1st session:
Introduction to Accounting
Objectives
• Develop the ability to read, analyze and
interpret financial statements
• Understand how financial accounting
statements are constructed
• Provide you with tools for economic decision
making
– Where to find information
– How the information got there
Textbook
• Financial & Management Accounting, an
Introduction by Pauline Weetman, 5th edition,
available in two forms:
– Softcover
– E-book
• Register on Prentice Hall website for additional
materials! (Process to be announced in class,
next time.)
Rules of the Game
• Read the assigned material, do the assigned
problems before the lecture
• Come to class on time
• Do the assignments on a timely basis
• Turn off cell phones and other communication
devices
• Ask questions and participate in class
Course Website & e-mail
I will use the schools e-learning portal to post
information.
Make sure you log in at:
http://sca.lisboa.ucp.pt/e-sca/esca.aspx
Email: rireis@ucp.pt
GRADING SCHEME
Final grades will be determined by the
following scheme:
– Assignments
– Midterm
– Final:
10%
40%
50%
FIRM OF THE DAY
Today’s Class
Overview of “Accounting” in general and “Financial
Accounting” in particular
Discussion of Accounting terminology
Mandatory Financial Reporting (including the Financial
Statements)
Financial Accounting
• Financial accounting is the language that
translates economic events into uniform and
comprehensive information, understandable
by OUTSIDE observers.
• Unfortunately, this language has become
extremely complex and heterogeneous…
• This is naturally a bad thing for the outside
observers.
In an ideal world…
“In an ideal world, the user of financial statements
could focus only on the bottom lines of financial
reporting. If financial statements were comparable
among companies, consistent over time, and always
fully reflecting the economic positions of the firms,
financial statement analysis would be simple.”
Adapted CFA Preparation Readings
Other Types of Accounting
(not covered in this course)
Tax Preparation and Compliance is pretty self-explanatory
Internal Information Systems and Reporting provides firm managers
useful, real-time performance information to help with decision making
Also referred to as Management Information Systems and/or
Managerial Accounting
Key element here is that information is for internal use only
Therefore, there are typically few rules to govern how this
“should be” done.
Information systems are designed specifically to cater to a single
firm’s managers’ needs, hence there is little standardization
General business performance consulting has attracted many accountants
since accountants are typically familiar with many facets of firm
operations
Who cares?
“Information Useful in Investment and Credit
Decisions
Financial reporting should provide information that is
useful to present and potential investors and
creditors and other users in making rational
investment, credit and similar decisions. The
information should be comprehensible to those who
have a reasonable understanding of business and
economic activities and are willing to study the
information with reasonable diligence.”
SFAC 1, paragraph 34.
Who cares?
• Credit and equity investors
Or, in other words:
• Agents in Capital Markets!
Types of Firm Ownership and Information Demand
There are generally three types of firms in two major categories of
ownership
Privately Held Firms:
1. Proprietorship—typically a small firm with one specific owner
2. Partnership—typically medium-sized firms with shared ownership
Publicly Held (or Traded) Firms:
3. Corporation—typically large firms with diverse ownership
Ownership rights can be bought or sold on an open market
We will talk primarily about corporations throughout this
course since virtually all corporations must create and file
financial reports
Why do publicly-traded Corporations have to
file financial reports? Monitoring
Separation of ownership (shareholders) and control (hired
managers) presents a classic principal-agent problem
(agency theory)
Agency theory suggests that, without proper monitoring
and incentives, agents will extract perquisites (Jensen and
Meckling, 1976)
Financial reports are one mechanism to help monitor
managers’ actions
Why do publicly-traded Corporations
have to file financial reports? Investing
• It is true that accounting information relates to past
economic events. Whereas capital market investors
are worried with future value.
• Financial analysis is therefore mostly a way to
anticipate future economic events from information
about past ones.
• Statistical techniques provide the tools for this.
• Financial analysis doesn’t tell what will happen, but it
tells you what can happen. There is a chance of
things going wrong. This chance defines risk and it
can be measured.
Risk vs Return
Equity vs Credit Investors
• If you want to share more risk and become a partner
of the firm, then you want to know the potential
growth of the firm and basically you want to know all
the info you can get: you want to be an equity
investor!
• If you want to limit your risk and you are a creditor,
then your concern will be the potential ability of the
borrower to pay.
• In between there is a rich palette of different flavors
of investors, concerned with accurate information
for their investments.
Financial Reporting
(Key Players)
Managers
Ultimately responsible for the information disclosed
Financial information reflects the economic outcome of their
decisions
May have their compensation linked to some financial numbers
Do possess some discretion power as to some of the decisions
conditioning the financial information
Shareholders
Can hire or fire managers
Use financial information to evaluate the performance of the
managers
Use financial information to make investment decisions
Financial Reporting
(Key Players)
Financial Accountant
Hired by a firm to help prepare the firm’s financial reports
Usually works beneath the senior supervision of the Chief
Financial Officer
Head Financial Accountant is usually called the Controller
Auditor
Independent Agent hired by the firm to regularly assess and attest
to the financial reporting quality of the firm
Maintains an on-going relationship with the firm (the audit
client) to allow for regular inspection of financial processes and
internal controls over financial processes
Typically works for a “CPA Firm”
Financial Reporting
(Key Players)
Auditor (continued)
Few major national “CPA Firms” exist, due to mergers and Enron
Many of these firms also offer internal control compliance
consulting services
•
Other potential users of the
informations
Authorities: government, regulatory bodies, and tax
authorities
– They want the information to monitor whether
their policies are been executed.
• General public and special interest groups: labor
unions, environmentalist, consumer groups.
– They want specific information that help them
protect their interests.
• Competitors:
– They want information to gain competitive edge.
Other professions using the
information
• ANALYSTS:
– They want the information to be vast!
• CONSULTANTS:
– They want the information to be exclusive.
• AUDITORS:
– They want clear information that easily signals wrongdoings.
• CORPORATE LAWYERS:
– They want normative (ambiguous) information…
• ACADEMICS:
– They want the information to be consistent with some rationality.
Rules for everyone?
• Can the financial reporting system keep everyone happy?
– Obviously not! There are contradicting incentives
surrounding accounting information.
• How does the system deal with this?
– By hearing as many people as possible.
– By aiming at simpler rules, that shift most of the
responsibility to the preparers of information.
• What’s the implication for financial analysis?
– There is a lot of room for ambiguity and a lot of need for
interpretation.
Financial Reporting System
Who decides what constitutes Generally Accepted Accounting
Principles (GAAP)?
• SEC
Securities and Exchange Commission
– http://www.sec.gov/
“The mission of the U.S. Securities and Exchange Commission is
to protect investors, maintain fair, orderly, and efficient markets,
and facilitate capital formation.”
– They do not set the accounting rules. They simply tell publicly
traded firms what rules to follow and what information to
disclose. (Regulation S-X)
Financial Reporting System
• AICPA
American Institute of Certified Public Accountants
– http://www.aicpa.org/
“Its mission is to provide members with the resources,
information, and leadership that enable them to provide
valuable services in the highest professional manner to
benefit the public as well as employers and clients. ”
– It is a professional organization for American accountants.
Financial Reporting System
• FASB
Financial Accounting Standards Board
– http://www.fasb.org/
“The mission of the Financial Accounting Standards Board
is to establish and improve standards of financial
accounting and reporting for the guidance and education
of the public, including issuers, auditors, and users of
financial information.”
– They are the ones setting the accounting rules!
Financial Reporting System
– FASB has 4 major types of publications:
• Statements of Financial Accounting Standards
• Statements of Financial Accounting Concepts
• Interpretations
• Technical Bulletins
Financial Reporting System
• Governmental Accounting Standards Board
(GASB)
• Other influential organizations (e.g. American
Accounting Association, Institute of
Management Accountants, Financial
Executives Institute)
International Financial Reporting Standards
• IASB
International Accounting Standards Board
– http://www.iasb.org/
“Its principal objectives are:
• to develop a single set of high quality, understandable, enforceable and
globally accepted international financial reporting standards (IFRSs);
• to promote the use and rigorous application of those standards;
• to take account of the financial reporting needs of emerging economies
and small and medium-sized entities (SMEs); and
• to bring about convergence of national accounting standards and IFRSs to
high quality solutions.”
International Financial Reporting Standards
• IFRS in a broad sense comprise:
– Framework for the Preparation and Presentation of
Financial Statements—stating basic principles and
grounds of IFRS
– IAS—standards issued before 2001
– IFRS—standards issued after 2001
– SIC—interpretations of accounting standards, giving
specific guidance on unclear issues
– IFRIC—newer interpretations, issued after 2001
Balance Sheet
• Assets
– Probable future economic benefits obtained or controlled by a
particular entity as a result of past transaction or events
• Liabilities
– Probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services
to other entities in the future as a result of past transactions or events
• Equity
– Residual interest in the net assets of an entity that remains after
deducting its liabilities.
FUNDAMENTAL EQUATION OF THE BALANCE SHEET
Assets = Liabilities + Equity
Income Statement
• Revenues
– Inflows from delivering or producing goods, rendering
services, or other activities that constitute the entity’s
ongoing major or central operations
• Expenses
– Outflows from delivering or producing goods, rendering
services, or carrying out other activities that constitute the
entity’s ongoing major or central operations
• Gains (and losses)
– Increased (decreases) in equity (net assets) from
peripheral or incidental transactions
Statement of Cash Flows
(SFAS 95)
•
•
•
Operating Cash Flows
– Breadwinner of the firm. Cash flow consequences of the revenue-producing
activities of the firm
– Reported directly, using major categories of gross cash receipts and payments
– Reported indirectly as reconciliation of net income to net cash from operating
activities
Investing Cash Flows
– Relates to decisions to maintain the firm operating in longer terms.
(Acquisitions or divestitures in PP&E or subsidiaries)
– Should be reported directed, as all investment/divestment related cash
payments and receipts should be identifiable. (gross, rather than net)
Financing Cash Flows
– In theory, this should be a residual category. What ever cash is left should
either go to retire debt or to return to the stockholders, which ever money is
lacking, should be raised from debt issuance or requested from stockholders.
Statement of Stockholders’ Equity
• Categories inside the SE:
–
–
–
–
–
–
–
Preferred shares
Common shares
Additional paid-in capital
Retained earnings
Treasury shares
Employee stock ownership plan adjustments
Accumulated Other comprehensive income
Footnotes
• Mostly they serve the purpose of providing
additional information to better interpret the
numbers disclosed in the financial statements.
They refer to:
– Accounting methods, assumptions, or estimates
used by the prepares to determine the data in the
fin. stat.
Contingencies
• Firms are required to disclose information related to added risk.
Some losses may happen with an increased probability and such
losses are called contingent losses.
– When it is probable that the assets have been impaired or a
liability has been incurred (SFAS 5 suggests a probability of 50%
or more)
– The expected value of the amount of the loss can be
reasonably estimated.
• Things such as:
– Environmental remediation liabilities, litigation, expropriation,
self/insurance, debt guarantees, repurchase agreements, takeor-pay contracts, and throughput arrangements.
Risks and Uncertainties
• Disclosure of Certain Significant Risks and
Uncertainties require the following:
– Nature of operations
– Use of estimates
– Certain significant estimates
– Current vulnerability due to certain concentrations
Supplementary Schedules
• Special Cases for certain industries require these additional
supplements
– Oil and gas companies are required to provide additional
data on their exploration activities, including the NPV of
some of their projects
– Impact of changing prices
– Segment disclosure of sales revenue, operating income,
according to geographical or business segments
– Financial instruments and hedging activities.
Management Discussion and Analysis
• Mandated by the SEC, the MD&A is required
to discuss:
– D&A of the management’s opinion on the current
and prospective situation of the operations of the
firm (trends in sales and expenses)
– Same for the cash flow situation. Where will the
funding come from?
Role of the Auditor
• Independent CPA, their role is to certify the financial
statements in conformity with GAAP.
• Must agree (or explain disagreement) with the management’s
choices of accounting policies and estimates.
• Hired by the management, they are expected to be
completely independent of it and do a thorough analysis of
the firm’s accounts, by verifying the internal control system
through their own separate control systems.
Role of the Auditor
• Audit Opinion: Summary of the audit results regarding
the financial reports and an assessment of internal
controls
– Unqualified: Financial statements appear to be presented fairly
and in accordance with Generally Accepted Accounting
Principles (GAAP); internal controls appear to be adequate
– Qualified: Generally, financial statements appear to be presented
fairly and in accordance with Generally Accepted Accounting
Principles (GAAP), but there is some material issue that needs to
be addressed; there is an issue that needs to be addressed
regarding internal controls
– Adverse: There is a high probability of material errors within the
financial statements; there are material weaknesses in internal
controls
Role of the Auditor
• Auditors should be the main Agency Problem mitigators as they operate
on behalf of the stockholders.
• Commonly ignored, their reports should always be checked by an analyst,
specially if it raises doubts about the firm’s financials.
• Auditors are mandated to express not only their disagreements but also
their doubts, mostly about:
– The going concern assumption;
– Uncertainties related to the value of some assets or liabilities;
– Some contingencies.
Critical definitions of terms used throughout
this course
Assets: items owned by the firm
Liabilities: items the firm owes to creditors
(One source of funds available to purchase or create assets)
Net Assets: Assets – Liabilities (the assets left over after paying off debt)
Owners’ Equity: the owners’ claims to the assets
Owners’ Equity = Net Assets. Why?
These are the fundamental concepts for the Balance Sheet
Assets
(what is owned)
=
Provide
funds for
Liabilities
(what is owed)
Owners’ Equity
(owners’ claims)
Critical definitions of terms used throughout
this course (contd.)
Accounting Equation: Assets = Liabilities + Owners’ Equity
Cash + Other Assets
(what is owned)
=
Liabilities
(what is owed)
Owners’ Equity
(owners’ claims)
Retained Earnings
(cumulative profits kept within
the firm)
Revenues
(inflows of resources)
Contributed Capital
(Stock Issues)
(note this is a second source of funds
for purchasing or creating assets)
Expenses
(outflows of resources)
Critical definitions of terms used throughout this course
(contd.)
Revenues: inflows to the firm (from providing services or sales)
Expenses: outflows by the firm that are generated to help create
revenues
Gains: increases in value of firm assets
Losses: decreases in value of firm assets
Net Income: “profit” earned during the period
Revenues
- Expenses
+ Gains
- Losses
Note: the difference between these
classifications is often subtle and confusing
Generally, “revenues” and “expenses” are
associated with fundamental operational
transactions
= Net Income
“Gains” and “losses” are associated with
tangential transactions
These are the fundamental
concepts for the
Income Statement
In N’ Out Burger’s sales of hamburgers
would generate “revenues”
In N’ Out Burger’s sales of a delivery truck
might generate a “gain” or a “loss”
Critical definitions of terms used throughout this course
(contd.)
Income Statement: summary of revenues and expenses for the period
Revenues
- Cost of Sales (Cost of Goods Sold)
= Gross Margin
Operations Section
- Selling and Administration Expenses
= Income from Operations
- Interest Expense
- Other Expenses or Losses
+ Other Revenues or Gains
Non operations Section
= Income before Taxes
- Income Tax Expense
= Income before Irregular Items
-/+ Loss or Gain from Discontinued Operations (net of tax)
-/+ Loss or Gain from Extraordinary Items (net of tax)
-/+ Loss or Gain from Change in Accounting Principle (net of tax)
= Net Income
Irregular Items Section
We’ll cover this in more detail later…
Revenues
$152,866
Expenses
$132,386
Net Income
$16,819
Critical definitions of terms used throughout this
course (contd.)
Dividend: periodic payment back to the owners; a
distribution of profits
Now, let’s put this all together…
The Big Picture Review
The firm also
borrows funds to
purchase or create
assets
Assets
(what is owned)
Owners’ funds are
used to purchase
or create firm
assets
Liabilities
(what is owed)
Owners’ Equity
(owners’
claims)
Investors (owners)
contribute funds to create a
firm
The Big Picture Review
Assets
(what is owned)
Liabilities
(what is owed)
Assets are used up (expenses)
to generate revenues
which nets to Net Income
Owners’ Equity
(owners’
claims)
Net Income (Revenues –
Expenses) is collected
within the firm (as
Retained Earnings)
Retained Earnings
Back to
Owners
Some proportion of
Retained Earnings is
distributed to owners
as a Dividend
Next Class…
Overview of the Financial Statements.
More detailed discussion of the Balance Sheet.