Accounting
Prof: Jim Wallace
TA: Golf
Overview of Week 1
Administrative stuff
 What is financial accounting?
 Some Myths
 Accrual versus Cash-based
 Financial statements
 GAAP
 Auditing

Administrative Stuff
Who am I
 Who is your T.A.
 Teaching philosophy
 Syllabus
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Homework
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://www.cgu.edu/pages/3472.asp
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What is Financial
Accounting?
A method to communicate financial
information to interested external
parties.
 Users include capital providers,
regulators, customers, suppliers,
employees, etc

• Capital suppliers include debt and equity
providers

Financial accounting is used for both
prediction and control
Accounting is rigid and
yields the truth

Generally-accepted accounting principles,
or GAAP, are a set of rigid rules that, if
followed correctly, will lead to a unique,
“correct” representation of the financial
performance and health of a firm.

The basic financial statements, consisting of
a balance sheet, an income statement, and
a statement of cash flows, reflect a
complete, accurate, and timely portrayal of
the financial performance and well-being of
a firm
Accounting is the sole
product of accountants

GAAP is created from a
comprehensive analytical process,
which is free from political influence.
It is all there

All of a firm’s identifiable assets and
liabilities appear on the balance
sheet, and the difference between a
firm’s assets and its liabilities
represents the value of the firm.
The statements stand alone

Each of the financial statements is
independent, with each reflecting a
different aspect of the firm’s
performance and financial health.
Cash is King!

Cash flow is ultimately what matters
to a firm and its investors; therefore,
it is not really necessary to worry
about the definition of earnings used
in the preparation of the income
statement. Rather, one need only
consider the sources and uses of
cash as reflected on the firm’s
statement of cash flows.
Some additional myths
 Accounting
is useless.
 Accounting is hard!
 Accountants are boring.
Other Types of Accounting
 Managerial
 Non-profit
 Tax
Accrual Accounting

Accrual accounting rests on two guiding
principles:
Revenue Recognition Principle – record
revenue when

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Matching Principle – record expenses when


Earned
Realized or Realizable
Incurred
Neither the recognition of revenue nor the
recording of expense necessarily involves the
receipt or payment of cash
How do you define a rich
person?
Has a lot of valuable stuff (worth more
than what is owed).
 Makes a lot of money

The Financial Statements
The accounting equation
 Balance Sheet
 Income Statement
 Statement of Cash Flows
 Statement of Owners Equity


Statement of retained earnings
Balance Sheet
Mirrors the Accounting Equation
Assets = Liabilities + Equity
Uses of funds = Sources of funds
 Assets are listed in order of liquidity
 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:
1.
2.
Be owned or controlled by
the company
Must possess expected
future benefits
Most Assets are Reported at
Historical Cost

Historical Cost is
Objective
 Verifiable
 Therefore, not subject to bias

However, historical cost is not
particularly “relevant” to most readers
of the balance sheet
 “Relevance vs. Reliability” is an
important issue with accountants.

Liabilities

Liabilities are listed in order of
maturity
Current Liabilities come due in less
than a year.
 Noncurrent liabilities come due
after a year.


Companies desire more current
assets than current liabilities – this
difference is called net working
capital
Equity
Equity consists of:
Contributed Capital (cash raised from the
issuance of shares)
Earned Capital (retained earnings).
Retained Earnings is updated each period
as follows:

Market Value vs. Book Value
Stockholders’ equity = Company book
value
 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
Statement of Stockholders’
Equity
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

Statement of Cash Flows

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Statement of cash flows (SCF) reports
cash inflows and outflows
Cash flows are reported based on the
three business activities of a company:
1.
2.
3.
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.
Articulation of Financial
Statements
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.

Exhibit 1.5 The Relationship Among the Basic Financial Statements
Change in Cash
Operating cash flows
Investing cash flows
Financing cash flows
Statement of cash flows
Cash
Liabilities
____
-------Balance
Sheet
(beginning
Other
of period)
assets
Shareholders’
equity
Income
statement
Revenues
-------------Expenses
-------------Net income
Cash
Liabilities
--------
Shareholders’
equity
____
Dividends
Other
assets
Change in shareholders’ equity
Statement of shareholders’ equity
Balance
Sheet
(end of
period)
In Class Example
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Baron Coburg
Oversight of Financial
Accounting
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)
Basic Assumptions and
Principles
Monetary Unit
 Fiscal period
 Going concern
 Objectivity (Reliability)
 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.
Exception to the
Basic Principles

Materiality
Only transactions with amounts large
enough to make a difference are
considered material
 Non-material transactions can be
treated in the easiest manner

Information Beyond Financial
Statements
Management Discussion and
Analysis (MD&A)
 Independent Auditor Report
 Financial Statement Footnotes
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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?
Takeaways
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

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

Human capital, internally generated
goodwill
• Could be argued that approach is more
conservative
Financial Statement
Limitations

Not all liabilities appear
Contingencies appear only in the
footnotes
 Off balance sheet financing
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Other limitations include management
biases and a lack of timeliness
Financial Accounting:
not an exact science
GAAP allows companies choices in
preparing financial statements
(inventories, property, and
equipment).
 Financial statements also depend on
countless estimates.

Financial Accounting in
Context
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.
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Ethical Question
 See
textbook