Financial Accounting Lesson 1: The Basics Ben Trnka / Boz Bostrom www.benandboz.com

Example A friend has his own business selling t-shirts to college students. On the surface, his business seems quite profitable, as he can buy the shirts for $5 apiece and then sell them for $15 apiece. What other costs may he have? Storage, advertising, inventory, shipping, taxes To help offset these additional costs, he has asked if you wish to invest in his business. What types of questions may you ask? Prior and expected sales (cash inflows) and expenses (cash outflows)

Example If your friend provides you with a printout showing his sales and expenses for last year, what additional questions may you have? More prior years Year to date information Future expectations Proof that what he is showing you is real What else might you want to know? How risky is this investment vs. what sort of returns can I expect? What would be the return on other investments of my cash?

Overview 1. Understand what is meant by the term financial accounting 2. Understand the four types of financial statements 3. Understand how and why financial statements are prepared 4. Understand the concept of corporate governance

What is meant by “financial accounting”? A set of established rules to prepare financial statements for external users Accounting Language of business Measures results of business / communicates results to users Established rules GAAP – Generally Accepted Accounting Principles Financial Statements Reports summarizing the financial information of a business External Users Shareholders and Creditors

Shareholders and Creditors Provide resources (usually cash) to the business in exchange for ownership Can be individuals or groups Two expectations: Dividends Appreciation of investment Creditors Provide resources (usually cash) to the business in exchange for promise of repayment Most common are banks, bondholders Two expectations: Repayment of principal Interest

Balance Sheet Measures financial condition of a company at a point in time Key equation: Assets = Liabilities + Stockholder’s Equity

Income Statement Measures revenues and expenses over a period of time Key equation Revenues - expenses = net income

Statement of Stockholders’ Equity Measures changes in equity over a period of time Key components are common stock and retained earnings Key equation Beginning stockholders’ equity + increases (less decreases) = ending stockholders equity Common increases – Profits, stock issuances Common decreases – Losses, dividend payments, and share repurchases

Statement of Cash Flows Summarizes cash flows going in and out of a business over a period of time Key equation Cash at the beginning of the year + Cash flows from operating, investing, and financing activities = Cash at the end of the year

Preparation of Financial Statements Most businesses are “private” and are not required to prepare financial statements Once a business becomes “publicly traded” it is required to prepare financial statements To be publicly traded means that a business has gone through a process to allow its shares to be freely traded (bought and sold) by investors Other non-public businesses may issue financial statements if required by banks or for various other purposes

Regulations behind financial statements Over four days in October, 1929, the stock market “crashed” and lost 25% of its value. Triggered the Great Depression and destroyed investor confidence in public companies Congress passed the Securities and Exchange Acts of 1933 and 1934, which created the Securities and Exchange Commission (SEC)

SEC FASB GAAP SEC, FASB, and GAAP The SEC regulates publicly traded companies The SEC delegated authority to the FASB (Financial Accounting Standards Board) The FASB created GAAP (Generally Accepted Accounting Principles) Financial Accounting is the method of accounting following GAAP

SEC Reports Two of the common reports required by the SEC 10-K 10-Q An annual report. Prepared 60-90 days after the end of each year 10-Q A quarterly report. Prepared 40-45 days after the end of each quarter Both reports include financial statements and additional information about the business

Corporate governance Big Question – How do stockholders make any decisions for the company? The stockholders of a corporation elect the Board of Directors The Directors make key decisions, such as appointing key executives, the top of which are the Chief Executive Officer (CEO) and the Chief Financial Officer (CFO) The CEO and CFO appoint other executives and managers The CEO and CFO are ultimately responsible for the financial statements

Home Depot Leaders

Corporate governance The Board of Directors has a subcommittee called the Audit Committee This committee appoints an independent CPA firm to audit the company’s financial statements for accuracy A CPA firm is a group of individuals who have earned Certified Public Accountants (CPA) certificates CPA’s often work together in accounting (CPA) firms The biggest 4 CPA firms in the world are Deloitte, EY, KPMG, and PWC Home Depot is audited by KPMG The government has created the PCAOB (Public Company Accounting Oversight Board) to oversee the audit of public companies

Impact of financial statements The value of a publicly traded company is set by supply and demand How much do investors believe the company is worth? Obviously very speculative so it is constantly changing As of July 2018, Home Depot has about 1.15 billion shares of stock worth about $202 each, making the total value of Home Depot about $230 billion As of July 2018, Apple has about 4.9 billion shares of stock worth about $190 each, making the total value of Apple about $930 billion

Impact of financial statements Shareholders often don’t know how a company is performing on a day-to-day basis Companies usually publish financial statements through a press release prior to issuing a 10-Q or 10-K Shareholders will react Higher than expected net earnings will often increase a company’s share price Lower than expected net earnings will often decrease a company’s share price On May 15, 2018, Home Depot “released earnings.” Earnings were better than expected, but sales were lower than expected. Its share price decreased slightly On July 25, 2018, Facebook “released earnings.” Share price declined by nearly 20%. Mark Zuckerberg’s net worth instantly declined by over $15 billion!

Key Takeaways Thanks for tuning in! Financial accounting – a method of accounting for a business’ results using GAAP 4 financial statements Results of financial statements will impact stock prices Governed by SEC and FASB, using GAAP Thanks for tuning in!