Financial Accounting 2

AQ013-3-1

Overview of Accounting
 Topic & Structure of the Lesson

• Definition of Financial Accounting

• The Financial Statements
• Assets
• Liabilities
• Owner’s Equity
• Accrual Accounting

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Learning Outcomes

At the end of this chapter, YOU should be

able to:

•To explain forms of business and different

reporting requirements.
•To describe function and role in the aspects
of financial accounting.

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 What is Financial Accounting?

• A method to communicate financial

information to interested external parties.
• Users include capital providers, regulators,
customers, suppliers, employees, etc
• Capital suppliers include debt and equity providers
• Financial accounting is used for both
prediction and control

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Some Preconceptions
- Misconceptions?
• Accounting yields the “truth.”
• Accounting is rigid.
• Accounting is useless.
• Accounting is hard!
• Accountants are boring.

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Other Types of Accounting

• Managerial
• Non-profit
• Tax

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 The Financial Statements
• The accounting equation
• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Statement of Owners Equity
– Statement of retained earnings

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Balance Sheet

• Mirrors the Accounting Equation

Assets = Liabilities + Equity
Uses of funds = Sources of funds
• Assets are listed in order of liquidity
– Current and non-current
• Liabilities are listed in order of maturity
• Equity consists of Contributed Capital
and
Retained Earnings
AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING
 Assets
To be reported on a balance sheet,
an asset must:

1. Be owned or controlled by
the company
2. Must possess expected
future benefits

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Most Assets are Reported at
Historical Cost
• Historical Cost is
– Objective
– Verifiable
– Therefore, not subject to bias
• However, historical cost is not particularly
“relevant” to most readers of the balance
sheet
• “Relevance vs. Reliability” is an important
issue with accountants.
AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING
 Disney’s Assets

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Liabilities

• Liabilities are listed in order of maturity

– Current Liabilities come due in less than a year.
– Noncurrent liabilities come due after a year.
• Companies desire more current assets than
current liabilities – this difference is called
net working capital

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Disney’s Liabilities and Equity

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Equity

Equity consists of:

– Contributed Capital (cash raised from the
issuance of shares)
– Earned Capital (retained earnings).
Retained Earnings is updated each period
as follows:

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Market Value vs. Book Value

Stockholders’ equity = Company book value

• Book value is determined using GAAP.

• Book value is not the same as Market Value.
• Market Value = # of Shares x Price per share
• On average, US company book value is
roughly two-thirds of market value.

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Income Statement

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Walt Disney’s Income Statement

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Accrual Accounting

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).

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Accrual Accounting
Accrual accounting rests on two guiding
principles:
• Revenue Recognition Principle – record
revenue when
– Earned
– Realized or Realizable
• Matching Principle – record expenses when
– Incurred
• Neither the recognition of revenue nor the
recording of expense necessarily involves the
receipt or payment of cash
AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING
 Statement of Stockholders’
Equity
• Statement of Equity is a reconciliation
of the beginning and ending balances
of stockholders’ equity accounts.
• Main equity categories are:
– Contributed capital
– Retained earnings (including Other
Comprehensive Income or OCI)
– Treasury stock

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Disney’s Statement of
Stockholders’ Equity

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Statement of Cash Flows

• Statement of cash flows (SCF) reports cash

inflows and outflows
• Cash flows are reported based on the three
business activities of a company:
1. Operating activities: transactions related to the
operations of the business.
2. Investing activities: acquisitions and divestitures
of long-term assets
3. Financing activities: issuances and payments
toward equity, borrowings, and long-term
liabilities.

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Walt Disney
Company’s
Statement of
Cash Flows

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Articulation of Financial
Statements
• Financial statements are linked within
and across time – they articulate.
• Balance sheet and income statement
are linked via retained earnings.
• 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.

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING
 Oversight of Financial
Accounting
• GAAP
• Oversight of Financial Accounting
– SEC oversees all publicly traded
companies
• Financial Accounting Standards Board
(FASB)
– Generally Accepted Accounting Principles
(GAAP)

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Basic Assumptions and Principles
• Monetary Unit
• Fiscal period
• Going concern
• Objectivity (Reliability)
• Consistency
– Versus comparability

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Question?
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.

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Exception to the
Basic Principles
• Materiality
– Only transactions with amounts large enough
to make a difference are considered material
– Non-material transactions can be treated in
the easiest manner

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Information Beyond Financial
Statements
• Management Discussion and Analysis
(MD&A)
• Independent Auditor Report
• Financial Statement Footnotes

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Audit Report

• Financial statements present fairly and in all material

respects company financial condition.
• Financial statements are prepared in conformity with
GAAP
• Financial statements are management’s responsibility.
Auditor responsibility is to express an opinion on those
statements
• Auditing involves a sampling of transactions, not
investigation of each transaction
• Audit opinion provides reasonable assurance that the
statements are free of material misstatements
• Auditors review accounting policies used by management
and estimates used in preparing the statements

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Question?
The SEC (Security and Exchange
Commission) 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?

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING
 What Number Do You Want?

• Accounting is a political process, not an

exact science.

• There is a great deal of discretion

available to managers.

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Earnings Management
• Reasons to manage earnings

– ACCOUNTING NUMBERS HAVE

ECONOMIC CONSEQUENCES BEYOND
SIMPLY RECORDING TRANSACTIONS

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Earnings Management - Why

• Compensation contracts

• Debt contracts

• Political considerations

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Transaction Analysis

• Transaction analysis is the process of

identifying impacts of transactions and events
on the balance sheet, income statement, or
both.
• We use the following template:

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Journal Entries

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Transaction Analysis

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Credit Sales Transaction

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Accrued Expense Transaction

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Deferred Revenue
Transaction

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Asset Write-Down
(Impairment) Transaction

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Takeaways

• Financial statements that are produced are

the result of one possible set of rules that
have resulted from a political process.
• Users need to be aware of these limitations.
• Users should read the notes to the financial
statements since these contain a lot of
useful guidance to interpreting the
statements.

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Financial Statement Limitations

• Assets are valued at historical cost less an

estimated depreciation
– Other possibilities include cost, net realizable
value, replacement cost, price level adjusted
• Not all assets appear
– Human capital, internally generated goodwill
• Could be argued that approach is more
conservative

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Financial Statement Limitations

• Not all liabilities appear

– Contingencies appear only in the footnotes
– Off balance sheet financing

• Other limitations include management

biases and a lack of timeliness

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Financial Accounting:
not an exact science
• GAAP allows companies choices in
preparing financial statements
(inventories, property, and equipment).
• Financial statements also depend on
countless estimates.

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Financial Accounting in Context

• A company’s financial statements only tell

part of the story.
• You must continually keep in mind the
world in which the company operates.
• Financial statement analysis must be
conducted within the framework of a
thorough understanding of the broader
forces which impact company performance.

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 Question and Answer Session

Q&A

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING

 What We Will Cover Next

Accounting Principles and

Concepts

AQ013-3-1-FINANCIAL ACCOUNTING 2 OVERVIEW OF ACCOUNTING