This document provides an overview of a course on corporate accounting. It discusses why accounting is an interesting field, why financial accounting information is needed, and the course objectives of making students sophisticated financial statement users. An overview of financial statements is also provided, including the balance sheet, income statement, statement of retained earnings, and statement of cash flows.

1. 1
Introduction
15.511 Corporate Accounting
Summer 2004
Professor SP Kothari
Sloan School of Management
Massachusetts Institute of Technology
June 7, 2004

2. 2
Session 1:
Agenda
ƒAdministrative matters
ƒDiscussion of Accounting
ƒ Why is accounting interesting?
ƒ Why do we need accounting?
ƒCourse objective
ƒ Sophisticated financial statement
user
ƒAn overview of information in
financial statements

3. 3
The required materials are:
ƒ 10th Edition of Stickney and Weil
ƒ Financial Accounting: An Introduction to Concepts,
Methods, and Uses
ƒ Case Packet
ƒ Class web server
ƒ Syllabus
ƒ Schedule
ƒ Homework assignments
ƒ Sample exams

4. 4
Course Grading
ƒWritten Problem Sets 25%
ƒMidterm 30%
ƒFinal 45%

5. 5
Accounting Introduction
ƒDiscussion of Accounting
ƒ Why is accounting interesting?
ƒ Why do we need accounting?
ƒCourse objective
ƒ Sophisticated financial statement
user
ƒAn overview of financial
information

6. 6
What is Accounting trying to do?
Demand for Information
ƒ Financial Accounting
ƒ Provides information primarily to people outside the company
ƒ Provides information that would be helpful in attracting capital
ƒ Equity and debt (useful in debt contracts)
ƒ Credit from suppliers
ƒ Customers
ƒ Employees
ƒ Provides information helpful in monitoring and evaluating
management performance
ƒ Managerial Accounting
ƒ Provides information to people inside the company
ƒ Internal investment decisions
ƒ Performance evaluation
ƒ Tax Accounting
ƒ Provides information to the tax authorities
ƒ Legal to prepare separate books for tax and financial purposes

7. 7
Why do We Need Financial Accounting?
Company
Outsiders
- investors
- employees
- suppliers
Resources
Today
Resources
Tomorrow

8. 8
Why do We Need Financial Accounting?
Company
Outsiders
- Investors
- Suppliers
- Creditors
Resources
Today
Resources
Tomorrow
Information
(e.g., financial
statements)
Financial accounting promotes the exchange of resources
Financial accounting promotes the exchange of resources

9. 9
Nature of Financial Accounting
Information
ƒ Useful to those making investment and credit decisions,
who have a reasonable understanding of business and
economic activities.
ƒ Helpful to
ƒ present and potential investors
ƒ creditors
ƒ other users
ƒ in assessing the amount, timing, and uncertainty of future cash
flows.
ƒ Provides information about economic resources, the
claims to those resources, and the changes in them.

10. 10
How important is this information?
The Reaction of Wal-Mart Stock to Announcement of 3rd Quarter Earnings
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1-Nov-03 3-Nov-03 5-Nov-03 7-Nov-03 9-Nov-03 11-Nov-03 13-Nov-03 15-Nov-03 17-Nov-03 19-Nov-03 21-Nov-03 23-Nov-03
DATE
STOCK
PRICE

11. 11
Financial Accounting
Introduction
ƒDiscussion of Accounting
ƒ Why is accounting interesting?
ƒ Why do we need accounting?
ƒCourse objective
ƒ Sophisticated financial
statement user
ƒAn overview of financial
information

12. 12
WHAT IS OUR COURSE
OBJECTIVE?
ƒ To become intelligent users of accounting
information. Examples:
ƒ Managers use accounting information in making
investment decisions
ƒ Investors use accounting information in valuing
stocks
ƒ Bankers rely on accounting information in
deciding whether to lend money to a business
and in assessing the risk of the loan
ƒ Accounting information is crucial in evaluating
the performance of employees at various levels
in an organization

13. 13
WHAT IS OUR COURSE
OBJECTIVE?
ƒ To become intelligent users of accounting
information
ƒ Be comfortable looking through an annual report
ƒ Learn the language and techniques
ƒ Begin to develop the ability to use financial
statements to assess a company’s performance
ƒ Have a sense of the limitations of financial
statement data
ƒ What are not our objectives
ƒ to train you to be an accountant or bookkeeper
ƒ Financial Statement Analysis - take 15.535

14. 14
World of a Sophisticated
Financial Statement User
Events are occurrences that affect the firm.
Examples include:
1) Microsoft sued by the Justice Department
2) McDonald’s sells hamburgers
3) United Airlines workers go on strike
4) The Gap announces a new marketing strategy for
its Old Navy Clothing stores

15. 15
World of a Sophisticated Financial
Statement User
Events / Actions
Rules
&
Management
choices
Financial Statements

16. 16
World of a Sophisticated Financial
Statement User
Rules
&
Management
choice
Financial Statements
Events
Financial Accounting = translates events
into financial statements
Generally
Accepted
Accounting
Principles (GAAP)
Management selects
from alternative rules
and from allowable
estimates under GAAP

17. 17
Three keys to becoming a sophisticated
financial statement user
ƒUnderstand the rules and management’s
discretion
ƒUnderstand what explains the rules and
the type of management discretion
ƒIncentives
ƒUnderstand how events affect firm value

18. 18
Understanding the genesis of
the rules
ƒ Demand for independence: Accounting enters
objective, verifiable information into accounting
records
ƒ Information produced by managers alone is not
believable. Outside investors demand
independently audited financial information
ƒ In the process, accounting misses out on forward-
looking information that might be valuable, but lacks
objective evidence (e.g., research in progress)

19. 19
Understanding the genesis of
the rules
ƒ Asymmetry
ƒ Asymmetric treatment of good and bad news
ƒ Faced with uncertain bad news, accounting
tends to enter it into the records
ƒ Faced with uncertain good news, tendency to
ignore it
ƒ Why?
ƒ Demand for bad news
ƒ Creditors with no upside, but all the downside
ƒ Investors believe bad news disclosed by
management, but skeptical of good news unless
supported by objective evidence
ƒ Management incentives affect believability of their
disclosures

20. 20
Financial Accounting
Introduction
ƒDiscussion of Accounting
ƒ Why is accounting interesting?
ƒ Why do we need accounting?
ƒCourse objective
ƒ Sophisticated financial statement user
ƒAn overview of financial information

21. 21
Accounting is complex and
interesting because……
ƒ Diversity of businesses and events
ƒ Many different players
ƒ Diverse incentives
ƒ Economic
ƒ Other
ƒ Uncertainty
ƒ Many regulations

22. 22
Financial Accounting
Introduction
ƒDiscussion of Accounting
ƒ Why is accounting interesting
ƒ Why do we need accounting?
ƒCourse objective
ƒ Sophisticated financial statement
user
ƒAn overview of financial
information

23. 23
Financial Reporting
Requirements
ƒ Audited Annual Report (10-K)
ƒ Unaudited Quarterly Reports (10-Q)
ƒ Current Reports (8-K)
ƒwithin 10 days of the end of a month
containing a significant event (e.g.,
major asset sales, changes in
ownership, bankruptcy, changing the
auditor)
ƒ Foreign Companies (20-F)

24. 24
Focus: The Annual Report
ƒ The Management Letter
ƒ Management discussion on developments during the
year and current state of the company
ƒ The Financial Statements
ƒ The Auditors’ Report

25. 25
Financial Reports:
The Auditors’ Report
ƒ GAAS (Generally Accepted Auditing Standards)
ƒ Reasonable assurance that financial statements are free of
material misstatement
ƒ Assess the accounting principles used and significant
estimates made by management
ƒ Actual opinion
ƒ financial statements present fairly, in all material respects, the
financial position, the results of operations, etc.
ƒ are in conformity with GAAP (Generally Accepted Accounting
Principles).

26. 26
Financial Reports:
The Auditors’ Report
ƒ Management responsible for
ƒ the preparation and integrity of the financial statements, etc.
ƒ Statements prepared in accordance with GAAP.
ƒ Estimated amounts based on management's best estimates
and judgments.
ƒ Maintenance of an internal control system to ensure that
assets are safeguarded and transactions are properly
authorized, recorded and reported.
ƒ The Board has an Audit Committee composed
entirely of outside directors
ƒ This committee appoints the auditor who has direct access
to the Audit Committee.

27. 27
Financial Statements
ƒ Contain primarily historical Information
ƒ Balance Sheet
ƒ Assets, liabilities & owners’ equity
ƒ Income Statement
ƒ Revenue (-) Expenses = Net Income
ƒ Statement of retained earnings
ƒ Cumulative sum of undistributed profits
ƒ Statement of cash flows
ƒ Operating, Investing and Financing activities
ƒ Footnotes
ƒ Significant accounting policies, estimates, etc.

28. 28
Financial Statements: Balance Sheet
ƒ Balance sheet
ƒ Statement of the financial position of a business as of a
certain date.
ƒ Assets
ƒ Resources owned by a corporation, e.g., cash, accounts
receivable, equipment, land
ƒ Liabilities
ƒ amounts/services owed by the company, e.g., loans
payable, accounts payable, customer advances, etc.
ƒ Stockholders’ equity
ƒ initial investment by the owners (capital stock -- common
and preferred stocks)
ƒ Plus the cumulative sum of undistributed profits (retained
earnings)

29. 29
Financial Statements: Income Statement
ƒ Income statement measures the “performance” of a
company over a period of time
ƒ Revenues -- a measure of economic benefits generated by
the sale of products or providing of services over a period
of time
ƒ Expenses -- a measure of economic sacrifices incurred to
“earn” the revenues of a given period
ƒ Examples of expenses -- cost of inventory sold, salaries to
employees, rent and lighting, advertising, .......
ƒ Net income = revenues (-) expenses

30. 30
Dividends
ƒ Are dividends paid to owners considered an
expense?
ƒ Owners are residual claimants
ƒ Dividends are distributions to the owners out of the
profits earned by the business
ƒ In determining accounting profits to the “residual”
owners, we only subtract the costs of all factors of
production, e.g., physical capital (depreciation),
human capital (salaries), debt capital (interest
cost), etc.
ƒ Dividends are not a factor of production

31. 31
Financial Statements: Retained
Earnings & Shareholders’ Equity
ƒ Retained earnings
ƒ A measure of undistributed profits of a business
ƒ Do not include capital contributed by owners
ƒ Retained earnings = Cumulative sum of profits
earned from the inception of business (-)
Cumulative sum of all “dividends” distributed to
the owners from the inception of business
ƒ Statement of shareholders’ equity describes the
change in retained earnings over a period of time
(e.g., a year)
ƒ Beginning balance in retained earnings
ƒ Add Net income earned during the period
ƒ Subtract Dividends distributed during the period
ƒ Ending balance in retained earnings

32. 32
Summary
ƒ Accounting is a complex field contrary to
common perceptions.
ƒ Financial accounting information facilitates the
exchange of resources.
ƒ To become a sophisticated financial statement
user, you need to understand how the
information in financial statements is recorded.