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Accounting
Prof: Jim Wallace
TA: Golf
Overview of Week 1
Administrative stuff What is financial accounting? Some Myths Accrual versus Cash-based Financial statements GAAP Auditing
Administrative Stuff
Who am I Who is your T.A. Teaching philosophy Syllabus
Homework Calculator
Web Access to Class Info
The site should contain: Syllabus PowerPoint slides Handouts Homework solutions
http://www.cgu.edu/pages/3472.asp
What is Financial Accounting? A method to communicate financial
information to interested external parties. Users include capital providers,
regulators, customers, suppliers, employees, etc
• Capital suppliers include debt and equity providers
Financial accounting is used for both prediction and control
Accounting is rigid and yields the truth Generally-accepted accounting principles,
or GAAP, are a set of rigid rules that, if followed correctly, will lead to a unique, “correct” representation of the financial performance and health of a firm.
The basic financial statements, consisting of a balance sheet, an income statement, and a statement of cash flows, reflect a complete, accurate, and timely portrayal of the financial performance and well-being of a firm
Accounting is the sole product of accountants
GAAP is created from a comprehensive analytical process, which is free from political influence.
It is all there
All of a firm’s identifiable assets and liabilities appear on the balance sheet, and the difference between a firm’s assets and its liabilities represents the value of the firm.
The statements stand alone
Each of the financial statements is independent, with each reflecting a different aspect of the firm’s performance and financial health.
Cash is King!
Cash flow is ultimately what matters to a firm and its investors; therefore, it is not really necessary to worry about the definition of earnings used in the preparation of the income statement. Rather, one need only consider the sources and uses of cash as reflected on the firm’s statement of cash flows.
Some additional myths
Accounting is useless.Accounting is hard!Accountants are boring.
Other Types of Accounting
ManagerialNon-profitTax
Accrual AccountingAccrual accounting rests on two guiding principles:
Revenue Recognition Principle – record revenue when Earned Realized or Realizable
Matching Principle – record expenses when Incurred
Neither the recognition of revenue nor the recording of expense necessarily involves the receipt or payment of cash
How do you define a rich person?
Has a lot of valuable stuff (worth more than what is owed).
Makes a lot of money
The Financial Statements The accounting equation Balance Sheet Income Statement Statement of Cash Flows Statement of Owners Equity
Statement of retained earnings
Balance Sheet
Mirrors the Accounting Equation Assets = Liabilities + EquityUses of funds = Sources of funds Assets are listed in order of liquidity
Current and non-current Liabilities are listed in order of maturity Equity consists of Contributed Capital
and Retained Earnings
Assets
To be reported on a balance sheet, an asset must:
1. Be owned or controlled by the company
2. Must possess expected future benefits
Most Assets are Reported at Historical Cost
Historical Cost isObjectiveVerifiableTherefore, not subject to bias
However, historical cost is not particularly “relevant” to most readers of the balance sheet
“Relevance vs. Reliability” is an important issue with accountants.
Liabilities
Liabilities 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
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
share On average, US company book value is
roughly two-thirds of market value.
Income Statement
Statement of Stockholders’ Equity
Statement 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
Statement of Cash Flows
Statement of cash flows (SCF) reports cash inflows and outflows
Cash flows are reported based on the three business activities of a company:
1. Operating activities: transactions related to the operations of the business.
2. Investing activities: acquisitions and divestitures of long-term assets
3. Financing activities: issuances and payments toward equity, borrowings, and long-term liabilities.
Articulation of Financial Statements
Financial 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.
Dividends
Change in Cash
Operating cash flowsInvesting cash flowsFinancing cash flows
Change in shareholders’ equity
Revenues--------------Expenses--------------Net income
Liabilities
____
Share-holders’equity
Cash
--------
Other assets
Liabilities
____
Share-holders’equity
Cash
--------
Other assets
BalanceSheet(beginningof period)
BalanceSheet(end ofperiod)
Incomestatement
Statement of cash flows
Statement of shareholders’ equity
Exhibit 1.5 The Relationship Among the Basic Financial Statements
Dividends
Change in Cash
Operating cash flowsInvesting cash flowsFinancing cash flows
Change in shareholders’ equity
Revenues--------------Expenses--------------Net income
Liabilities
____
Share-holders’equity
Cash
--------
Other assets
Liabilities
____
Share-holders’equity
Cash
--------
Other assets
Liabilities
____
Share-holders’equity
Cash
--------
Other assets
BalanceSheet(beginningof period)
BalanceSheet(end ofperiod)
Incomestatement
Statement of cash flows
Statement of shareholders’ equity
Exhibit 1.5 The Relationship Among the Basic Financial Statements
In Class Example
Baron Coburg
Oversight of Financial Accounting
GAAP Oversight of Financial Accounting
SEC oversees all publicly traded companies
Financial Accounting Standards Board (FASB) Generally Accepted Accounting
Principles (GAAP)
Basic Assumptions and Principles Monetary Unit Fiscal period Going concern Objectivity (Reliability) Consistency
Versus 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 Principles Materiality
Only transactions with amounts large enough to make a difference are considered material
Non-material transactions can be treated in the easiest manner
Information Beyond Financial Statements
Management Discussion and Analysis (MD&A)
Independent Auditor Report Financial Statement Footnotes
Audit Report
Financial statements present fairly and in all material respects company financial condition.
Financial statements are prepared in conformity with GAAP
Financial statements are management’s responsibility. Auditor responsibility is to express an opinion on those statements
Auditing involves a sampling of transactions, not investigation of each transaction
Audit 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?
Takeaways
Financial 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 Limitations Assets are valued at historical cost less an
estimated depreciationOther possibilities include cost, net
realizable value, replacement cost, price level adjusted
Not all assets appearHuman capital, internally generated
goodwill• Could be argued that approach is more
conservative
Financial Statement Limitations
Not 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 science
GAAP allows companies choices in preparing financial statements (inventories, property, and equipment).
Financial statements also depend on countless estimates.
Financial Accounting in Context
A company’s 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.
Ethical Question
See textbook