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1.01 Generally Accepted Accounting Principles – Accounting Constraints, Concepts, Assumptions, and Principles

GAAP PowerPoint #3

1.01 Generally Accepted Accounting Principles – Accounting Constraints, Concepts, Assumptions, and Principles GAAP PowerPoint #3

in PPT #2

Discussed

Hierarchy of Qualitative Information

Comparability and Consistency

Decision Usefulness

Decision Usefulness

Cost/Benefit

in PPT #2 Discussed Hierarchy of Qualitative Information Comparability and Consistency Decision Usefulness Decision Usefulness Cost/Benefit

Materiality

www.fasb.org

Constraints

A constraint is a limit, regulation, or confinement within prescribed bounds.

This term refers to the accounting guidelines that border the Hierarchy of Qualitative Information

They consist of:

Cost Effectiveness Materiality Conservatism

Constraints  A constraint is a limit, regulation, or confinement within prescribed bounds.  This term

Cost Effectiveness Constraint

Also called Cost Benefit Constraint

The cost of providing accounting information should not exceed the benefit of the information it is reporting.

Example: Your checkbook register and bank statement differs by $0.10. Rather than waste time to find the $0.10, the accountant should record the amount as miscellaneous expense or income.

Cost Effectiveness Constraint  Also called Cost Benefit Constraint  The cost of providing accounting information

Materiality Constraint

Material means big enough to make a difference in the user’s decision-making process.

States that the requirements of any accounting principle may be ignored when there is no effect on the decisions of the user of financial information.

Example: A company purchases a Trashcan for $10. Per GAAP, this amount should be capitalized as an asset and depreciated. Because the amount is immaterial, the $10 can be recorded as an expense.

Materiality Constraint  Material means big enough to make a difference in the user’s decision-making process.

Conservatism Constraint

Accountants use their judgment to record transactions that require estimation.

Conservatism helps the accountant choose between 2 equally likely alternatives.

Requires the accountant to record the transaction using the less optimistic choice.

Example: There is the potential for a customer to sue the company. Although, the customer may choose not to sue, the accountant will disclose this potential lawsuit

to investors.

Conservatism Constraint  Accountants use their judgment to record transactions that require estimation.  Conservatism helps

Concepts

Concepts are the ground rules of accounting that should be followed when preparing financial statements.

These are:

Recognition Concept Measurement Concept

Concepts  Concepts are the ground rules of accounting that should be followed when preparing financial

Recognition Concept

States that an item should be recognized (recorded) in the financial statements when:

It can be defined by GAAP assumptions and principles

It can be measured It is relevant to decision-making by users It is reliable

Recognition Concept  States that an item should be recognized (recorded) in the financial statements when:

Measurement Concept

States that every transaction is measured by the stated unit of measurement, such as the dollar

The stated procedure of valuing assets, liabilities, equity, revenue, and expenses as defined by GAAP

Measurement Concept  States that every transaction is measured by the stated unit of measurement, such

Assumptions

Assumptions are agreed upon rules of accounting, and are basic, understood beliefs.

There are Four Basic Assumptions of Accounting:

Economic Business Entity Going Concern Monetary Unit Time Period

Assumptions  Assumptions are agreed upon rules of accounting, and are basic, understood beliefs.  There

Economic Business Entity Assumption

All of the business transactions should be separate from the business owner’s personal transactions

There should be no co-mingling of personal funds with business funds.

Economic Business Entity Assumption  All of the business transactions should be separate from the business

Going Concern Assumption

Financial statements are prepared under the assumption that the company will remain in business indefinitely unless there is sufficient evidence otherwise.

If there is evidence that a company may possibly have a going concern issue, this must be disclosed in the financial statements.

Going Concern Assumption  Financial statements are prepared under the assumption that the company will remain

Monetary Unit Assumption

Assumes a stable currency is going to be the unit of record.

FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for inflation.

Monetary Unit Assumption  Assumes a stable currency is going to be the unit of record.

Time Period Assumption

The entity’s activities are separated into periods of time such as months, quarters or years.

Transactions must be accounted for within the time period they occur regardless of when cash is exchanged.

Time Period Assumption  The entity’s activities are separated into periods of time such as months,

Principles of Accounting

Principles are accounting rules used to prepare, present, and report financial statements.

Principles dictate how events should be recorded and reported.

Principles of Accounting  Principles are accounting rules used to prepare, present, and report financial statements.

Cost Principle

Assets are recorded at historical cost, not fair market value.

For example, if a company purchases a building for $500,000 it should be recorded as such, and should remain on the books for that amount until disposed of.

If the building appreciates to $700,000 in the next few years, no adjustment should be made.

Cost Principle  Assets are recorded at historical cost, not fair market value.  For example,

Full Disclosure Principle

All information pertaining to the operations and financial position of the entity must be reported within the period of time in question.

Circumstances and events that make a difference to financial statement users should be disclosed.

Full Disclosure Principle  All information pertaining to the operations and financial position of the entity

Revenue Recognition Principle

Revenue is earned and recognized upon product delivery or service completion, without regard to when cash is actually received.

Also called accrual basis accounting

Example: A customer purchases inventory from a company on credit. Even though no cash has yet been received, the sale is recorded.

Revenue Recognition Principle  Revenue is earned and recognized upon product delivery or service completion, without

Matching Principle

The costs of doing business are recorded in the same period as the revenue they help generate, regardless of when the money is actually paid.

Also called accrual basis accounting

Example: A company orders merchandise on credit and has 30 days in which to pay. This purchase is recorded immediately, even though no cash has been paid.

Matching Principle  The costs of doing business are recorded in the same period as the

Questions for Understanding/Discussion

Explain what is meant by “The benefits of accounting information must exceed the costs.”

What is meant by the term materiality in financial reporting?

What is meant by the term conservatism in financial reporting?

Explain the Going Concern assumption. Explain the Time Period assumption.

Explain the accounting principles that guide accounting practice.

Questions for Understanding/Discussion  Explain what is meant by “The benefits of accounting information must exceed

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Chapter 1 Getting Started: Principles of Finance Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Chapter 1

Getting Started:

Principles of Finance

Chapter 1 Getting Started: Principles of Finance Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Slide Contents

Learning Objectives

Introduction

1.Finance: An Overview 2.Three Types of Business Organizations 3.The Goal of the Financial Manager 4.The Four Basic Principles of Finance Key Terms

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Learning Objectives

1. Understand the importance of finance in your personal and professional lives and identify the three primary business decisions that financial managers make.

2. Identify the key differences between three major legal forms of business.

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Learning Objectives (cont.)

Understand the role of the financial manager within the firm and the goal for making financial choices.

Explain the four principles of finance that form the basis of financial management for both businesses and individuals.

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Introduction

Give examples of financial decisions faced by corporations and individuals.

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1.1 FINANCE: AN OVERVIEW Copyright © 2011 Pearson Prentice Hall. All rights reserved.

1.1 FINANCE:

AN OVERVIEW

1.1 FINANCE: AN OVERVIEW Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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What is Finance?

Finance is the study of how people and businesses evaluate investments and raise capital to fund them.

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Three Questions Addressed by the Study of Finance:

1. What long-term investments should the firm undertake? (capital budgeting decisions)

  • 2. How should the firm fund these investments? (capital structure decisions)

  • 3. How can the firm best manage its cash flows as they arise in its day-to-day operations? (working capital management decisions)

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Why Study Finance?

Knowledge of financial tools is critical to making good decisions in both professional world and personal lives.

Finance is an integral part of corporate world

How will GM’s strategic decision to invest $740 million to produce the Chevy Volt require the expertise of different disciplines within the business school such as marketing, management, accounting, operations management, and finance?

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Why Study Finance? (cont.)

Many personal decisions require financial knowledge (for example: buying a house, planning for retirement, leasing a car)

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1.2 THREE TYPES OF BUSINESS ORGANIZATIONS Copyright © 2011 Pearson Prentice Hall. All rights reserved.

1.2 THREE TYPES OF BUSINESS ORGANIZATIONS

1.2 THREE TYPES OF BUSINESS ORGANIZATIONS Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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Business Organizational Forms

FINC-301, Chapter 1, Russel

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Sole Proprietorship

It is a business owned by a single individual that is entitled to all the firm’s profits and is responsible for all the firm’s debt.

There is no separation between the business and the owner when it comes to debts or being sued.

Sole proprietorships are generally financed by personal loans from family and friends and business loans from banks.

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Sole Proprietorship (cont.)

Advantages:

Easy to start No need to consult others while making decisions Taxed at the personal tax rate

Disadvantages:

Personally liable for the business debts Ceases on the death of the propreitor

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Partnership

A general partnership is an association of two or more persons who come together as co-owners for the purpose of operating a business for profit.

There is no separation between the partnership and the owners with respect to debts or being sued.

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Partnership (cont.)

Advantages:

Relatively easy to start Taxed at the personal tax rate Access to funds from multiple sources or partners

Disadvantages:

Partners jointly share unlimited liability

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Partnership (cont.)

In limited partnerships, there are two classes of partners: general and limited.

The general partners runs the business and face unlimited liability for the firm’s debts, while the limited partners are only liable on the amount invested.

One of the drawback of this form is that it is difficult to transfer the ownership of the general partner.

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Corporation

Corporation is “an artificial being, invisible, intangible, and existing only in the contemplation of the law.”

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Corporation (cont.)

Corporation can individually sue and be sued, purchase, sell or own property, and its personnel are subject to criminal punishment for crimes committed in the name of the corporation.

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Corporation (cont.)

Corporation is legally owned by its current stockholders.

The Board of directors are elected by the firm’s shareholders. One responsibility of the board of directors is to appoint the senior management of the firm.

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Corporation (cont.)

Advantages

Liability of owners limited to invested funds Life of corporation is not tied to the owner Easier to transfer ownership Easier to raise Capital

Disadvantages

Greater regulation Double taxation of dividends

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Hybrid Organizations

These organizational forms provide a cross between a partnership and a corporation.

Limited liability company (LLC) combines the tax benefits of a partnership (no double taxation of earnings) and limited liability benefit of corporation (the owner’s liability is limited to what they invest).

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Hybrid Organizations (cont.)

S-type corporation provides limited liability while allowing the business owners to be taxed as if they were a partnership – that is, distributions back to the owners are not taxed twice as is the case with dividends in the standard corporate form.

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How Does Finance Fit into the Firm’s Organizational Structure?

In a corporation, the Chief Financial Officer (CFO) is responsible for managing the firm’s financial affairs.

Figure 1-2 shows how the finance function fits into a firm’s organizational chart.

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1.3 THE GOAL OF THE FINANCIAL MANAGER Copyright © 2011 Pearson Prentice Hall. All rights reserved.

1.3 THE GOAL OF THE FINANCIAL MANAGER

1.3 THE GOAL OF THE FINANCIAL MANAGER Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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The Goal of the Financial Manager

The goal of the financial manager must be consistent with the mission of the corporation.

What is the generally accepted mission of a corporation?

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Corporate Mission

To maximize firm value shareholder’s wealth (as measured by share prices)

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Corporate Mission: Coca-Cola

“To achieve sustainable growth, we have established a vision with clear goals:

Maximizing return to shareholders while being mindful of our overall responsibilities” (part of Coca-Cola’s mission statement)

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Corporate Mission: Johnson & Johnson

“Our final responsibility is to our stockholders …when we operate according to these principles, the stockholders should realize a fair return” (part of Johnson & Johnson’s credo)

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Corporate Mission: Google

“Optimize for the long-term rather than trying to produce smooth earnings for each quarter”

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Corporate Mission

While managers have to cater to all the stakeholders (such as consumers, employees, suppliers etc.), they need to pay particular attention to the owners of the corporation i.e. shareholders.

If managers fail to pursue shareholder wealth maximization, they will lose the support of investors and lenders. The business may cease to exist and ultimately, the managers will lose their jobs!

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Ethics in Finance

What do we mean by Ethics?

Give examples of recent financial scandals and discuss what went wrong from an ethical perspective.

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Agency Considerations in Corporate Finance

Agency relationship exists when one or more persons (known as the principal) contracts with one or more persons (the agent) to make decisions on their behalf.

In a corporation, the managers are the agents and the stockholders are the principal.

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Agency Considerations in Corporate Finance (cont.)

Agency problems arise when there is conflict of interest between the stockholders and the managers. Such problems are likely to arise more when the managers have little or no ownership in the firm.

Examples:

Not pursuing risky project for fear of losing jobs, stealing, expensive perks.

All else equal, agency problems will reduce the firm value.

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How to Reduce Agency Problems?

  • 1. Monitoring

(Examples: Reports, Meetings, Auditors, board of directors, financial markets, bankers, credit agencies)

  • 2. Compensation plans

(Examples: Performance based bonus, salary, stock options, benefits)

  • 3. Others

(Examples: Threat of being fired, Threat of takeovers, Stock market, regulations such as SOX)

The above will help to reduce agency problems/costs.

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1.4 THE FOUR BASIC PRINCIPLES OF FINANCE Copyright © 2011 Pearson Prentice Hall. All rights reserved.

1.4 THE FOUR BASIC PRINCIPLES OF FINANCE

1.4 THE FOUR BASIC PRINCIPLES OF FINANCE Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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PRINCIPLE 1: Money Has a Time Value.

A dollar received today is more valuable than a dollar received in the future.

We can invest the dollar received today to earn interest. Thus, in the future, you will have more than one dollar, as you will receive the interest on your investment plus your initial invested dollar.

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PRINCIPLE 2: There is a Risk-Return Trade-off.

We only take risk when we expect to be compensated for the extra risk with additional return.

Higher the risk, higher will be the expected return.

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PRINCIPLE 3: Cash Flows Are The Source of Value.

Profit is an accounting concept designed to measure a business’s performance over an interval of time.

Cash flow is the amount of cash that can actually be taken out of the business over this same interval.

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Profits versus Cash

It is possible for a firm to report profits but have no cash.

For example, if all sales are on credit, the firm may report profits even though no cash is being generated.

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Incremental Cash Flow

Financial decisions in a firm should consider “incremental cash flow” i.e. the difference between the cash flows the company will produce with the potential new investment it’s thinking about making and what it would make without the investment.

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PRINCIPLE 4: Market Prices Reflect Information.

Investors respond to new information by buying and selling their investments.

The speed with which investors act and the way that prices respond to new information determines the efficiency of the market. In efficient markets like United States, this process occurs very quickly. As a result, it is hard to profit from trading investments on publicly released information.

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PRINCIPLE 4: Market Prices Reflect Information. (cont.)

Investors in capital markets will tend to react positively to good decisions made by the firm resulting in higher stock prices.

Stock prices will tend to decrease when there is bad information released on the firm in the capital market.

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Key Terms

Agency problem Capital budgeting Capital structure Corporation Debt Equity Financial market

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Key Terms (cont.)

General partner General partnership Limited liability company (LLC) Limited partner Limited partnership Opportunity cost Partnership

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Key Terms (cont.)

Shareholder Shares Sole proprietorship Stock Stockholders Working capital management

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