2. 326 - Financial Accounting Prof: Jim Wallace TA: Charles Yeh

3. Overview of Week 1 Administrative stuff Administrative stuff What is financial accounting? What is financial accounting? Financial statements Financial statements What number do you want? What number do you want? GAAP GAAP

4. Administrative Stuff Who am I Who am I Who is your T.A. Who is your T.A. Available help Available help Teaching philosophy Teaching philosophy Syllabus Syllabus Homework, tests Homework, tests Calculator Calculator

5. Web Access to Class Info The site should contain: The site should contain: Syllabus Syllabus PowerPoint slides PowerPoint slides Handouts Handouts Homework solutions Homework solutions http://wfs.cgu.edu/wallacja/326F05/ http://wfs.cgu.edu/wallacja/326F05/ http://wfs.cgu.edu/wallacja/326F05/ I will be creating a new web site during the quarter that will replace this temporary solution. I will be creating a new web site during the quarter that will replace this temporary solution.

6. What is Financial Accounting? A method to communicate financial information to interested external parties. A method to communicate financial information to interested external parties. Users include capital providers, regulators, customers, suppliers, employees, etc Users include capital providers, regulators, customers, suppliers, employees, etc Capital suppliers include debt and equity providers Capital suppliers include debt and equity providers Financial accounting is used for both prediction and control Financial accounting is used for both prediction and control

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

8. Other Types of Accounting Managerial Managerial Non-profit Non-profit Tax Tax

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

10. Balance Sheet Mirrors the Accounting Equation Mirrors the Accounting Equation Assets = Liabilities + Equity Assets = Liabilities + Equity Uses of funds = Sources of funds Uses of funds = Sources of funds Assets are listed in order of liquidity Assets are listed in order of liquidity Current and non-current Current and non-current Liabilities are listed in order of maturity Liabilities are listed in order of maturity Equity consists of Contributed Capital and Equity consists of Contributed Capital and Retained Earnings Retained Earnings

11. Assets To be reported on a balance sheet, an asset must 1. Be owned or controlled by the company a) Generally, this means owning title to the asset b) Leased assets are recorded under certain circumstances 2. Must possess expected future benefits a) When the receipt of future benefits is in doubt, the asset may become “impaired” and written down of off entirely

12. Most Assets are Reported at Historical Cost Historical Cost is Historical Cost is Objective Objective Verifiable Verifiable Therefore, not subject to bias Therefore, not subject to bias However, historical cost is not particularly “relevant” to most readers of the balance sheet However, historical cost is not particularly “relevant” to most readers of the balance sheet “Relevance vs. Reliability” is an important issue with accountants. “Relevance vs. Reliability” is an important issue with accountants.

13. Disney’s Assets

14. Liabilities Liabilities are listed in order of maturity Liabilities are listed in order of maturity Current Liabilities come due in less than a year. Current Liabilities come due in less than a year. Noncurrent liabilities come due after a year. Noncurrent liabilities come due after a year. Companies desire more current assets than current liabilities – this difference is called net working capital Companies desire more current assets than current liabilities – this difference is called net working capital

15. Disney’s Liabilities and Equity

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

17. Market Value vs. Book Value Stockholders’ equity = Company book value Book value is determined using GAAP. Book value is determined using GAAP. Book value is not the same as Market Value. Book value is not the same as Market Value. Market Value = # of Shares x Price per share Market Value = # of Shares x Price per share On average, US company book value is roughly two-thirds of market value. On average, US company book value is roughly two-thirds of market value.

18. Income Statement

19. Walt Disney’s Income Statement

20. 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).

21. Accrual Accounting Accrual accounting rests on two guiding principles: Revenue Recognition Principle – record revenue when Revenue Recognition Principle – record revenue when Earned Earned Realized or Realizable Realized or Realizable Matching Principle – record expenses when Matching Principle – record expenses when Incurred Incurred Neither the recognition of revenue nor the recording of expense necessarily involves the receipt or payment of cash Neither the recognition of revenue nor the recording of expense necessarily involves the receipt or payment of cash

22. Accrual Example Assume the following: Purchase of $100 of inventory on account Sale of all of the inventory for $150 on account Employees earn $20 of wages to be paid next period

23. In Class Example Baron Coburg Baron Coburg

24. Statement of Stockholders’ Equity Statement of Equity is a reconciliation of the beginning and ending balances of stockholders’ equity accounts. Statement of Equity is a reconciliation of the beginning and ending balances of stockholders’ equity accounts. Main equity categories are: Main equity categories are: Contributed capital Contributed capital Retained earnings (including Other Comprehensive Income or OCI) Retained earnings (including Other Comprehensive Income or OCI) Treasury stock Treasury stock

25. Disney’s Statement of Stockholders’ Equity

26. Statement of Cash Flows Statement of cash flows (SCF) reports cash inflows and outflows Statement of cash flows (SCF) reports cash inflows and outflows Cash flows are reported based on the three business activities of a company: 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.

27. Walt Disney Company’s Statement of Cash Flows

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

30. Oversight of Financial Accounting GAAP GAAP Oversight of Financial Accounting Oversight of Financial Accounting SEC oversees all publicly traded companies SEC oversees all publicly traded companies Financial Accounting Standards Board (FASB) Financial Accounting Standards Board (FASB) Generally Accepted Accounting Principles (GAAP) Generally Accepted Accounting Principles (GAAP)

31. Sarbanes-Oxley Act The SEC requires the CEO and CFO of a company to personally sign a statement attesting to the accuracy and completeness of the company’s financial statements. The SEC requires the CEO and CFO of a company to personally sign a statement attesting to the accuracy and completeness of the company’s financial statements. The statements signed by both the CEO and CFO contain the following commitments: The statements signed by both the CEO and CFO contain the following commitments: The CEO and CFO have personally reviewed the annual report The CEO and CFO have personally reviewed the annual report There are no untrue statements of a material fact or failure to state a material fact necessary to make the statements not misleading There are no untrue statements of a material fact or failure to state a material fact necessary to make the statements not misleading The financial statements fairly present in all material respects the financial condition of the company The financial statements fairly present in all material respects the financial condition of the company All material facts are disclosed to the company’s auditors and Board of Directors All material facts are disclosed to the company’s auditors and Board of Directors No changes to the company’s system of internal controls are made unless properly communicated No changes to the company’s system of internal controls are made unless properly communicated

32. Basic Assumptions and Principles Monetary Unit Monetary Unit Fiscal period Fiscal period Going concern Going concern Stable dollar Stable dollar Objectivity Objectivity Consistency Consistency Versus comparability Versus comparability

33. 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.

34. Exceptions to the Basic Principles Materiality Materiality Only transactions with amounts large enough to make a difference are considered material Only transactions with amounts large enough to make a difference are considered material Non-material transactions are ignored Non-material transactions are ignored Conservatism Conservatism When in doubt… When in doubt… Understate assets Understate assets Overstate liabilities Overstate liabilities Accelerate recognition of losses Accelerate recognition of losses Delay recognition of gains Delay recognition of gains

35. Information Beyond Financial Statements Management Discussion and Analysis (MD&A) Management Discussion and Analysis (MD&A) Independent Auditor Report Independent Auditor Report Financial Statement Footnotes Financial Statement Footnotes Regulatory Filings and Proxy Statements Regulatory Filings and Proxy Statements

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

37. Question? 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?

39. Transaction Analysis Transaction analysis is the process of identifying impacts of transactions and events on the balance sheet, income statement, or both. 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: We use the following template:

40. Journal Entries

41. Transaction Analysis

42. Credit Sales Transaction

43. Expense Payment Transaction

44. Accrued Expense Transaction

45. Deferred Revenue Transaction

46. Asset Write-Down (Impairment) Transaction

47. What Number Do You Want? Accounting is a political process, not an exact science. Accounting is a political process, not an exact science. There is a great deal of discretion available to managers. There is a great deal of discretion available to managers.

48. Earnings Management Reasons to manage earnings Reasons to manage earnings ACCOUNTING NUMBERS HAVE ECONOMIC CONSEQUENCES BEYOND SIMPLY RECORDING TRANSACTIONS ACCOUNTING NUMBERS HAVE ECONOMIC CONSEQUENCES BEYOND SIMPLY RECORDING TRANSACTIONS

49. Earnings Management - Why Compensation contracts Compensation contracts Debt contracts Debt contracts Political considerations Political considerations

50. Question? Why might a company’s stockholders want its managers to be paid part of their total compensation as a bonus or stock instead of a straight cash salary?

51. Debt Contracts Firms that are near violation of their debt contracts have incentives to manage earnings upward. Firms that are near violation of their debt contracts have incentives to manage earnings upward.

52. Question? The following excerpt was taken from a recent financial statement of Cummins Engine Company: Loan agreements contain covenants which impose restrictions on the payment of dividends and distribution of stock, require maintenance of a 1.25:1 current ratio, and limit the amount of future borrowings. Why would a creditor such as a bank impose such restrictions when making a loan?

53. Political Reasons Firms may wish to portray a certain image to the public, government, or regulatory body. Firms may wish to portray a certain image to the public, government, or regulatory body.

54. Common Earnings Management Smoothing earnings Smoothing earnings Managing earnings upward Managing earnings upward Taking a bath Taking a bath Off balance sheet financing Off balance sheet financing

55. Takeaways Financial statements that are produced are the result of one possible set of rules that have resulted from a political process. 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 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. Users should read the notes to the financial statements since these contain a lot of useful guidance to interpreting the statements.

56. Financial Statement Limitations Assets are valued at historical cost less an estimated depreciation Assets are valued at historical cost less an estimated depreciation Other possibilities include cost, net realizable value, replacement cost, price level adjusted Other possibilities include cost, net realizable value, replacement cost, price level adjusted Not all assets appear Not all assets appear Human capital, internally generated goodwill Human capital, internally generated goodwill Could be argued that approach is more conservative Could be argued that approach is more conservative

57. Financial Statement Limitations Not all liabilities appear Not all liabilities appear Contingencies appear only in the footnotes Contingencies appear only in the footnotes Off balance sheet financing Off balance sheet financing Employee stock options Employee stock options Other limitations include management biases and a lack of timeliness Other limitations include management biases and a lack of timeliness

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

59. Financial Accounting in Context A company’s financial statements only tell part of the story. A company’s financial statements only tell part of the story. You must continually keep in mind the world in which the company operates. 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. Financial statement analysis must be conducted within the framework of a thorough understanding of the broader forces which impact company performance.