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Prof: Jim Wallace TA: Charles Yeh

Overview of Week 1

Administrative stuff What is financial accounting? Financial statements GAAP What number do you want?

Administrative Stuff

Who am I Who is your T.A. Teaching philosophy Syllabus



Web Access to Class Info

The site should contain:

Syllabus PowerPoint slides Handouts Homework solutions

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

Some Preconceptions - Misconceptions?

Accounting yields the truth. Accounting is rigid. Accounting is useless. Accounting is hard! Accountants are boring.

Other Types of Accounting

Managerial Non-profit Tax

The Financial Statements

The accounting equation Balance Sheet Income Statement Statement of Cash Flows Statement of Owners Equity

Statement of retained earnings

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

To be reported on a balance sheet, an asset must:
1. 2.

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

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.

Disneys Assets


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

Disneys Liabilities and 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:

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.

Income Statement

Walt Disneys Income Statement

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).

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

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

Disneys Statement of Stockholders Equity

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:



Operating activities: transactions related to the operations of the business. Investing activities: acquisitions and divestitures of long-term assets Financing activities: issuances and payments toward equity, borrowings, and long-term liabilities.

Walt Disney Companys Statement of Cash Flows

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.

In Class Example

Baron Coburg

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)

Basic Assumptions and Principles

Monetary Unit Fiscal period Going concern Objectivity (Reliability) Consistency

Versus comparability

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.

Exception to the Basic Principles

Only transactions with amounts large enough to make a difference are considered material Non-material transactions can be treated in the easiest manner

Information Beyond Financial Statements

Management Discussion and Analysis (MD&A) Independent Auditor Report Financial Statement Footnotes

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 managements 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

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?

What Number Do You Want?

Accounting is a political process, not an exact science. There is a great deal of discretion available to managers.

Earnings Management

Reasons to manage earnings


Earnings Management - Why

Compensation contracts Debt contracts Political considerations

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:

Journal Entries

Transaction Analysis

Credit Sales Transaction

Accrued Expense Transaction

Deferred Revenue Transaction

Asset Write-Down (Impairment) Transaction


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.

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 Human capital, internally generated goodwill

Not all assets appear

Could be argued that approach is more conservative

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

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.

Financial Accounting in Context

A companys 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.