Introduction

15.501/516 Accounting Spring 2004

Professor Sugata Roychowdhury

Sloan School of Management Massachusetts Institute of Technology

Feb 4, 2004
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Session 1: Agenda

Administrative matters Discussion of Accounting Course objective

user

Why is accounting interesting? Why do we need accounting? Sophisticated financial statement

financial statements

An overview of information in
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The required materials are: 5th Edition of Jamie Pratt

Financial Accounting In An Economic Context Case Packet Sloan Space Syllabus Schedule Homework assignments Textbook problem solutions Sample exams
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Few quick issues

Access to MITServer

MIT students Non-MIT students

First point of contact: TAs

Best way to contact me: email Syllabus:

Schedule conflict April 26 material

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Course Grading

Written Problem Sets Class participation Midterm 1 Midterm 2 Final

10% 10 20 20 40

Accounting Introduction

Discussion of Accounting Course objective

user

Why is accounting interesting? Why do we need accounting? Sophisticated financial statement

information

An overview of financial
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What is Accounting trying to do? Demand for Information

Financial Accounting

provides information primarily to people outside the company provides information that would be helpful in attracting capital
Equity and debt (useful in debt contracts) Credit from suppliers Customers Employees

Managerial Accounting

provides information to people inside the company

Internal investment decisions Performance evaluation

Tax Accounting

provides information to the tax authorities

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Why do We Need Financial Accounting?

Resources Today Company

Outsiders - investors - employees - suppliers

Resources Tomorrow

Why do We Need Financial Accounting?

Financial Financialaccounting accountingpromotes promotesthe theexchange exchangeof ofresources resources

Resources Today Company Information (e.g., financial statements) Resources Tomorrow

Outsiders - Investors - Suppliers - Creditors

Nature of Financial Accounting Information

Useful to those making investment and credit decisions,

who have a reasonable understanding of business and economic activities. Helpful to present and potential investors creditors other users in assessing the amount, timing, and uncertainty of future cash
flows.

Provides information about economic resources, the

claims to those resources, and the changes in them.

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How important is this information?

The Reaction of Walmart Stock to Announcement of 3rd Quarter Earnings
59.5 59 58.5 58 57.5

ST O C K PR IC E

57 56.5 56 55.5 55 54.5 54 1-Nov-03

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3-Nov-03 5-Nov-03 7-Nov-03 9-Nov-03 11-Nov-03 13-Nov-03 15-Nov-03 17-Nov-03 19-Nov-03 21-Nov-03 23-Nov-03 DATE

Financial Accounting Introduction

Discussion of Accounting Course objective

Why is accounting interesting? Why do we need accounting?

Sophisticated financial

An overview of financial
information
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statement user

WHAT IS OUR COURSE OBJECTIVE?

To become intelligent users of accounting information Be comfortable looking through an annual report Learn the language and techniques Begin to develop the ability to use financial statements to assess a companys performance Have a sense of the limitations of financial statement data What are not our objectives to train you to be an accountant or bookkeeper Financial Statement Analysis - take 15.535
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World of a Sophisticated Financial Statement User

Events are occurrences that affect the firm. Examples include: 1) Microsoft sued by the Justice Department 2) McDonald's sells hamburgers 3) United Airlines workers go on strike 4) The GAP announces a new marketing strategy for its Old Navy Clothing stores
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World of a Sophisticated Financial Statement User

Events / Actions

Rules & Management choices

Financial Statements
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World of a Sophisticated Financial Statement User

Financial Accounting = translates events into financial statements
Events

Rules & Management choice

Generally Accepted Accounting Principals (GAAP) Management selects from alternative rules and from allowable estimates under GAAP
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Financial Statements

Three keys to becoming a sophisticated financial statement user

Understand the rules and managements

discretion

Understand what explains the rules and

the type of management discretion

Incentives

Understand how events affect firm value

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Financial Accounting Introduction

Discussion of Accounting Course objective

Why is accounting interesting? Why do we need accounting? Sophisticated financial statement user

An overview of financial information

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Accounting is complex and interesting because Diversity of businesses and events Many different players Diverse incentives
Economic Other Uncertainty Many regulations

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Financial Accounting Introduction

Discussion of Accounting Course objective

user

Why is accounting interesting Why do we need accounting? Sophisticated financial statement

information

An overview of financial
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Financial Reporting Requirements Audited Annual Report (10-K) Unaudited Quarterly Reports (10-Q) Current Reports (8-K)

within 10 days of the end of a month

Foreign Companies (20-F)

containing a significant event (e.g., major asset sales, changes in ownership, bankruptcy, changing the auditor)

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Focus: The Annual Report

The Management Letter
Management discussion on developments during the
year and current state of the company

The Financial Statements The Auditors Report

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Financial Reports: The Auditor's Report

GAAS (Generally Accepted Auditing Standards)
Reasonable assurance that financial statements are free of
material misstatement Assess the accounting principles used and significant estimates made by management

Actual opinion
financial statements present fairly, in all material respects, the
financial position, the results of operations, etc. are in conformity with GAAP (Generally Accepted Accounting Principles).
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Financial Reports: The Auditors Report

Management responsible for
and judgments.

the preparation and integrity of the financial statements, etc.

Statements prepared in accordance with GAAP. Estimated amounts based on management's best estimates

Maintenance of an internal control system to ensure that

assets are safeguarded and transactions are properly authorized, recorded and reported.

The Board has an Audit Committee composed

to the Audit Committee.

entirely of outside directors This committee appoints the auditor who has direct access

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Financial Statements
Contain primarily historical Information Balance Sheet Assets, liabilities & owners equity Income Statement Revenue (-) Expenses = Net Income Statement of retained earnings Cumulative sum of undistributed profits Statement of cash flows Operating, Investing and Financing activities Footnotes

Significant accounting policies, estimates, etc.

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Financial Statements: Balance Sheet

Balance sheet is a statement of the

financial position of a business as of a certain date. Assets, e.g., cash, accounts receivable, equipment, land Liabilities -- amounts/services owed by the company, e.g., loans payable, accounts payable, customer advances, etc. Stockholders equity -- initial investment by the owners (capital stock -- common and preferred stocks) plus the sum of undistributed profits (retained earnings)
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Financial Statements: Income Statement

Income statement measures the performance of a company over a period of time Revenues -- a measure of economic benefits generated by the sale of products or providing of services over a period of time Expenses -- a measure of economic sacrifices incurred to earn the revenues of a given period Examples of expenses -- cost of inventory sold, salaries to employees, rent and lighting,, advertising, ....... Net income = revenues (-) expenses
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Dividends

Are dividends paid to owners considered an

expense? Owners are residual claimants Dividends are distributions to the owners out of the

profits earned by the business In determining accounting profits to the residual owners, we only subtract the costs of all factors of production, e.g., physical capital (depreciation), human capital (salaries), debt capital (interest cost), etc. Dividends are not a factor of production
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Financial Statements: Retained Earnings & Shareholders Equity

Retained earnings

A measure of undistributed profits of a business Do not include capital contributed by owners Retained earnings = Cumulative sum of profits earned from the inception of business (-) Cumulative sum of all dividends distributed to the owners from the inception of business Statement of shareholders equity describes the change in retained earnings over a period of time (e.g., a year) Beginning balance in retained earnings Add Net income earned during the period Subtract Dividends distributed during the period Ending balance in retained earnings

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Summary

Accounting is a complex field contrary to

common perceptions.

Financial accounting information facilitates the

exchange of resources.

To become a sophisticated financial statement

user, you need to understand how the information in financial statements is recorded.
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