326 - Financial 326 - Financial AccountingAccounting

Prof: Jim WallaceProf: Jim Wallace

TA: Charles YehTA: Charles Yeh

Overview of Week 1Overview of Week 1

Administrative stuffAdministrative stuff What is financial accounting?What is financial accounting? Financial statementsFinancial statements What number do you want?What number do you want? GAAPGAAP

Administrative StuffAdministrative Stuff

Who am IWho am I Who is your T.A.Who is your T.A. Available helpAvailable help Teaching philosophyTeaching philosophy SyllabusSyllabus Homework, testsHomework, tests CalculatorCalculator

Web Access to Class InfoWeb Access to Class Info The site should contain:The site should contain:

SyllabusSyllabus PowerPoint slidesPowerPoint slides HandoutsHandouts Homework solutionsHomework solutions

http://wfs.cgu.edu/wallacja/326F05/http://wfs.cgu.edu/wallacja/326F05/

I will be creating a new web site during the I will be creating a new web site during the quarter that will replace this temporary quarter that will replace this temporary solution.solution.

What is Financial What is Financial Accounting?Accounting?

A method to communicate financial A method to communicate financial information to interested external information to interested external parties.parties.

Users include capital providers, Users include capital providers, regulators, customers, suppliers, regulators, customers, suppliers, employees, etcemployees, etc

Capital suppliers include debt and equity Capital suppliers include debt and equity providersproviders

Financial accounting is used for both Financial accounting is used for both prediction and controlprediction and control

Some PreconceptionsSome Preconceptions- Misconceptions?- Misconceptions?

Accounting yields the “truth.”Accounting yields the “truth.” Accounting is rigid.Accounting is rigid. Accounting is useless.Accounting is useless. Accounting is hard!Accounting is hard! Accountants are boring.Accountants are boring.

Other Types of Other Types of AccountingAccounting

ManagerialManagerial Non-profitNon-profit TaxTax

The Financial StatementsThe Financial Statements The accounting equationThe accounting equation Balance SheetBalance Sheet Income StatementIncome Statement Statement of Cash FlowsStatement of Cash Flows Statement of Owners Equity Statement of Owners Equity

Statement of retained earningsStatement of retained earnings

Balance SheetBalance Sheet Mirrors the Accounting Equation Mirrors the Accounting Equation

Assets = Liabilities + EquityAssets = Liabilities + Equity Uses of funds = Sources of fundsUses of funds = Sources of funds Assets are listed in order of liquidityAssets are listed in order of liquidity

Current and non-current Current and non-current Liabilities are listed in order of Liabilities are listed in order of

maturitymaturity Equity consists of Contributed Capital Equity consists of Contributed Capital

andand Retained EarningsRetained Earnings

AssetsAssetsTo be reported on a balance sheet, an To be reported on a balance sheet, an

asset mustasset must1.1. Be owned or controlled by the Be owned or controlled by the

companycompanya)a) Generally, this means owning title Generally, this means owning title

to the assetto the assetb)b) Leased assets are recorded under Leased assets are recorded under

certain circumstancescertain circumstances2.2. Must possess expected future Must possess expected future

benefitsbenefitsa)a) When the receipt of future benefits When the receipt of future benefits

is in doubt, the asset may become is in doubt, the asset may become “impaired” and written down of off “impaired” and written down of off entirelyentirely

Most Assets are Reported at Most Assets are Reported at

Historical CostHistorical Cost Historical Cost isHistorical Cost is

ObjectiveObjective VerifiableVerifiable Therefore, not subject to biasTherefore, not subject to bias

However, historical cost is not However, historical cost is not particularly “relevant” to most particularly “relevant” to most readers of the balance sheetreaders of the balance sheet

““Relevance vs. Reliability” is an Relevance vs. Reliability” is an important issue with accountants.important issue with accountants.

Disney’s AssetsDisney’s Assets

LiabilitiesLiabilities Liabilities are listed in order of maturityLiabilities are listed in order of maturity

Current Liabilities come due in less than a Current Liabilities come due in less than a year.year.

Noncurrent liabilities come due after a year.Noncurrent liabilities come due after a year. Companies desire more current assets Companies desire more current assets

than current liabilities – this difference than current liabilities – this difference is called net working capitalis called net working capital

Disney’s Liabilities and Disney’s Liabilities and EquityEquity

Equity Equity

Equity consists of: Equity consists of:

Contributed Capital (cash raised Contributed Capital (cash raised from the issuance of shares)from the issuance of shares)

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

Market Value vs. Book Market Value vs. Book ValueValue

Stockholders’ equity = Company book valueStockholders’ equity = Company book value

Book value is determined using GAAP. Book value is determined using GAAP. Book value is not the same as Market Book value is not the same as Market

Value.Value. Market Value = # of Shares x Price per Market Value = # of Shares x Price per

shareshare On average, US company book value is On average, US company book value is

roughly two-thirds of market value.roughly two-thirds of market value.

Income StatementIncome Statement

Walt Disney’s Income Walt Disney’s Income StatementStatement

Accrual AccountingAccrual Accounting

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

Accrual AccountingAccrual AccountingAccrual accounting rests on two Accrual accounting rests on two guiding principles:guiding principles:

Revenue Recognition Principle – record Revenue Recognition Principle – record revenue whenrevenue when EarnedEarned Realized or RealizableRealized or Realizable

Matching Principle – record expenses Matching Principle – record expenses whenwhen IncurredIncurred

Neither the recognition of revenue nor Neither the recognition of revenue nor the recording of expense necessarily the recording of expense necessarily involves the receipt or payment of cashinvolves the receipt or payment of cash

Accrual ExampleAccrual ExampleAssume the following:• Purchase of $100 of inventory on account• Sale of all of the inventory for $150 on

account• Employees earn $20 of wages to be paid

next period

In Class ExampleIn Class Example

Baron CoburgBaron Coburg

Statement of Stockholders’ Statement of Stockholders’ EquityEquity

Statement of Equity is a Statement of Equity is a reconciliation of the beginning reconciliation of the beginning and ending balances of and ending balances of stockholders’ equity accounts.stockholders’ equity accounts.

Main equity categories are:Main equity categories are: Contributed capitalContributed capital Retained earnings (including Other Retained earnings (including Other

Comprehensive Income or OCI)Comprehensive Income or OCI) Treasury stockTreasury stock

Disney’s Statement of Disney’s Statement of Stockholders’ EquityStockholders’ Equity

Statement of Cash FlowsStatement of Cash Flows

Statement of cash flows (SCF) reports Statement of cash flows (SCF) reports cash inflows and outflowscash inflows and outflows

Cash flows are reported based on the Cash flows are reported based on the three business activities of a company:three business activities of a company:

1.1. Operating activitiesOperating activities: transactions related : transactions related to the operations of the business.to the operations of the business.

2.2. Investing activitiesInvesting activities: acquisitions and : acquisitions and divestitures of long-term assetsdivestitures of long-term assets

3.3. Financing activitiesFinancing activities: issuances and : issuances and payments toward equity, borrowings, and payments toward equity, borrowings, and long-term liabilities.long-term liabilities.

Walt Walt Disney Disney

Company’s Company’s Statement Statement

of Cash of Cash FlowsFlows

Articulation of Financial Articulation of Financial StatementsStatements

Financial statements are linked Financial statements are linked within and across time – they within and across time – they articulatearticulate..

Balance sheet and income statement Balance sheet and income statement are linked via retained earnings.are linked via retained earnings.

Absent of equity transactions such Absent of equity transactions such as stock issuances and purchases as stock issuances and purchases and dividend payments, the change and dividend payments, the change in stockholders’ equity equals the in stockholders’ equity equals the income or loss for the period.income or loss for the period.

Oversight of Financial Oversight of Financial AccountingAccounting

GAAPGAAP Oversight of Financial Oversight of Financial

AccountingAccounting SEC oversees all publicly traded SEC oversees all publicly traded

companiescompanies Financial Accounting Standards Financial Accounting Standards

Board (FASB)Board (FASB) Generally Accepted Accounting Generally Accepted Accounting

Principles (GAAP)Principles (GAAP)

Sarbanes-Oxley Act Sarbanes-Oxley Act The SEC requires the CEO and CFO of a company to The SEC requires the CEO and CFO of a company to

personally sign a statement attesting to the personally sign a statement attesting to the accuracy and completeness of the company’s accuracy and completeness of the company’s financial statements. financial statements.

The statements signed by both the CEO and CFO The statements signed by both the CEO and CFO contain the following commitments:contain the following commitments: The CEO and CFO have personally reviewed the annual The CEO and CFO have personally reviewed the annual

reportreport There are no untrue statements of a material fact or failure There are no untrue statements of a material fact or failure

to state a material fact necessary to make the statements to state a material fact necessary to make the statements not misleadingnot misleading

The financial statements fairly present in all material The financial statements fairly present in all material respects the financial condition of the company respects the financial condition of the company

All material facts are disclosed to the company’s auditors All material facts are disclosed to the company’s auditors and Board of Directorsand Board of Directors

No changes to the company’s system of internal controls No changes to the company’s system of internal controls are made unless properly communicatedare made unless properly communicated

Basic Assumptions and Basic Assumptions and PrinciplesPrinciples

Monetary UnitMonetary Unit Fiscal periodFiscal period Going concernGoing concern Stable dollarStable dollar ObjectivityObjectivity ConsistencyConsistency

Versus comparabilityVersus comparability

Question?Question?Financial statements must contain Financial statements must contain

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

Exceptions to the Exceptions to the Basic PrinciplesBasic Principles

MaterialityMateriality Only transactions with amounts large Only transactions with amounts large

enough to make a difference are enough to make a difference are considered materialconsidered material

Non-material transactions are ignoredNon-material transactions are ignored ConservatismConservatism

When in doubt…When in doubt… Understate assetsUnderstate assets Overstate liabilitiesOverstate liabilities Accelerate recognition of lossesAccelerate recognition of losses Delay recognition of gainsDelay recognition of gains

Information Beyond Information Beyond Financial StatementsFinancial Statements

Management Discussion and Management Discussion and Analysis (MD&A)Analysis (MD&A)

Independent Auditor ReportIndependent Auditor Report Financial Statement FootnotesFinancial Statement Footnotes Regulatory Filings and Proxy Regulatory Filings and Proxy

StatementsStatements

Audit ReportAudit Report Financial statements Financial statements present fairlypresent fairly and and in all in all

material respectsmaterial respects company financial condition. company financial condition. Financial statements are prepared in conformity Financial statements are prepared in conformity

with GAAPwith GAAP Financial statements are management’s Financial statements are management’s

responsibility. Auditor responsibility is to express an responsibility. Auditor responsibility is to express an opinion on those statementsopinion on those statements

Auditing involves a sampling of transactions, not Auditing involves a sampling of transactions, not investigation of each transactioninvestigation of each transaction

Audit opinion provides Audit opinion provides reasonable assurancereasonable assurance that that the statements are free of the statements are free of material material misstatements misstatements

Auditors review accounting policies used by Auditors review accounting policies used by management and estimates used in preparing the management and estimates used in preparing the statementsstatements

Question?Question?The SEC requires all publicly traded The SEC requires all publicly traded

companies to have their financial companies to have their financial statements audited. Prior to this statements audited. Prior to this requirement many companies requirement many companies voluntarily had their statements voluntarily had their statements audited. Given the cost and audited. Given the cost and inconvenience, why would they do inconvenience, why would they do this?this?

Transaction AnalysisTransaction Analysis

Transaction analysis is the process of Transaction analysis is the process of identifying impacts of transactions and identifying impacts of transactions and events on the balance sheet, income events on the balance sheet, income statement, or both.statement, or both.

We use the following template:We use the following template:

Journal EntriesJournal Entries

Transaction AnalysisTransaction Analysis

Credit Sales TransactionCredit Sales Transaction

Expense Payment Expense Payment TransactionTransaction

Accrued Expense Accrued Expense TransactionTransaction

Deferred Revenue Deferred Revenue TransactionTransaction

Asset Write-Down Asset Write-Down (Impairment) Transaction(Impairment) Transaction

What Number Do You What Number Do You Want?Want?

Accounting is a political process, not Accounting is a political process, not an exact science.an exact science.

There is a great deal of discretion There is a great deal of discretion available to managers.available to managers.

Earnings ManagementEarnings Management Reasons to manage earningsReasons to manage earnings

ACCOUNTING NUMBERS HAVE ACCOUNTING NUMBERS HAVE ECONOMIC CONSEQUENCES ECONOMIC CONSEQUENCES BEYOND SIMPLY RECORDING BEYOND SIMPLY RECORDING TRANSACTIONSTRANSACTIONS

Earnings Management - Earnings Management - WhyWhy

Compensation contractsCompensation contracts

Debt contractsDebt contracts

Political considerationsPolitical considerations

Question?Question?Why might a company’s stockholders Why might a company’s stockholders

want its managers to be paid part of want its managers to be paid part of their total compensation as a bonus their total compensation as a bonus or stock instead of a straight cash or stock instead of a straight cash salary?salary?

Debt ContractsDebt Contracts

Firms that are near violation of their Firms that are near violation of their debt contracts have incentives to debt contracts have incentives to manage earnings upward.manage earnings upward.

Question?Question?The following excerpt was taken from a The following excerpt was taken from a

recent financial statement of Cummins recent financial statement of Cummins Engine Company:Engine Company:

Loan agreements contain covenants which Loan agreements contain covenants which impose restrictions on the payment of impose restrictions on the payment of dividends and distribution of stock, require dividends and distribution of stock, require maintenance of a 1.25:1 current ratio, and maintenance of a 1.25:1 current ratio, and limit the amount of future borrowings.limit the amount of future borrowings.

Why would a creditor such as a bank impose Why would a creditor such as a bank impose such restrictions when making a loan?such restrictions when making a loan?

Political ReasonsPolitical Reasons

Firms may wish to portray a certain Firms may wish to portray a certain image to the public, government, or image to the public, government, or regulatory body.regulatory body.

Common Earnings Common Earnings ManagementManagement

Smoothing earningsSmoothing earnings Managing earnings upwardManaging earnings upward Taking a bathTaking a bath Off balance sheet financingOff balance sheet financing

TakeawaysTakeaways

Financial statements that are produced Financial statements that are produced are the result of one possible set of rules are the result of one possible set of rules that have resulted from a political that have resulted from a political process.process.

Users need to be aware of these Users need to be aware of these limitations.limitations.

Users should read the notes to the Users should read the notes to the financial statements since these contain financial statements since these contain a lot of useful guidance to interpreting a lot of useful guidance to interpreting the statements. the statements.

Financial Statement Financial Statement LimitationsLimitations

Assets are valued at historical cost Assets are valued at historical cost less an estimated depreciationless an estimated depreciation Other possibilities include cost, net Other possibilities include cost, net

realizable value, replacement cost, price realizable value, replacement cost, price level adjustedlevel adjusted

Not all assets appearNot all assets appear Human capital, internally generated Human capital, internally generated

goodwillgoodwill Could be argued that approach is more Could be argued that approach is more

conservativeconservative

Financial Statement Financial Statement LimitationsLimitations

Not all liabilities appearNot all liabilities appear Contingencies appear only in the Contingencies appear only in the

footnotesfootnotes Off balance sheet financingOff balance sheet financing Employee stock optionsEmployee stock options

Other limitations include Other limitations include management biases and a lack of management biases and a lack of timelinesstimeliness

Financial Accounting: Financial Accounting: not an exact sciencenot an exact science

GAAP allows companies choices in GAAP allows companies choices in preparing financial statements preparing financial statements (inventories, property, and (inventories, property, and equipment). equipment).

Financial statements also depend on Financial statements also depend on countless estimates.countless estimates.

Financial Accounting in Financial Accounting in ContextContext

A company’s financial statements only A company’s financial statements only tell part of the story.tell part of the story.

You must continually keep in mind the You must continually keep in mind the world in which the company operates.world in which the company operates.

Financial statement analysis must be Financial statement analysis must be conducted within the framework of a conducted within the framework of a thorough understanding of the thorough understanding of the broader forces which impact company broader forces which impact company performance. performance.