Chapter 1 - Introducing Financial Accounting

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FINANCIAL ACCOUNTING
Fifth Edition
Thomas Dyckman
Robert Magee
Michelle Hanlon
Glenn Pfeiffer
CHAPTER 1
Introducing Financial
Accounting
©Cambridge Business Publishers, 2017
2
Learning Objective 1
Identify the users of accounting
information and discuss the costs
and benefits of disclosure.
©Cambridge Business Publishers, 2017
3
What is Accounting?
 Accounting is…
 The process of recording, summarizing, and
analyzing financial transactions
 To help people make economic decisions
Financial Accounting
Managerial Accounting
Designed primarily
for decision makers
outside of the company
Designed primarily
for decision makers
within the company
©Cambridge Business Publishers, 2017
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Who Uses Accounting Information?
Current
Shareholders
Management
Customers
Potential
Shareholders
Demand for
Information
Directors
Suppliers
Creditors
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Government
Agencies
Financial
Analysts
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Information Needs of Decision Makers
Financial Accounting
Managerial Accounting
Who are the Decision Makers?
 Investors and analysts
 Top management
 Creditors
 Marketing teams
 Suppliers and customers
 Production and operations
What Decisions are Made?
 Buy or sell stock?
 Develop new strategy?
 Lend or not?
 Launch a new product or not?
 Purchase/sell goods or not?  Manage operations
What Information is Needed?
 Sales and costs
 Product sales and costs
 Cash in and cash out
 Department performance
 Assets and liabilities
 Budgets and quality reports
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Forms of Business Ownership
CORPORATION
A Legal Entity
A large number of owners or shareholders not involved in
managing day-to-day operations of the company
SOLE PROPRIETORSHIP
A single owner who typically manages the daily operations
PARTNERSHIP
Two or more owners who are usually involved in managing
the business
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Shareholders
 The shareholders of large corporations…
 Provide resources such as cash to a
corporation in exchange for stock ownership
 Not involved in day-to-day business operations
 Rely on financial statement information
 To evaluate management performance
 Assess the company’s financial condition
 Predict future success
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Growth of Corporations
Expansion requires more
capital for growth
Begin as small,
privately held businesses
Publicly through organized
stock exchanges
Private funding
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Banks,
investors
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Creditors and Suppliers
Creditors
 Banks and other lenders that provide money
that must be repaid
 Use financial accounting information to assess
loan terms, loan amounts, interest rates,
collateral
Suppliers
 Provide supplies, inventory, etc. needed for
operations
 Use financial information to establish credit
sales terms and to determine long-term
commitment to supply-chain relations
©Cambridge Business Publishers, 2017
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Managers and Directors
Management
 Compensation often linked to financial
performance through bonuses, stock options
and other incentive compensation
Board of Directors
 Elected by shareholders to represent
shareholder interest and oversee management
 Required by law for publicly traded companies
 Uses financial accounting to review the results
of operations, evaluate future strategy, and
assess management performance
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Other Users of Financial Information
Financial Analysts
Prospective employees
Labor unions
Customers
Tax agencies
Other government agencies
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Costs and Benefits of Disclosure
 What is disclosure?
 Providing financial information to external users
 Benefits
 May lower financing costs through lower
borrowing rates
 May lower operating costs through better prices
from suppliers who see a long-term relationship
 Costs
 Hiring accountants to prepare financial statements
 Cost of allowing competitors to see information
 Political costs–regulation and increased taxes
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Learning Objective 2
Describe a company’s business
activities and explain how these
activities are represented by the
accounting equation.
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Business Activities
A business plans activities, finances those activities,
invests resources into those activities, and then engages
in operating activities.
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Planning Activities
Goals
Planning
Primary goal is to create
value for the owners
Strategies
How a company plans
to achieve its goals
Strategic plan describes
how the company plans
to achieve its goals
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Investing Activities
 What are investing activities?
 Activities that consist of acquiring and
disposing of resources (assets) that a company
uses to produce and sell its products or provide
its services
Short-term Assets
Long-term Assets
Resources used quickly
such as inventory
Resources used over
longer periods
of time, such as
equipment
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Mix of Assets Held by Companies
Why might Verizon and Procter & Gamble have
high proportions of long-term assets?
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Financing Activities
 What are financing activities?
 Methods that companies use to fund
investments
 What is financial management?
 Planning of resource needs, including the
proper mix of financing sources
Two Sources of
External Financing
Debt Financing
(Creditors)
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Equity Financing
(Owners)
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Mix of Financing Sources Held by Companies
Which company has the lowest proportion of liabilities?
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Financing Activities
Investing
=
Creditor
Financing
+
Owner
Financing
Assets
Liabilities
Equity
Economic
resources
Nonowner
claims on
assets
Owner
claims on
assets
=
+
At fiscal year-end 2014, Nike reported:
$18,594
million
$14
©Cambridge Business Publishers, 2017
=
$7,770
million
+
$10,824
million
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Operating Activities
 The production, promotion, and selling of products
and services
Inventory
Salaries
Input
Materials Markets
Logistics
Generate operating
expenses
Output
Markets
Customers
Generate operating revenues
and some operating expenses
(marketing and distribution)
In 2014, Nike reported:
Income = Revenues – Expenses
$2,693 million
©Cambridge Business Publishers, 2017
=
$27,799 million – $25,106 million
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Learning Objective 3
Introduce the four key financial
statements including the
balance sheet, income statement,
statement of stockholders’ equity,
and statement of cash flows.
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Financial Statement Links
Reports the company’s financial
position at a point in time.
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Reports performance
over a period of time.
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Reporting Periods
 Can be annual, semiannual, quarterly, or
monthly reporting periods
 Fiscal year
 A one-year reporting period
 Often called an accounting year
 Sometimes ends on a date other than
December 31
Nike’s fiscal year ends
on May 31.
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Balance Sheet
Lists the company’s investments and sources
of financing using the accounting equation.
Assets = Liabilities + Equities
A.K.A.
Statement of
Financial Position
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Liabilities
Assets
+
Equities
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Nike’s Balance Sheet
In millions
Nike’s owner financing totals $10,824 million,
while creditor financing totals $7,770 million.
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Income Statement
Reports the results of a company’s operating
activities over a period of time.
Revenues – Expenses = Net Income
A.K.A.
Statement of Income
and the
Statement of Earnings
and the
Statement of Operations
and the
Statement of Profit and Loss
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Covers a
specified period
of time
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Nike’s Income Statement
Nike’s profit is $2,693 million for its
fiscal year ending May 31, 2014.
Income Statement ($ millions)
A more detailed format……
Income Statement with Gross Profit Subtotal ($ millions)
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Statement of Stockholders’ Equity
 Reports on changes in equity over a period
of time
 Contributed capital
 Amounts from issuing new stock during the
period
 Common stock and additional paid-in capital
 Retained earnings
 Cumulative income since the company began
business minus dividends paid out to
shareholders
 Other stockholders’ equity changes
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Nike’s Statement of Stockholders’ Equity
Statement of Stockholder Equity ($ millions)
Nike paid out $821 million of its profit as dividends to
shareholders during its fiscal year ending May 31, 2014.
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Statement of Cash Flows
 Reports net cash flows from operating,
investing, and financing activities over a
period of time
 Operating cash flows differ from net income
 Due to differences in the time that revenues
and expenses are recorded and the time
the cash is received and paid
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Nike’s Statement of Cash Flows
Statement of Cash Flows ($ millions)
Nike generated $3,003 million of cash from operations
during the year ending May 31, 2014.
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Comparison of Net Income
to Operating Cash Flows
Comparison of Net Income to Operating Cash Flows
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Learning Objective 3
(continued)
Review the linkages between
the four key financial statements:
balance sheet, income statement,
statement of stockholders’ equity,
and statement of cash flows.
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Financial Statement Links
Reports the company’s financial
position at a point in time.
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Reports performance
over a period of time.
36
Financial Statement Linkages
A central feature of accounting is the linkage
among the 4 primary statements
 Called articulation of financial statements
How did cash (on the
balance sheet) change?
Look at
Statement of
Cash Flows
How did equity (on the
balance sheet) change?
Look at
Statement of
Stockholders’ Equity
How did operations
affect retained earnings
(on the balance sheet)?
Look at
Statement of
Income
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Nike’s Statement Articulation
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Information Beyond Financial Statements
Extensive review of company information is
communicated in these reports.
Management Discussion and Analysis
(MD&A)
Independent Auditor Report
Financial Statement Footnotes
Regulatory filings, including proxy
statements and other SEC filings
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Learning Objective 4
Describe the institutions that
regulate financial accounting
and their role in establishing
generally accepted
accounting principles.
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Generally Accepted Accounting Principles
 Standards and accepted practices
designed to guide the preparation of
financial statements
 Based on underlying principles
 Allows considerable discretion in
preparation
 Enables external users to rely on audited
financial statements
These financial statements
were prepared in accordance
with GAAP
and were audited!
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Regulation and Oversight – The SEC
Securities Act
of 1934
created
Securities & Exchange
Commission (SEC)
The SEC’s Authority
Regulates the issuance and trading
of securities in the U.S.
Who must report to the SEC?
Companies with more than $10 million of assets
and whose securities are held by more than 500
owners must file annual and other periodic reports.
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Regulation and Oversight – FASB
Financial Accounting Standards Board
 Currently establishes accounting standards in
the U.S.
 Developed a Conceptual Framework to serve
as a guide for accounting issues not covered
by standards
Referred to as FASB by the
accounting profession
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Management , Auditors, and
Financial Statements
MANAGEMENT
 Prepares the financial statements
 Takes responsibility for what is disclosed in the
financial statements
Independent
auditors ‘audit’
financial
statements
As assurance of accuracy and
completeness, financial statements
of publicly traded companies must
be audited by an independent
audit firm.
An audit opinion is not a guarantee.
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Regulation and Oversight – SOX
Sarbanes-Oxley Act of 2002
Referred to as SOX by the accounting profession.
 Developed by Congress due to concerns over
the quality of corporate financial reporting
 Goal was to increase the level of confidence
that external users have in financial statements
 SOX then established the Public Accounting
Oversight Board (PCAOB) to approve auditing
standards and to monitor the quality of
financial statements and audits (GAAP).
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Regulation and Oversight
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Global Perspective
Globalization of
capital markets
+
The diversity of international
accounting principles
….has led to an effort to increase comparability
of financial information across countries.
International Accounting Standards Board (IASB)
 Charged with creating International Financial
Reporting Standards (IFRS)
 Has no legal authority to impose accounting
standards in any country
©Cambridge Business Publishers, 2017
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Learning Objective 5
Compute two key ratios
that are commonly used to
assess profitability and risk—
return on equity and
the debt-to-equity ratio.
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Profitability Analysis
Profitability reveals whether a company is able to bring its
product or service to the market in an efficient manner, and
whether the market places value on that product or service.
Return on Equity
(ROE)
=
Net Income
Average Stockholders’ Equity
Nike
2014
$2,693
=24.6%
[($10,824+$11,081)/2]
*adidas
€ 496
[(5,618+5,481)/2]
2013
€ 790
[(5,481+5,291)/2]
$2,472
=23.0%
[($11,081+$10,381)/2]
=8.94%
=14.67%
*Source: www.adidas-Group.com/annualreports.
Nike’s ROE improved between 2013 and 2014.
Nike’s profitability is more efficient than Adidas.
©Cambridge Business Publishers, 2017
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Credit Risk Analysis
Solvency refers to the ability of a company to remain in
business and avoid bankruptcy or financial distress; a risk
measure.
Debt-to-Equity
Ratio
=
Total Liabilities
Total Stockholders’ Equity
Nike
2014 $7,770
$10,824
=.72
2013
=.58
$6,464
$11,081
*adidas
€ 6,800 =1.21
€ 5,618
€ 6,118 =1.12
€ 5,481
*Source: www.adidas-Group.com/annualreports.
Nike’s Debt-to-Equity Ratio increased between 2013 and 2014.
Adidas has significantly more credit risk than Nike.
©Cambridge Business Publishers, 2017
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Learning Objective 6
Appendix 1A
Explain the conceptual framework
for financial reporting.
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Conceptual Framework
Objectives of Financial Reporting
Financial accounting should provide….
 Information that is useful to investors, creditors, and
other decision makers.
 Information to help investors and creditors assess the
amount, timing, and uncertainty of cash flows.
 Information about economic resources and financial
claims on these resources.
 Information about a company’s financial performance.
 Information that allows decision makers to monitor
company management to evaluate their
effectiveness, efficiency, and ethical stewardship of
company resources.
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Qualitative Characteristics of
Accounting Information
Qualitative Characteristics of Accounting Information
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Conceptual Framework
Qualitative Characteristics
Developed to help managers, accountants, auditors,
and standard setters make reasonable choices among
accounting alternatives.
Benefits > Costs
Reported accounting information must
be cost effective
Materiality
Information that is not large enough to
affect one’s decision need not comply
with GAAP
Understandability
Should be presented so that a
knowledgeable reader can understand
how it relates to the decision process
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Conceptual Framework
Qualitative Characteristics
Relevance
Must have the ability to make a
difference in a decision
 Timeliness
 Predictive value
 Feedback value
Reliability
Must be accurate and free of
misstatement or bias
 Representational faithfulness
 Verifiability
 Neutrality
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Conceptual Framework
Qualitative Characteristics
Comparability
Should enable users to identify
similarities and differences between
sets of economic phenomena
Consistency
Should exhibit conformity from one
reporting period to the next with
unchanging policies and
procedures
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Conceptual Framework
Qualitative Characteristics
Underlying Assumptions
Separate
Economic Entity
Going Concern
Accounting Period
Measuring Unit
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Activities of a company are considered
independent, distinct, and separate from
activities of its stockholders and other
companies
Companies are assumed to have
continuity
Operations must be reported periodically
Unit of measure is the monetary unit—
the dollar in the U.S.
The End
©Cambridge Business Publishers, 2017
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