Chapter 1 Financial Accounting & Its Economic Context

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HKUST
ACCT2010
Principle of Accounting I
Prof. Tony Shieh
1
Chapter 1:
Financial Accounting
and
Its Economic Context
2
Understanding the Business
The Players
Investors
Creditors
Managers
1. Purchase parts
and labor
2. Manufacture
product
The
Business
Operations
4. Collect cash from
customers and pay
creditors
1-3
3. Sell products
to customers
UNDERSTANDING THE BUSINESS
Stockholders
Potential Return for
Stockholders:
Dividends
Higher future stock prices
Creditors
Potential Return for
Creditors:
Interest
1-4
The Accounting System
Managers
(internal
decision
makers)
Collects and processes
financial information
1-5
Reports
information
to decision
makers
Investors
and
Creditors
(external
decision
makers)
THE ACCOUNTING SYSTEM
ACCT2010
ACCT2200
1-6
The Role of Financial Reporting in
Investment Decisions
Profit-seeking companies - managers
prepare reports for stakeholders of the
companies.
 Owners and other interested parties (Users)
- use reports to assess financial condition
and performance of companies.
 User decisions - users obtain information
from reports to make investment decisions.
 Effects of user decisions - decisions affect
the company and its managers.

7
8
Content of Financial Reports
The Auditor’s Report
 The Management Letter
 The Financial Statements:

–
–
–
–

Balance Sheet
Income Statement
Statement of Stockholders’ Equity
Statement of Cash Flows
The Footnotes
9
The Auditor’s Report
The auditor’s report is a statement to
the board of directors of the company
and to the shareholders of the company.
 It expresses an opinion as to whether
the financial statements present fairly
the financial activities of the company
and whether the financials were
prepared in accordance with GAAP

10
The Management Letter
The management letter is the statement
of management to the investors.
 It indicates:

– management is responsible for the
preparation and content of the financial
report.
– the statements were prepared in accordance
with generally accepted accounting
principles (GAAP).
– the company maintains a system of internal
controls to safeguard assets.
11
The Financial Statements

Include a balance sheet, income
statement, statement of stockholders’
equity, and a statement of cash flows
(discussed in a later chapter).
12
Financial
Statements
Financial Statements
For Microline
Figure 1-4
13
The Footnotes

The footnotes to the financials are
considered an integral part of the
financials, and explain many of the
policies and assumptions used to
prepare the financials.
14
Make a Decision

Analysis of Financial Statements
– Cash position
– Earning power
– Ratio Analysis

Form of Investment
– Debt (Loan)
– Equity (Ownership)
15
The Economic Environment of
Financial Reporting
Providers of capital - debt and equity
investors
 Reporting entities
 Corporate governance

– Financial information users and capital markets
– Debt covenants and management compensation

Financial reporting regulations & standards
– the accounting policymaking process
Sarbanes-Oxley Act
 Legal liability
 Professional reputation and ethics

16
Providers of Capital

Provide capital
– equity capital through stock investments
– debt capital through bond and loan investments
(creditors)

Receive returns
– equity investors receive dividends
– creditors and bond investors receive interest

Stock investors choose board of directors
 Board of directors
– Select corporate officers (management)
– Set company policy
– Select audit committee

Management – runs the company
17
Reporting Entities
Reporting entities are called companies,
businesses and firms.
 The companies may be further divided
into segments and subsidiaries, which
may provide their own financials.
 Consolidated financials are prepared
when subsidiaries are combined with
the parent’s financials.
 Industries are important to understand
when analyzing financial statements

18
Corporate Governance
Financial Information Users

Financial statements used by a variety of groups.
– Equity investors: purchase shares of stock,
which represent ownership in the company.
The financials are used by investors to analyze
management’s decisions.
– Debt investors (creditors): provide capital
through loans. The financials are used by
creditors to assess likelihood of default.
– Management: uses other companies financials
to asses the competition.
– Others, including government bodies, labor
unions, employees, use financials to assess the
financial status of the company.
19
Corporate Governance
and Capital Markets
Capital markets value the publicly
traded equity and debt securities.
 The financials are a component of the
information that the markets use to
value companies securities, along with
a number of nonfinancial measures.
 The market reacts to financial and other
information as it is released by
management.

20
Debt Covenants and Management
Compensation Contracts
Debt covenants are part of debt
contracts between the company and
creditors. Violation of debt covenants
may lead to more costly debt terms.
 Management compensation contracts
often base pay on certain income or
stock price goals.
 Such goals are designed to encourage
certain management behavior.

21
Regulations and Standards
The Securities and Exchange Commission
(SEC) governs financial reporting for
publicly traded companies. Congress and
other regulatory agencies have influence
with the SEC.
 The Financial Accounting Standards Board
(FASB) is responsible for the promulgation
of generally accepted accounting
principles (GAAP) for financial statements.
The FASB accepts input from all interested
parties, including accountants,
corporations, academics, and
governmental entities.

22
Policymakers
SEC
FASB
Generally Accepted
Accounting Principles
(GAAP)
Actual Accounting
Practices
Economic Consequences
Congress, White House,
government agencies
Public
Input
Public hearings, letters
Perceived
economic
consequences
Sarbanes-Oxley Act
Passed by Congress in 2002, in
response to a series of corporate
scandals.
 Requires principal executive and
financial officers to certify a number of
statements regarding the financials.
 Places additional responsibilities on
management to ensure that adequate
internal controls are in place.

24
Audit reports provide
assurance on the fair
presentation of the
financial statements
and effectiveness of
internal controls.
25
Legal Liability
Management is legally responsible to the
stockholders to act in their interest.
 Auditors are legally responsible to the
stockholders to conduct a thorough and
independent audit.
 If management or auditors fail in their
duties, investors and others may sue to
recover any losses that might occur as a
result the failure.
 Many recent examples of management
and audit failure exist: Enron, WorldCom,
HealthSouth, Xerox, Rite Aid, and Quest.

26
Professional Reputation and Ethics
Ethical behavior is in the long-run
interest of managers, stockholders, and
auditors.
 Many companies,universities, and
professional organizations have
enacted increased emphasis on ethics.
 Auditors’ reputations are integral to their
ability to perform their duties. High
ethical conduct is imperative to their
continued success.

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Makeup Class
on Saturday, Sep 10
Sec
Time
Classroom
L5
10:00am – 11:20am
L4
11:30am – 12:50pm LSKG007
L6
1:00pm – 2:30pm
28
The Four Kinds of Accounting (Figure 1A-1)
Financial Accounting
Economic
Entity
Managers
Profit-making Finance or
companies
accounting
department
System
GAAP
Financial
Information
•Income
statement
•Balance
sheet
•Statement
of stockholders’
equity
•Statement
of cash
flows
•Other
disclosures
•Auditor
report
Recipients
Decisions
External
•Investors
•Creditors
•Suppliers
•Employees
•Managers
•Government
•General
public
•Equity
and debt
investments
•Contract
negotiations
•Regulation
•Dividend
payments
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The Four Kinds of Accounting (Figure 1A-1)
Managerial Accounting
Economic
Entity
All entities
Managers
Finance or
accounting
department
System
Financial
Information
Recipients
Decisions
•Manager
Internal
reports
•Managers
•Production
costs
•Performance
evaluation,
etc.
•Operating
decisions
30
The Four Kinds of Accounting (Figure 1A-1)
Not-for-profit Accounting
Economic
Entity
Nonprofit
entities
Managers
Finance or
accounting
department
System
Financial
Information
Fund
•Balance
accounting sheet
principles •Funds flow
statements
Recipients
Decisions
External
•Creditors
•Government
•General
public
•Debt
investments
•Budget
allocations
31
The Four Kinds of Accounting (Figure 1A-1)
Tax Accounting
Economic
Entity
All entities
Managers
System
Finance or
accounting
department
Internal
revenue
code
Financial
Information
Official tax
forms:
•1040 for
individuals
•1120 for
corporations
Recipients
External
•Internal
Revenue
Service
Decisions
•Collection of
government
revenues
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