WELCOME TO WELCOME TO ACCOUNTING AND FINANCEACCOUNTING AND FINANCE

"I'll tell you, Harris, they don't make accountants like they used to. Those I had in the 1990s never brought me figures like these."

Cartoon by Dave CarpenterCopyright 2002, Harvard Business Review

ACCOUNTING AND FINANCEACCOUNTING AND FINANCE

OBJECTIVESACCOUNTINGACCOUNTING

Recording and Reporting Financial ActivitiesRecording and Reporting Financial ActivitiesThree Reports and Analytical MetricsThree Reports and Analytical Metrics

FINANCEFINANCESources of Funds: Debt versus EquitySources of Funds: Debt versus EquityImplications of Funding Sources on Firm Implications of Funding Sources on Firm Governance and ValueGovernance and Value

ACCOUNTING AND FINANCEACCOUNTING AND FINANCE

Definitions

Accounting’s FunctionAccounting’s Function: Recording : Recording and and Reporting a Firm’s Financial HistoryReporting a Firm’s Financial History

Finance’s FunctionFinance’s Function: Managing a Firm’s : Managing a Firm’s Capital StructureCapital Structure

ACCOUNTING AND FINANCEACCOUNTING AND FINANCE

Accounting’s FocusAccounting’s Focus Consistency: Financial Reporting in support Consistency: Financial Reporting in support

of Comparative Decision-Makingof Comparative Decision-Making Regulation: Detect Non-Compliant or Regulation: Detect Non-Compliant or

Unacceptable PracticesUnacceptable Practices Taxation: Adjustments that convert Taxation: Adjustments that convert

Profits into IncomeProfits into Income

ACCOUNTING AND FINANCEACCOUNTING AND FINANCE

Finance’s FocusFinance’s Focus

Reconcile Sources and Uses of Cash: Match Reconcile Sources and Uses of Cash: Match Timing and Amounts of Operating and Timing and Amounts of Operating and Capital NeedsCapital Needs

Evaluate Implications of Capital Structure Evaluate Implications of Capital Structure Choices: Impacts of Rights and Claims of Choices: Impacts of Rights and Claims of Funding Sources on Firm’s Governance Funding Sources on Firm’s Governance and and ValueValue

ESSENTIAL ACCOUNTING REPORTSESSENTIAL ACCOUNTING REPORTS

Balance SheetBalance Sheet

Income StatementIncome Statement

Statement of Cash Statement of Cash

FlowsFlows

BALANCE SHEETBALANCE SHEET

Reports Assets, Liabilities and Equity Assets: Property Owned by Firm Liabilities: Debts and Financial Obligations Equity: Stock Sales/Investments and

Retained Earnings Reports Financial Condition as of Specified Date

(Month/Quarter/Year End) Amounts reported at Lower of Cost or Market Value

INCOME STATMENTINCOME STATMENT

Reports Revenues, Expenses, Profits and Reports Revenues, Expenses, Profits and IncomeIncome

Profits are Financial Results of Firm’s Profits are Financial Results of Firm’s OperationsOperationsIncome includes Allowable Adjustments to Income includes Allowable Adjustments to Profits for Tax and Investment ReportingProfits for Tax and Investment ReportingInformation Reported for Prior Period (Month, Information Reported for Prior Period (Month, Quarter or Year)Quarter or Year)

STATEMENT OF CASH FLOWSSTATEMENT OF CASH FLOWS

Reports Sources and Uses of Cash and…Reports Sources and Uses of Cash and…Categorizes Uses by Nature of ActivityCategorizes Uses by Nature of Activity

OperatingOperating – Cash Generated by and Used in – Cash Generated by and Used in Core Core Business FunctionBusiness FunctionInvestingInvesting – Cash used to Purchase Assets and – Cash used to Purchase Assets and Generated from Selling AssetsGenerated from Selling AssetsFinancingFinancing – Cash used to pay Debts or – Cash used to pay Debts or Dividends Dividends and Generated from Borrowings or and Generated from Borrowings or Equity InvestmentsEquity Investments

ESSENTIAL ACCOUNTING CONCEPTSESSENTIAL ACCOUNTING CONCEPTS

The Accounting Equation

Assets = Liabilities + EquityAssets = Liabilities + Equity

Variation for Business Valuation: Variation for Business Valuation: Equity = Assets – LiabilitiesEquity = Assets – Liabilities

ACCOUNTING QUANDRIESACCOUNTING QUANDRIES

When to Recognize/When to ReportWhen to Recognize/When to Report

When is Income Earned? When is an When is Income Earned? When is an Expense Incurred?Expense Incurred?

What is “It?”What is “It?”

Is “It” a “Current Operating Expense” or an Is “It” a “Current Operating Expense” or an “Asset with Revenue-Generating Capacity?”“Asset with Revenue-Generating Capacity?”

Is Managing Earnings a “Material Misstatement” or Is Managing Earnings a “Material Misstatement” or Good Management?Good Management?

ACCOUNTING QUANDRIESACCOUNTING QUANDRIES

Who Audits the Auditors?Who Audits the Auditors?Which Rule Provides Better Information?Which Rule Provides Better Information?

Transactions that are reported when…Transactions that are reported when…Cash is Received or Paid (Cash Basis) or...Cash is Received or Paid (Cash Basis) or...Services or Products are Performed (Accrual Basis)Services or Products are Performed (Accrual Basis)

GAAP says to Report Transactions when their Primary GAAP says to Report Transactions when their Primary Purpose is accomplished (Payment not relevant)Purpose is accomplished (Payment not relevant)

Business Management and Creditors concerned with Business Management and Creditors concerned with when when Cash is Received or PaidCash is Received or Paid

THREE ESSENTIAL METRICSTHREE ESSENTIAL METRICS

Current RatioCurrent Ratio

Debt-to-Equity RatioDebt-to-Equity Ratio

Return-on-Equity RatioReturn-on-Equity Ratio

THREE ESSENTIAL THREE ESSENTIAL METRICSMETRICS

CURRENT RATIOCURRENT RATIOMeasures Firm’s Liquidity; Calculates Relationship between Measures Firm’s Liquidity; Calculates Relationship between Available Cash and Short-Term Liabilities (less than 1 Available Cash and Short-Term Liabilities (less than 1

year until due)year until due)FORMULAFORMULA: : Current Assets Current Assets Current Liabilities Current LiabilitiesANALYSISANALYSIS:: Minimum Level - 1.2:1Minimum Level - 1.2:1

Analyze Trends: Changes caused by Analyze Trends: Changes caused by decreasing cash or increasing liabilities?decreasing cash or increasing liabilities?

THREE ESSENTIAL THREE ESSENTIAL METRICSMETRICS

DEBT-TO-EQUITY RATIODEBT-TO-EQUITY RATIOEvaluates Capital Structure: Mix of How Firm is Evaluates Capital Structure: Mix of How Firm is

Financed – Debt versus Equity (“Leveraging”) Financed – Debt versus Equity (“Leveraging”) FORMULAFORMULA: Debt : Debt Equity EquityANALYSISANALYSIS: Debt requires Mandatory Periodic : Debt requires Mandatory Periodic

Cash Payments; Equity does notCash Payments; Equity does not Evaluate Evaluate Mandatory Fixed Cost BurdenMandatory Fixed Cost Burden

THREE ESSENTIAL THREE ESSENTIAL METRICSMETRICS

RETURN-ON-EQUITYRETURN-ON-EQUITY Measures Rate of Return produced by Firm for its Equity Measures Rate of Return produced by Firm for its Equity

InvestorsInvestorsFORMULAFORMULA: Net Income : Net Income Shareholders Equity Shareholders EquityANALYSISANALYSIS: Measure of Return from Investing in : Measure of Return from Investing in

Aggregate Risks of Firm Management, Aggregate Risks of Firm Management, Product and Market Share Product and Market Share

Note: Not Return-on-Investment (individual Note: Not Return-on-Investment (individual shareholder returns)shareholder returns)

Southwest received 225,895 resumes and hired 1706 new Southwest received 225,895 resumes and hired 1706 new Employees in 2004Employees in 2004

In 2004 Southwest served 49 million cans of soda, juices, In 2004 Southwest served 49 million cans of soda, juices, and water; 8.1 million alcoholic beverages; 3.3 million and water; 8.1 million alcoholic beverages; 3.3 million bags of pretzels; 95.3 million bags of peanuts; and bags of pretzels; 95.3 million bags of peanuts; and

28 28 million other snacksmillion other snacks Southwest consumed 1.2 billion gallons of fuel in 2004Southwest consumed 1.2 billion gallons of fuel in 2004 Shortest daily Southwest flight: Austin and Houston (149 Shortest daily Southwest flight: Austin and Houston (149

miles). Longest daily Southwest flight: Philadelphia miles). Longest daily Southwest flight: Philadelphia and and Oakland (2,510 miles)Oakland (2,510 miles)

Southwest's average airfare is $88.57 and trip length is about Southwest's average airfare is $88.57 and trip length is about 753 miles753 miles

Since 1987, Southwest has ranked number one in fewest Since 1987, Southwest has ranked number one in fewest overall Customer complaintsoverall Customer complaints

In 1973, Southwest adopted the airline industry’s first profit-In 1973, Southwest adopted the airline industry’s first profit-sharing plan; Employees own about 10% of the Companysharing plan; Employees own about 10% of the Company

Southwest is about 81% unionizedSouthwest is about 81% unionized The Southwest Airlines LUV Classic golf tournaments have The Southwest Airlines LUV Classic golf tournaments have

provided over $7 million to Ronald McDonald Housesprovided over $7 million to Ronald McDonald Houses

CAPITAL STRUCTURECAPITAL STRUCTURE

Sources for Funds

Selection Criteria: Selection Criteria: (1) Sufficient Amount from Fewest (1) Sufficient Amount from Fewest

Number of Sources Number of Sources and…and…

(2) Optimize Direct and Indirect Costs(2) Optimize Direct and Indirect Costs

CAPITAL STRUCTURECAPITAL STRUCTURE

Sources of Funds may be either:Sources of Funds may be either:

Internally Generated or…Internally Generated or…

Externally Obtained Debt or EquityExternally Obtained Debt or Equity

Choice depends on Timing, Available Amounts Choice depends on Timing, Available Amounts and Costs to Obtain and Costs to Obtain andand… Implications for … Implications for Future Operations and GovernanceFuture Operations and Governance

CAPITAL STRUCTURECAPITAL STRUCTURE

Internally Generated FundingInternally Generated Funding: : Retained Earnings (No Dividend Payout), Retained Earnings (No Dividend Payout), Vendor Financing or Sales TermsVendor Financing or Sales Terms

No Application/Approval ProcessNo Application/Approval Process

Immediately AvailableImmediately Available

No Cash Flow or Governance ImplicationsNo Cash Flow or Governance Implications

CAPITAL STRUCTURECAPITAL STRUCTURE

External Funding: Debt

Obtained from Commercial Banks, Finance Obtained from Commercial Banks, Finance Companies and Private PartiesCompanies and Private Parties

Availability subject to Creditworthiness and Debt Availability subject to Creditworthiness and Debt Servicing CapacityServicing CapacityNegative Covenants: Restrictions on Other Negative Covenants: Restrictions on Other Borrowings, Profitability, Current Ratio and more…Borrowings, Profitability, Current Ratio and more…Cash Flow Implications: Repayment Terms, Interest Cash Flow Implications: Repayment Terms, Interest

Charges, Fees, Reports and more…Charges, Fees, Reports and more…

CAPITAL STRUCTURECAPITAL STRUCTURE

External Funding: EquityObtained from Investment Banker : Public Equity through Stock Offering or Initial Public Offering (IPO) or…

Private Party: Venture Capital Sale of Fractional Ownership: Cost will be tradeoff Sale of Fractional Ownership: Cost will be tradeoff between Capital received and Control Given upbetween Capital received and Control Given upControl Rights include Employment Agreements, Control Rights include Employment Agreements, Board Board Memberships, Decision-Making and Memberships, Decision-Making and Voting InterestsVoting Interests

DEBT VERSUS EQUITYDEBT VERSUS EQUITY

DEBTRules-Based: Terms and Conditions negotiated Rules-Based: Terms and Conditions negotiated ex ex ante ante and documented in legally binding contractand documented in legally binding contract

Repayment required on Date CertainRepayment required on Date Certain

Periodic Debt ServicePeriodic Debt Service

Lender’s Claim limited to Loan Amount and Specific Lender’s Claim limited to Loan Amount and Specific or General Assets Claimor General Assets Claim

"Debt is like cholesterol: There's 'good' debt and there's 'bad' debt."

Cartoon by Dave Carpenter Copyright 2004, Harvard Business Review

DEBT VERSUS EQUITYDEBT VERSUS EQUITY

EQUITYEQUITY

Discretion-Based: Terms and Conditions Discretion-Based: Terms and Conditions negotiated for negotiated for ex postex post application, but application, but not specifiednot specified

Repayment and Dividends not requiredRepayment and Dividends not required

Consideration for Investment includes Consideration for Investment includes Limited Liability and Voting Rights Limited Liability and Voting Rights

FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT

Primary Responsibility: Reconcile Sources and Uses of Cash

Operating NeedsOperating NeedsGrowth, Contraction or New EnterprisesGrowth, Contraction or New EnterprisesInternal and External ContingenciesInternal and External ContingenciesStrategic Equilibrium: Income-Producing Character of Strategic Equilibrium: Income-Producing Character of Assets versus Costs and Implications of Capital Assets versus Costs and Implications of Capital StructureStructure

FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT

Capital Structure: Governance Implications

Use of Internal Funds (Retained Earnings)Use of Internal Funds (Retained Earnings)– Shareholder Expectations; Limit Availability of Other SourcesShareholder Expectations; Limit Availability of Other Sources

Use of External Debt (Commercial Bank Loans)Use of External Debt (Commercial Bank Loans)– Covenants may restrict Growth; Short-Term VariabilityCovenants may restrict Growth; Short-Term Variability

Use of External Equity (Sale of Ownership Interest)Use of External Equity (Sale of Ownership Interest)Implications of Voting RightsImplications of Voting Rights

ACCOUNTING AND FINANCEACCOUNTING AND FINANCE

Accounting’s RoleAccounting’s RoleKnow and Evaluate Results of DecisionsKnow and Evaluate Results of Decisions

Complexities of Product Development and GlobalizationComplexities of Product Development and Globalization

Finance’s RoleFinance’s RoleBalance Sheet’s Right Side as important as Firm’s AssetsBalance Sheet’s Right Side as important as Firm’s Assets

Develop Financing Methods for Innovative Growth with Develop Financing Methods for Innovative Growth with Intangible Assets and Knowledge-based WorkIntangible Assets and Knowledge-based Work