326 - financial accounting prof: jim wallace
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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.