Understanding financial accounting                                                  Fundamental structure and principles

...
Understanding financial accounting                                Accounting, management, and governance

A model of relat...
Understanding financial accounting                                                          Ideas from finance and economi...
Understanding financial accounting                                               … philosophy

As suggested by the foregoi...
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Understanding financial accounting

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The core ideas (maybe 80%-90%) underlying financial accounting can be summarized very succinctly!

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Understanding financial accounting

  1. 1. Understanding financial accounting Fundamental structure and principles There are only a (very) small number of fundamental concepts and principles underlying accounting: ● Fundamental accounting concepts and identities owners' residual economic non-ownerhsip claims to resources     resources claims to resources      ASSETSt  LIABILITIESt  EQUITYt 1  ETt  REVt  EXPt  G L   t   NET INCOMEt ● Historical exchange price principle FMV(consideration received )  FMV(consideration given )    the cleaer of the LHS or RHS is the HEP , quot; historical exchange pricequot; ● Revenue recognition principle REVt  min(%earnedt , %realizablet )  HEP ● Expense recognition principle EXPt  % resource consumedt  HEP ● Disclosure principle Accounting principles and methods used by the firm—as well as descriptions and details of financial statement components and other financial matters relevant to users—are fully disclosed in the financial statements. 1 © 2009 M. J. McLelland
  2. 2. Understanding financial accounting Accounting, management, and governance A model of relationships between accounting, management, and corporate governance: fundamental management functions  organize/   plan control direct 1    accounting information system managerial exchange managerial    decisions events reporting entries for entries financial  ordinary subject to  reporting exchange and managerial nonexchange economic discretion events conditions and governmental    nonexchange reporting events     domain of management control systems domain of internal control systems     domain of integrated organizational control systems (i.e., quot;corporate governancequot; systems) 2 © 2009 M. J. McLelland
  3. 3. Understanding financial accounting Ideas from finance and economics ● Under certain assumptions, payoffs to equity holders equal profit generated: Et  Et 1  EC t  EDt  NI t  Et  DIVt  NI t       0 profit  DIVt payoffs to equity holders ● The value versus the market price of a firm’s equity regarded as functions of NI:   V   NI t / r V0  DIV1R 1  ...  FMVT R T      1 T P  NI t / r  P0  DIV1R  ...  FMVT R roughly     ● How management creates equity value:  NI(a)  V (a)    management takes action(s)  0    such that ak ak  r (a)     increasing profits and decreasing risk  … keeping in mind equity value can be created—or destroyed—in other ways, as well. 3 © 2009 M. J. McLelland
  4. 4. Understanding financial accounting … philosophy As suggested by the foregoing outline … To understand accounting in a clear, concise way, we need to use math (specifically, algebra). To begin to see why this might be so, it’s helpful to consider some philosophy: quot;If you want literal realism, look at the world around you; if you want understanding, look at theories.quot; Robert Dorfman quot;If we spoke a different language, we would perceive a different world.quot; Ludwig Wittgenstein quot;Mathematics … [is] a mirror, an incredibly pure mirror, of the relations that link the facts of our existence.quot; Konrad Knopp quot;At a more advanced level, we have such tools as the equation or formula which enable [us] to learn in a few hours fundamental and pervasive features of the behavior of things which [we] could otherwise learn only imperfectly with great labor or not at all.quot; E. L. Thorndike  4 © 2009 M. J. McLelland

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