326 - Financial Accounting Prof: Jim Wallace


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326 - Financial Accounting Prof: Jim Wallace

  1. 1. 326 - Financial Accounting Prof: Jim Wallace TA: Charles Yeh
  2. 2. Overview of Week 1 <ul><li>Administrative stuff </li></ul><ul><li>What is financial accounting? </li></ul><ul><li>Financial statements </li></ul><ul><li>What number do you want? </li></ul><ul><li>GAAP </li></ul>
  3. 3. Administrative Stuff <ul><li>Who am I </li></ul><ul><li>Who is your T.A. </li></ul><ul><li>Available help </li></ul><ul><li>Teaching philosophy </li></ul><ul><li>Syllabus </li></ul><ul><li>Homework, tests </li></ul><ul><li>Calculator </li></ul>
  4. 4. Web Access to Class Info <ul><li>The site should contain: </li></ul><ul><ul><li>Syllabus </li></ul></ul><ul><ul><li>PowerPoint slides </li></ul></ul><ul><ul><li>Handouts </li></ul></ul><ul><ul><li>Homework solutions </li></ul></ul><ul><li>http://wfs.cgu.edu/wallacja/326F05/ </li></ul><ul><li>I will be creating a new web site during the quarter that will replace this temporary solution. </li></ul>
  5. 5. What is Financial Accounting? <ul><li>A method to communicate financial information to interested external parties. </li></ul><ul><li>Users include capital providers, regulators, customers, suppliers, employees, etc </li></ul><ul><ul><ul><li>Capital suppliers include debt and equity providers </li></ul></ul></ul><ul><li>Financial accounting is used for both prediction and control </li></ul>
  6. 6. Some Preconceptions - Misconceptions? <ul><li>Accounting yields the “truth.” </li></ul><ul><li>Accounting is rigid. </li></ul><ul><li>Accounting is useless. </li></ul><ul><li>Accounting is hard! </li></ul><ul><li>Accountants are boring. </li></ul>
  7. 7. Other Types of Accounting <ul><li>Managerial </li></ul><ul><li>Non-profit </li></ul><ul><li>Tax </li></ul>
  8. 8. The Financial Statements <ul><li>The accounting equation </li></ul><ul><li>Balance Sheet </li></ul><ul><li>Income Statement </li></ul><ul><li>Statement of Cash Flows </li></ul><ul><li>Statement of Owners Equity </li></ul><ul><ul><li>Statement of retained earnings </li></ul></ul>
  9. 9. Balance Sheet <ul><li>Mirrors the Accounting Equation </li></ul><ul><li>Assets = Liabilities + Equity </li></ul><ul><li>Uses of funds = Sources of funds </li></ul><ul><li>Assets are listed in order of liquidity </li></ul><ul><ul><li>Current and non-current </li></ul></ul><ul><li>Liabilities are listed in order of maturity </li></ul><ul><li>Equity consists of Contributed Capital and </li></ul><ul><li>Retained Earnings </li></ul>
  10. 10. Assets <ul><li>To be reported on a balance sheet, an asset must </li></ul><ul><ul><li>Be owned or controlled by the company </li></ul></ul><ul><ul><ul><li>Generally, this means owning title to the asset </li></ul></ul></ul><ul><ul><ul><li>Leased assets are recorded under certain circumstances </li></ul></ul></ul><ul><ul><li>Must possess expected future benefits </li></ul></ul><ul><ul><ul><li>When the receipt of future benefits is in doubt, the asset may become “impaired” and written down of off entirely </li></ul></ul></ul>
  11. 11. Most Assets are Reported at Historical Cost <ul><li>Historical Cost is </li></ul><ul><ul><li>Objective </li></ul></ul><ul><ul><li>Verifiable </li></ul></ul><ul><ul><li>Therefore, not subject to bias </li></ul></ul><ul><li>However, historical cost is not particularly “relevant” to most readers of the balance sheet </li></ul><ul><li>“Relevance vs. Reliability” is an important issue with accountants. </li></ul>
  12. 12. Disney’s Assets
  13. 13. Liabilities <ul><li>Liabilities are listed in order of maturity </li></ul><ul><ul><li>Current Liabilities come due in less than a year. </li></ul></ul><ul><ul><li>Noncurrent liabilities come due after a year. </li></ul></ul><ul><li>Companies desire more current assets than current liabilities – this difference is called net working capital </li></ul>
  14. 14. Disney’s Liabilities and Equity
  15. 15. Equity <ul><li>Equity consists of: </li></ul><ul><ul><li>Contributed Capital (cash raised from the issuance of shares) </li></ul></ul><ul><ul><li>Earned Capital (retained earnings). Retained Earnings is updated each period as follows: </li></ul></ul>
  16. 16. Market Value vs. Book Value <ul><li>Stockholders’ equity = Company book value </li></ul><ul><li>Book value is determined using GAAP. </li></ul><ul><li>Book value is not the same as Market Value. </li></ul><ul><li>Market Value = # of Shares x Price per share </li></ul><ul><li>On average, US company book value is roughly two-thirds of market value. </li></ul>
  17. 17. Income Statement
  18. 18. Walt Disney’s Income Statement
  19. 19. Accrual Accounting <ul><li>Accrual accounting refers to the recognition of revenue when earned (even if not received in cash) and the matching of expenses when incurred (even if not paid in cash). </li></ul>
  20. 20. Accrual Accounting <ul><li>Accrual accounting rests on two guiding principles: </li></ul><ul><li>Revenue Recognition Principle – record revenue when </li></ul><ul><ul><li>Earned </li></ul></ul><ul><ul><li>Realized or Realizable </li></ul></ul><ul><li>Matching Principle – record expenses when </li></ul><ul><ul><li>Incurred </li></ul></ul><ul><li>Neither the recognition of revenue nor the recording of expense necessarily involves the receipt or payment of cash </li></ul>
  21. 21. Accrual Example <ul><li>Assume the following: </li></ul><ul><li>Purchase of $100 of inventory on account </li></ul><ul><li>Sale of all of the inventory for $150 on account </li></ul><ul><li>Employees earn $20 of wages to be paid next period </li></ul>
  22. 22. In Class Example <ul><li>Baron Coburg </li></ul>
  23. 23. Statement of Stockholders’ Equity <ul><li>Statement of Equity is a reconciliation of the beginning and ending balances of stockholders’ equity accounts. </li></ul><ul><li>Main equity categories are: </li></ul><ul><ul><li>Contributed capital </li></ul></ul><ul><ul><li>Retained earnings (including Other Comprehensive Income or OCI) </li></ul></ul><ul><ul><li>Treasury stock </li></ul></ul>
  24. 24. Disney’s Statement of Stockholders’ Equity
  25. 25. Statement of Cash Flows <ul><li>Statement of cash flows (SCF) reports cash inflows and outflows </li></ul><ul><li>Cash flows are reported based on the three business activities of a company: </li></ul><ul><ul><li>Operating activities : transactions related to the operations of the business. </li></ul></ul><ul><ul><li>Investing activities : acquisitions and divestitures of long-term assets </li></ul></ul><ul><ul><li>Financing activities : issuances and payments toward equity, borrowings, and long-term liabilities. </li></ul></ul>
  26. 26. Walt Disney Company’s Statement of Cash Flows
  27. 27. Articulation of Financial Statements <ul><li>Financial statements are linked within and across time – they articulate . </li></ul><ul><li>Balance sheet and income statement are linked via retained earnings. </li></ul><ul><li>Absent of equity transactions such as stock issuances and purchases and dividend payments, the change in stockholders’ equity equals the income or loss for the period. </li></ul>
  28. 29. Oversight of Financial Accounting <ul><li>GAAP </li></ul><ul><li>Oversight of Financial Accounting </li></ul><ul><ul><li>SEC oversees all publicly traded companies </li></ul></ul><ul><li>Financial Accounting Standards Board (FASB) </li></ul><ul><ul><li>Generally Accepted Accounting Principles (GAAP) </li></ul></ul>
  29. 30. Sarbanes-Oxley Act <ul><li>The SEC requires the CEO and CFO of a company to personally sign a statement attesting to the accuracy and completeness of the company’s financial statements. </li></ul><ul><li>The statements signed by both the CEO and CFO contain the following commitments: </li></ul><ul><ul><li>The CEO and CFO have personally reviewed the annual report </li></ul></ul><ul><ul><li>There are no untrue statements of a material fact or failure to state a material fact necessary to make the statements not misleading </li></ul></ul><ul><ul><li>The financial statements fairly present in all material respects the financial condition of the company </li></ul></ul><ul><ul><li>All material facts are disclosed to the company’s auditors and Board of Directors </li></ul></ul><ul><ul><li>No changes to the company’s system of internal controls are made unless properly communicated </li></ul></ul>
  30. 31. Basic Assumptions and Principles <ul><li>Monetary Unit </li></ul><ul><li>Fiscal period </li></ul><ul><li>Going concern </li></ul><ul><li>Stable dollar </li></ul><ul><li>Objectivity </li></ul><ul><li>Consistency </li></ul><ul><ul><li>Versus comparability </li></ul></ul>
  31. 32. Question? <ul><li>Financial statements must contain objective and verifiable numbers if they are to be useful. Yet, many estimates and subjective assumptions are required for the preparation of these reports. Please reconcile these apparently inconsistent statements. </li></ul>
  32. 33. Exceptions to the Basic Principles <ul><li>Materiality </li></ul><ul><ul><li>Only transactions with amounts large enough to make a difference are considered material </li></ul></ul><ul><ul><li>Non-material transactions are ignored </li></ul></ul><ul><li>Conservatism </li></ul><ul><ul><li>When in doubt… </li></ul></ul><ul><ul><ul><li>Understate assets </li></ul></ul></ul><ul><ul><ul><li>Overstate liabilities </li></ul></ul></ul><ul><ul><ul><li>Accelerate recognition of losses </li></ul></ul></ul><ul><ul><ul><li>Delay recognition of gains </li></ul></ul></ul>
  33. 34. Information Beyond Financial Statements <ul><li>Management Discussion and Analysis (MD&A) </li></ul><ul><li>Independent Auditor Report </li></ul><ul><li>Financial Statement Footnotes </li></ul><ul><li>Regulatory Filings and Proxy Statements </li></ul>
  34. 35. Audit Report <ul><li>Financial statements present fairly and in all material respects company financial condition. </li></ul><ul><li>Financial statements are prepared in conformity with GAAP </li></ul><ul><li>Financial statements are management’s responsibility. Auditor responsibility is to express an opinion on those statements </li></ul><ul><li>Auditing involves a sampling of transactions, not investigation of each transaction </li></ul><ul><li>Audit opinion provides reasonable assurance that the statements are free of material misstatements </li></ul><ul><li>Auditors review accounting policies used by management and estimates used in preparing the statements </li></ul>
  35. 36. Question? <ul><li>The SEC requires all publicly traded companies to have their financial statements audited. Prior to this requirement many companies voluntarily had their statements audited. Given the cost and inconvenience, why would they do this? </li></ul>
  36. 38. Transaction Analysis <ul><li>Transaction analysis is the process of identifying impacts of transactions and events on the balance sheet, income statement, or both. </li></ul><ul><li>We use the following template: </li></ul>
  37. 39. Journal Entries
  38. 40. Transaction Analysis
  39. 41. Credit Sales Transaction
  40. 42. Expense Payment Transaction
  41. 43. Accrued Expense Transaction
  42. 44. Deferred Revenue Transaction
  43. 45. Asset Write-Down (Impairment) Transaction
  44. 46. What Number Do You Want? <ul><li>Accounting is a political process, not an exact science. </li></ul><ul><li>There is a great deal of discretion available to managers. </li></ul>
  45. 47. Earnings Management <ul><li>Reasons to manage earnings </li></ul><ul><ul><li>ACCOUNTING NUMBERS HAVE ECONOMIC CONSEQUENCES BEYOND SIMPLY RECORDING TRANSACTIONS </li></ul></ul>
  46. 48. Earnings Management - Why <ul><li>Compensation contracts </li></ul><ul><li>Debt contracts </li></ul><ul><li>Political considerations </li></ul>
  47. 49. Question? <ul><li>Why might a company’s stockholders want its managers to be paid part of their total compensation as a bonus or stock instead of a straight cash salary? </li></ul>
  48. 50. Debt Contracts <ul><li>Firms that are near violation of their debt contracts have incentives to manage earnings upward. </li></ul>
  49. 51. Question? <ul><li>The following excerpt was taken from a recent financial statement of Cummins Engine Company: </li></ul><ul><li>Loan agreements contain covenants which impose restrictions on the payment of dividends and distribution of stock, require maintenance of a 1.25:1 current ratio, and limit the amount of future borrowings. </li></ul><ul><li>Why would a creditor such as a bank impose such restrictions when making a loan? </li></ul>
  50. 52. Political Reasons <ul><li>Firms may wish to portray a certain image to the public, government, or regulatory body. </li></ul>
  51. 53. Common Earnings Management <ul><li>Smoothing earnings </li></ul><ul><li>Managing earnings upward </li></ul><ul><li>Taking a bath </li></ul><ul><li>Off balance sheet financing </li></ul>
  52. 54. Takeaways <ul><li>Financial statements that are produced are the result of one possible set of rules that have resulted from a political process. </li></ul><ul><li>Users need to be aware of these limitations. </li></ul><ul><li>Users should read the notes to the financial statements since these contain a lot of useful guidance to interpreting the statements. </li></ul>
  53. 55. Financial Statement Limitations <ul><li>Assets are valued at historical cost less an estimated depreciation </li></ul><ul><ul><li>Other possibilities include cost, net realizable value, replacement cost, price level adjusted </li></ul></ul><ul><li>Not all assets appear </li></ul><ul><ul><li>Human capital, internally generated goodwill </li></ul></ul><ul><ul><ul><li>Could be argued that approach is more conservative </li></ul></ul></ul>
  54. 56. Financial Statement Limitations <ul><li>Not all liabilities appear </li></ul><ul><ul><li>Contingencies appear only in the footnotes </li></ul></ul><ul><ul><li>Off balance sheet financing </li></ul></ul><ul><ul><li>Employee stock options </li></ul></ul><ul><li>Other limitations include management biases and a lack of timeliness </li></ul>
  55. 57. Financial Accounting: not an exact science <ul><li>GAAP allows companies choices in preparing financial statements (inventories, property, and equipment). </li></ul><ul><li>Financial statements also depend on countless estimates. </li></ul>
  56. 58. Financial Accounting in Context <ul><li>A company’s financial statements only tell part of the story. </li></ul><ul><li>You must continually keep in mind the world in which the company operates. </li></ul><ul><li>Financial statement analysis must be conducted within the framework of a thorough understanding of the broader forces which impact company performance. </li></ul>