Overview of week 1

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” re

Prof: Jim Wallace

TA: Golf

Web Access to Class Info

 The site should contain:

 Users include capital providers,

regulators, customers, suppliers,

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

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

 Neither the recognition of revenue nor the

recording of expense necessarily involves the receipt or payment of cash

How do you define a rich

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

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

 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

 Main equity categories are:

 Contributed capital

 Retained earnings (including Other Comprehensive Income or OCI)

 Treasury stock

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:

1 Operating activities : transactions

related to the operations of the business.

2 Investing activities : acquisitions and

divestitures of long-term assets

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

In Class Example

 Baron Coburg

Oversight of Financial

Accounting

 GAAP

 Oversight of Financial Accounting

 SEC oversees all publicly traded companies

 Financial Accounting Standards

Board (FASB)

 Generally Accepted Accounting

Principles (GAAP)

Basic Assumptions and Principles

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

 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

Audit Report

material respects company financial condition

GAAP

responsibility Auditor responsibility is to express an opinion on those statements

investigation of each transaction

the statements are free of material misstatements

management and estimates used in preparing the

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?

 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

 Not all assets appear

 Human capital, internally generated goodwill

Financial Statement

Limitations

 Not all liabilities appear

 Contingencies appear only in the

footnotes

 Off balance sheet financing

 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

broader forces which impact company

Ethical Question

 See textbook