326 - Financial
Accounting
Prof: Jim Wallace
TA: Charles Yeh
Overview of Week 1
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Administrative stuff
What is financial accounting?
Financial statements
What number do you want?
GAAP
Administrative Stuff
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Who am I
Who is your T.A.
Available help
Teaching philosophy
Syllabus
Homework, tests
Calculator
Web Access to Class Info
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The site should contain:
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Syllabus
PowerPoint slides
Handouts
Homework solutions
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http://wfs.cgu.edu/wallacja/326F05/
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I will be creating a new web site during the quarter that
will replace this temporary solution.
What is Financial Accounting?
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A method to communicate financial information
to interested external parties.
Users include capital providers, regulators,
customers, suppliers, employees, etc
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Capital suppliers include debt and equity providers
Financial accounting is used for both prediction
and control
Some Preconceptions
- Misconceptions?
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Accounting yields the “truth.”
Accounting is rigid.
Accounting is useless.
Accounting is hard!
Accountants are boring.
Other Types of Accounting
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Managerial
Non-profit
Tax
The Financial Statements
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The accounting equation
Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Owners Equity
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Statement of retained earnings
Balance Sheet
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Mirrors the Accounting Equation
Assets = Liabilities + Equity
Uses of funds = Sources of funds
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Assets are listed in order of liquidity
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Current and non-current
Liabilities are listed in order of maturity
Equity consists of Contributed Capital and
Retained Earnings
Assets
To be reported on a balance sheet, an asset must
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Be owned or controlled by the company
a) Generally, this means owning title to the asset
b) Leased assets are recorded under certain
circumstances
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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
Most Assets are Reported at
Historical Cost
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Historical Cost is
Objective
 Verifiable
 Therefore, not subject to bias
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However, historical cost is not particularly
“relevant” to most readers of the balance sheet
“Relevance vs. Reliability” is an important issue
with accountants.
Disney’s Assets
Liabilities
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Liabilities are listed in order of maturity
Current Liabilities come due in less than a year.
 Noncurrent liabilities come due after a year.
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Companies desire more current assets than
current liabilities – this difference is called
net working capital
Disney’s Liabilities and Equity
Equity
Equity consists of:
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Contributed Capital (cash raised from the
issuance of shares)
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Earned Capital (retained earnings). Retained
Earnings is updated each period as follows:
Market Value vs. Book Value
Stockholders’ equity = Company book value
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Book value is determined using GAAP.
Book value is not the same as Market Value.
Market Value = # of Shares x Price per share
On average, US company book value is roughly
two-thirds of market value.
Income Statement
Walt Disney’s Income Statement
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).
Accrual Accounting
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Accrual accounting rests on two guiding
principles:
Revenue Recognition Principle – record revenue
when
 Earned
 Realized or Realizable
Matching Principle – record expenses when
 Incurred
Neither the recognition of revenue nor the
recording of expense necessarily involves the
receipt or payment of cash
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
In Class Example
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Baron Coburg
Statement of Stockholders’ Equity
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Statement of Equity is a reconciliation of
the beginning and ending balances of
stockholders’ equity accounts.
Main equity categories are:
Contributed capital
 Retained earnings (including Other
Comprehensive Income or OCI)
 Treasury stock
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Disney’s Statement of Stockholders’
Equity
Statement of Cash Flows
Statement of cash flows (SCF) reports cash
inflows and outflows
Cash flows are reported based on the three
business activities of a company:
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Operating activities: transactions related to the
operations of the business.
Investing activities: acquisitions and divestitures of
long-term assets
Financing activities: issuances and payments toward
equity, borrowings, and long-term liabilities.
Walt Disney
Company’s
Statement of
Cash Flows
Articulation of Financial Statements
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Financial statements are linked within and
across time – they articulate.
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.
Oversight of Financial Accounting
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GAAP
Oversight of Financial Accounting
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SEC oversees all publicly traded companies
Financial Accounting Standards Board
(FASB)
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Generally Accepted Accounting Principles
(GAAP)
Sarbanes-Oxley Act
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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:
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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
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
No changes to the company’s system of internal controls are made unless
properly communicated
Basic Assumptions and
Principles
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Monetary Unit
Fiscal period
Going concern
Stable dollar
Objectivity
Consistency
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Versus comparability
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.
Exceptions to the
Basic Principles
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Materiality
Only transactions with amounts large enough to
make a difference are considered material
 Non-material transactions are ignored
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Conservatism
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When in doubt…
Understate assets
 Overstate liabilities
 Accelerate recognition of losses
 Delay recognition of gains
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Information Beyond Financial
Statements
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Management Discussion and Analysis
(MD&A)
Independent Auditor Report
Financial Statement Footnotes
Regulatory Filings and Proxy Statements
Audit Report
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Financial statements present fairly and in all material respects
company financial condition.
Financial statements are prepared in conformity with GAAP
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
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
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?
Transaction Analysis
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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:
Journal Entries
Transaction Analysis
Credit Sales Transaction
Expense Payment Transaction
Accrued Expense Transaction
Deferred Revenue Transaction
Asset Write-Down
(Impairment) Transaction
What Number Do You Want?
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Accounting is a political process, not an exact
science.
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There is a great deal of discretion available to
managers.
Earnings Management
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Reasons to manage earnings
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ACCOUNTING NUMBERS HAVE
ECONOMIC CONSEQUENCES BEYOND
SIMPLY RECORDING TRANSACTIONS
Earnings Management - Why
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Compensation contracts
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Debt contracts
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Political considerations
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?
Debt Contracts
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Firms that are near violation of their debt
contracts have incentives to manage earnings
upward.
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?
Political Reasons
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Firms may wish to portray a certain image to the
public, government, or regulatory body.
Common Earnings Management
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Smoothing earnings
Managing earnings upward
Taking a bath
Off balance sheet financing
Takeaways
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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 should read the notes to the financial
statements since these contain a lot of useful
guidance to interpreting the statements.
Financial Statement Limitations
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Assets are valued at historical cost less an
estimated depreciation
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Other possibilities include cost, net realizable value,
replacement cost, price level adjusted
Not all assets appear
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Human capital, internally generated goodwill
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Could be argued that approach is more conservative
Financial Statement Limitations
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Not all liabilities appear
Contingencies appear only in the footnotes
 Off balance sheet financing
 Employee stock options
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Other limitations include management biases
and a lack of timeliness
Financial Accounting:
not an exact science
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GAAP allows companies choices in preparing
financial statements (inventories, property, and
equipment).
Financial statements also depend on countless
estimates.
Financial Accounting in Context
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A company’s financial statements only tell part
of the story.
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.