor responsibility is to express an opinion on those statementsAuditing involves a sampling of transactions, not investigation of each transactionAudit opinion provides reasonable assurance that the statements are free of material misstatements Auditors review accounting policies used by management and estimates used in preparing the statements

Question?The SEC requires all publicly traded companies to have their financial statements audited. Prior to this requirement many companies voluntarily had their statements audited. Given the cost and inconvenience, why would they do this?

What Number Do You Want?Accounting is a political process, not an exact science.

There is a great deal of discretion available to managers.

Earnings ManagementReasons to manage earnings

ACCOUNTING NUMBERS HAVE ECONOMIC CONSEQUENCES BEYOND SIMPLY RECORDING TRANSACTIONS

Earnings Management - WhyCompensation contracts

Debt contracts

Political considerations

Transaction AnalysisTransaction analysis is the process of identifying impacts of transactions and events on the balance sheet, income statement, or both.We use the following template:

Journal Entries

Transaction Analysis

Credit Sales Transaction

Accrued Expense Transaction

Deferred Revenue Transaction

Asset Write-Down (Impairment) Transaction

TakeawaysFinancial statements that are produced are the result of one possible set of rules that have resulted from a political process.Users need to be aware of these limitations.Users should read the notes to the financial statements since these contain a lot of useful guidance to interpreting the statements.

Financial Statement LimitationsAssets are valued at historical cost less an estimated depreciationOther possibilities include cost, net realizable value, replacement cost, price level adjustedNot all assets appearHuman capital, internally generated goodwillCould be argued that approach is more conservative

Financial Statement LimitationsNot all liabilities appearContingencies appear only in the footnotesOff balance sheet financing

Other limitations include management biases and a lack of timeliness

Financial Accounting: not an exact scienceGAAP allows companies choices in preparing financial statements (inventories, property, and equipment). Financial statements also depend on countless estimates.

Financial Accounting in ContextA companys financial statements only tell part of the story.You must continually keep in mind the world in which the company operates.Financial statement analysis must be conducted within the framework of a thorough understanding of the broader forces which impact company performance.