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1.

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

Hierarchy of Qualitative
Information
Comparability
and Consistency
Decision Usefulness

Discussed
in PPT #2

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

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.

Materiality Constraint

Material means big enough to make a difference


in the users 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.

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.

Concepts
Concepts are the ground rules of
accounting that should be followed when
preparing financial statements.
These are:
Recognition Concept
Measurement Concept

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

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

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

Economic Business Entity


Assumption
All of the business transactions should be
separate from the business owners
personal transactions
There should be no co-mingling of personal
funds with business funds.

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.

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.

Time Period Assumption


The entitys 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.

Principles of Accounting
Principles are accounting rules used to
prepare, present, and report financial
statements.
Principles dictate how events should be
recorded and reported.

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.

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.

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.

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.

Chapter 1

Getting Started:
Principles of
Finance

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1.1 FINANCE:
AN OVERVIEW

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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 GMs 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

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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 firms profits and is
responsible for all the firms 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 firms
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.
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
firms 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
owners 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 Firms


Organizational Structure?

In a corporation, the Chief Financial Officer


(CFO) is responsible for managing the
firms financial affairs.
Figure 1-2 shows how the finance function
fits into a firms organizational chart.

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1.3 THE GOAL OF


THE FINANCIAL
MANAGER

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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 shareholders


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-Colas
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 &
Johnsons 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.

2.

3.

Monitoring
(Examples: Reports, Meetings, Auditors, board of
directors, financial markets, bankers, credit agencies)
Compensation plans
(Examples: Performance based bonus, salary, stock
options, benefits)
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

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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 businesss 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 its 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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