week 1: financial accounting

Mutual Investment Club of Cornell

Week 1: Financial Accounting

Sept. 8, 2010


Announcement

Get your junior analyst applications in by Friday at 11:59 PM.

JP Morgan Senior Speaker Event Monday, Sept. 13, 2010 Statler Hotel Fireside Chat: 5:00 – 6:00 p.m., Amphitheater Networking: 6:00 – 6:30 p.m., Yale/Princeton

Room For freshmen, sophomores and juniors

interested in summer opportunities in Investment Banking, IB Risk, Sales & Trading, and Research.


Schedule

Week Topic1 Accounting2 Corporate Finance3 Financial System4 Macroeconomics5 Basic Excel Valuation6 Advanced Excel Valuation7 Research Methods8 Jobs in finance9 Financial Products

10 Resume Review/Interviewing11 Mock-pitch12 Pitch idea generation


For today…

Introduction to accounting Three financial statements

Balance Sheet Income Statement Cash Flow Statement

Annual and Quarterly Reports


What is Financial Accounting? Accounting is a system for recording

financial information about a business and reporting it to decision makers

Financial accounting refers specifically to accounting for external decision makers: creditors, investors, suppliers, etc. This is what we care about.


The Balance Sheet

A list of the assets and liabilities of the firm at a particular time.

Can be thought of as a “snapshot” of the business at one point in time.

Three major components Assets: resources of the firm Liabilities: things the firm owes to others Stockholder’s equity: Everything else

Money investors put in or have reinvested from earnings.


Balance Sheet: XOM


The details

Current Assets are those that will be used up or can be sold within one year.

Current Liabilities have a maturity of less than one year.

Assets Investments: Money the firm has invested

in other companies (usually when it is sitting on a pile of cash)

Receivables: Money owed to the firm by others (usually customers)


The details

Liabilities Accounts payable: money owed by the firm

to suppliers, usually Deferred Long-term liability charges: a

collection of future liabilities of the firm.’

Stockholder’s equity Common stock: money that investors have

invested in the business. Retained earnings: money that has been

reinvested in the business from its profits.


Things to Notice

The Accounting Equation always holds Assets = Liabilities + Stockholder’s Equity Why?

Balance sheet items are recorded at the cost to acquire them, not at market value (for now).

The balance sheet is valid for a single date.

Note: All financial statements have notes accompanying them that explain some numbers.


The Income Statement

Statement showing revenues and expenses over a period.

Can be thought of as a continuous video of the firm over time.

Revenue is NOT the same as cash inflow and expenses are NOT the same as cash outflow. More on that soon

Income Statement: XOM


Amount paid for goods sold over the period (aka Cost of Goods Sold)

Op. expenses are those incurred in the normal operations of the business.

Calculating operating income or loss is important for determining income tax

Interest expense is not considered an operating expense: it does not relate to the normal operations of the business.


Why distinguish operating income/loss?

When examining a business, we want to be able to determine how much profit it can make from the business itself.

Interest expense adds noise: it reflects how the firm is financed, not how it operates. If we bought the business, we might radically change its capital structure, so we want to see a picture of the business that is independent of that.


Profit ≠ Cash Flow: example 1 The firm sells some inventory to a

customer on credit, due next month. Is that profit? Yes (assuming the

customer will pay). Is that cash flow? No.

In accounting, revenue is recorded when earned, not when cash is received.


Profit ≠ Cash Flow: example 2

A firm uses its cash reserves of $10,000,000 to buy a plant, and uses the plant to generate $2,000,000 of cash per year for 10 years.

It would not be very useful to say the firm had a loss of $10 m in the first year, and $2 m profit thereafter, even though that is our cash flow.

Instead, we can classify the purchase as an investing activity and include the cost of the plant as an expense over time as it is used This is a process called “depreciation.”


The Cash Flow Statement

Provides a summary of cash inflows and outflows over a specified period of time.

Like the income statement, it can be thought of as a continuous video over time.

This is the statement we care most about, as predicting future cash flows is the most important aspect of investing in stocks.


Cash Flow Statement: XOM

Operating Cash Flow (OCF) is calculated by making adjustments to Net Income for non-cash items on the income statement and balance sheet.

Not that important exactly how this is done, but just know that OCF is calculated indirectly from Net Income

ICF includes purchase and sale of plant, equipment, land, etc. and other investments.

FCF includes inflows and outflows related to financing the business. Inflows from investors and loans, outflows from paying dividends and paying debt.

Net Change in cash balances


Why distinguish O, I, and F?

As before, we are interested in seeing how much cash the business is capable of generating through its normal (operating) activities.

Cash flows from investing and financing activities are typically unrelated to this; that is, they generate noise around what we are really looking for.

By looking at operating activities, we get a feel for what kind of cash the business can generate even if we change its financing and investing cash flows


Another word on Depreciation

Suppose a business spends $10 m on a plant that is used to generate $2 m in profit per year for 10 years.

The company might “depreciate” the plant by $1 m per year for 10 years.

This depreciation will count as an expense on the income statement, so the firm will show $1 m in profit per year.

In this way we spread the cost out over the useful life of the plant.


Reports

Released annually and quarterly Mandated by the Securities & Exchange

Commission (SEC).


Reports

Annual report includes: Non-financial section

Discusses the company and its operations Financial section

The main financial statements Financial history for 5 or 10 years Management’s discussion Other minor things

Quarterly report Less rigorous than annual report Unaudited


SEC Filings

Form 10-K: annual Everything in the annual report More detailed description of the business Etc.

Form 10-Q: Quarterly Everything in the quarterly report More detailed description of the business Etc.


Why do reports and filings matter? They are an excellent first source when

evaluating a company. They contain detailed information

about the company’s financial and non-financial history, operations, management, etc.

If you want to learn more about a company, pull up its annual report and see what you find.


Further Information

Books Financial Accounting by Libby, Libby &

Short Courses at Cornell

AEM 2210 (I’m a TA for that) HADM 2210 ORIE 3150


See you next week!

Don’t forget to apply for a Junior Analyst position. www.cornell-micc.com

http://www.cornell-micc.com/

week 1: financial accounting

Documents

investment banking

financial information

financial accountingsept

operating income

current liabilities

income tax

balance sheet items

noticethe accounting