Accounting & Financial Reporting BUSG 503 Michael Dimond

Michael Dimond School of Business Administration Financial Accounting for MBAs Course Overview Introductions Schedule Resources How do I get an A in this class?

Michael Dimond School of Business Administration Financial Accounting for MBAs Accounting Information Who uses it? What does it contain? How is it presented?

Michael Dimond School of Business Administration Organizations and Social Responsibility U.S. business entities recognize the societal aspects of their overall mission and have established programs to meet these responsibilities

Michael Dimond School of Business Administration Nature of Business Activity Businesses engage in three types of activities: Financing Activities Borrowing Sale of stock Investing Activities Purchase and sale of assets Operating Activities Sale of products & services Costs incurred to operate business

Michael Dimond School of Business Administration Exhibit 1.3—A Model of Business Activities

Michael Dimond School of Business Administration What is Accounting? Measuring Communicating Identifying Various Users  Management  Stockholders  Creditors  Financial analysts  Government Various Users  Management  Stockholders  Creditors  Financial analysts  Government Economic Information

Michael Dimond School of Business Administration Users of Accounting Info and Their Needs Internal Users: Primarily the managers of a company Involved in the daily affairs of the business External Users: Not directly involved in the operations of a business Need information that differs from that needed by internal users Outsiders must rely on information presented by management

Michael Dimond School of Business Administration Financial Statements

Michael Dimond School of Business Administration Qualitative Characteristics of Accounting Information Understandability: the quality of accounting information that makes it comprehensible to those willing to spend the necessary time Relevance: the capacity of information to make a difference in a decision Faithful representation: the quality of information that makes it complete, neutral, and free from error Comparability: for accounting information, the quality that allows a user to analyze two or more companies and look for similarities and differences Consistency: for accounting information, the quality that allows a user to compare two or more accounting periods for a single company Materiality: the magnitude of an accounting information omission or misstatement that will affect the judgment of someone relying on the information Conservatism: the practice of using the least optimistic estimate when two estimates of amounts are about equally likely

Michael Dimond School of Business Administration Relationships Among the Financial Statements

Michael Dimond School of Business Administration The Balance Sheet Financial statement that summarizes the assets, liabilities, and owners’ equity at a specific point in time At any point in time, assets must equal liabilities and owners’ equity

Michael Dimond School of Business Administration The Accounting Equation Assets = Liabilities + Shareholders’ Equity Left side: valuable economic resources and that will provide future benefit to the company Right side: indicates who provided, or has a claim to, the assets Stockholders’ equity or shareholders’ equity: used to refer to the owners’ equity of a corporation Equity is created when a company issues stock to an investor Equity is increased by retained earnings Earnings accumulated or retained by the company Part of owners’ equity that represents the income earned less dividends paid over the life of an entity

Michael Dimond School of Business Administration Preparing a Balance Sheet

Michael Dimond School of Business Administration The Income Statement Summarizes the revenues and expenses of a company for a period of time

Michael Dimond School of Business Administration Single-Step Income Statement

Michael Dimond School of Business Administration Multiple-Step Income Statement

Michael Dimond School of Business Administration The Statement of Retained Earnings Summarizes the income earned and dividends paid over the life of a business Dividends: Distribution of the net income of a business to its owners

Michael Dimond School of Business Administration The Statement of Cash Flows Summarizes a company’s cash receipts and cash payments during the period from operating, investing, and financing activities

Michael Dimond School of Business Administration Financial Statement Assumptions LO 6 Economic Entity Concept Cost Principle Going Concern Monetary Unit Time Period Assumption

Michael Dimond School of Business Administration Setting Accounting Standards Generally accepted accounting principles (GAAP) Various methods, rules, practices, and other procedures Securities and Exchange Commission (SEC) Federal agency with ultimate authority to determine the rules for preparing statements Financial Accounting Standards Board (FASB) Authority to set accounting standards American Institute of Certified Public Accountants (AICPA) Professional organization of Certified Public Accountants (CPA) Public Company Accounting Oversight Board (PCAOB) Five-member body to set auditing standards (since 2002) International Accounting Standards Board (IASB) Develop worldwide accounting standards

Michael Dimond School of Business Administration Audit of Financial Statements Most stockholders are not actively involved in the daily affairs of the business Auditing: examining whether financial statements are fairly presented External auditor performs various tests and procedures and render his opinion Auditors’ report is an opinion, not a statement of fact

Michael Dimond School of Business Administration Ethics in Accounting Ethics plays a critical role in providing useful financial information Investors and other users must have confidence in a company, its accountants, and its outside auditors that the information presented in financial statements is relevant, complete, neutral, and free from error Moral and social ethical behavior must be considered while making decisions

Michael Dimond School of Business Administration Sarbanes-Oxley Act An attempt to bring about major reforms in corporate accountability and stewardship Most important provisions in the act: Establishment of the Public Company Accounting Oversight Board Requirement that the external auditors report directly to the company’s audit committee Clause to prohibit public accounting firms from providing any other services that could impair their ability to act independently in the course of their audit

Michael Dimond School of Business Administration Financial Statements

Michael Dimond School of Business Administration Basic Financial Analysis Financial figures are related, and they can reveal many details about a company, its performance, and its value Accounting figures are prepared according to specific rules and certain distortions exist. There are so many numbers… where shall we begin?

Michael Dimond School of Business Administration Meaningful Ratio Analysis Analysis means to break something down to understand it. Ratio analysis should be used to answer a specific question or set of questions. If you were examining the financial statements for a company, you might start with this basic question: “Is this a good use of investors’ money?” What financial ratio would answer this question? How about Return on Equity? How do you compute Return on Equity (ROE)?

Michael Dimond School of Business Administration Analyzing ROE ROE = NI ÷ Equity and answers the question, “is this a good use of investors’ money?” If you were to break this down, there are three basic questions to answer: How profitable is this business? How efficiently are assets being used? How much does financial leverage help the investors? What financial ratios would answer these questions? Profit Margin (PM) Total Asset Turnover (TAT) Equity Multiplier (EM)

Michael Dimond School of Business Administration Drivers of ROE Profit Margin (PM) = NI ÷ Sales and answers the question, “How profitable is this business?” Total Asset Turnover (TAT) = Sales ÷ Total Assets and answers the question, “How efficiently are assets being used?” Equity Multiplier (EM) = Total Assets ÷ Equity and answers the question, “How much does financial leverage help the investors?”

Michael Dimond School of Business Administration The DuPont Identity ROE is directly driven by profitability, efficiency and leverage. ROE = PM x TAT x EM How does that work? The numerators and denominators cancel to reduce the equation to NI ÷ Equity

Michael Dimond School of Business Administration A word about ROA ROA = Return on Assets What’s the difference between Equity & Assets? Leverage What’s the difference between ROE & ROA? Leverage ROE = PM x TAT x EM EM represents leverage ROA = PM x TAT No leverage

Michael Dimond School of Business Administration Digging Deeper with Financial Ratios How would you analyze profitability, efficiency and leverage? How do profitability, efficiency and leverage relate? What affects profitability? What drives sales? What is the composition of assets? How were assets paid for? How are liabilities managed? Where shall we begin?

Michael Dimond School of Business Administration Common-Size Financial Statements Shows each line item as a percent of an appropriate total. Common-size balance sheet % of Total Assets Shows the composition of assets Liabilities & equity items are also shown as % of total assets Debt Ratio = Total Liabilities ÷ Total Assets Common-size income statement % of Sales PM = Net Income as % of Sales

Michael Dimond School of Business Administration Common-Size Income Statement 100% 11.4% 60.8%

Michael Dimond School of Business Administration Common-Size Balance Sheet 100%

Michael Dimond School of Business Administration We don’t make a common-size CF Statement There are other ways to examine relevant information which would be more helpful

Michael Dimond School of Business Administration Vertical & Horizontal Analysis Vertical Analysis compares figures as a percent of a relevant total (“common size” financial statements) Horizontal Analysis compares the same figure over a series of periods (showing % change or % growth)

Michael Dimond School of Business Administration Measuring growth Financial figures change from year to year To find the % change (“% growth”) over a 1-year period, divide the difference of the two figures by the first year’s value: [ending – beginning] / [beginning] OR [ending] / [beginning] - 1 Measuring growth over more than one period means we need to find the average growth during that time.

Michael Dimond School of Business Administration Operating Cycle Period of time between the purchase of inventory and the collection of any receivable from the sale of the inventory

Michael Dimond School of Business Administration Using the SEC website for information