Accounting

Overview of Week 1

 Administrative stuff
 What is financial accounting?

 Some Myths

 Accrual versus Cash-based

 Financial statements

 GAAP

 Auditing
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

 Managerial

 Non-profit

 Tax
 Accrual Accounting
Accrual 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 + Equity
Uses 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 is
 Objective
 Verifiable
 Therefore, 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 maturity
 Current 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 capital
 Retained 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.
 Exhibit 1.5 The Relationship Among the Basic Financial Statements

Change in Cash

Operating cash flows

Investing cash flows
Financing cash flows

Statement of cash flows

Cash Liabilities
Cash Liabilities
____ Income
statement ____
-------- Share-
Balance holders’ -------- Share- Balance
Sheet equity Revenues holders’ Sheet
(beginning -------------- equity (end of
Other
of period) Expenses Other period)
assets
-------------- assets
Dividends
Net income

Change in shareholders’ equity

Statement of shareholders’ equity

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 depreciation
 Other possibilities include cost, net
realizable value, replacement cost, price
level adjusted
 Not all assets appear
 Human capital, internally generated goodwill
• Could be argued that approach is more
conservative
Financial Statement
Limitations
 Not all liabilities appear
 Contingencies appear only in the
footnotes
 Off 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