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Overview of Week 1
Administrative stuff What is financial accounting? Financial statements GAAP What number do you want?
Administrative Stuff
Homework
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http://www.cgu.edu/pages/3471.asp
A method to communicate financial information to interested external parties. Users include capital providers, regulators, customers, suppliers, employees, etc
Accounting yields the truth. Accounting is rigid. Accounting is useless. Accounting is hard! Accountants are boring.
The accounting equation Balance Sheet Income Statement Statement of Cash Flows Statement of Owners Equity
Balance Sheet
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.
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.
Disneys Assets
Liabilities
Companies desire more current assets than current liabilities this difference is called net working capital
Equity
Equity consists of:
Earned Capital (retained earnings). Retained Earnings is updated each period as follows:
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
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
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
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 (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.
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.
In Class Example
Baron Coburg
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.
Materiality
Only transactions with amounts large enough to make a difference are considered material Non-material transactions can be treated in the easiest manner
Management Discussion and Analysis (MD&A) Independent Auditor Report Financial Statement Footnotes
Audit Report
Financial statements present fairly and in all material respects company financial condition. Financial statements are prepared in conformity with GAAP Financial statements are managements 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?
Accounting is a political process, not an exact science. There is a great deal of discretion available to managers.
Earnings Management
Transaction Analysis
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
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.
Other possibilities include cost, net realizable value, replacement cost, price level adjusted Human capital, internally generated goodwill
GAAP allows companies choices in preparing financial statements (inventories, property, and equipment). Financial statements also depend on countless estimates.
A companys 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.