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					Core Accounting Concepts


Financial Management
                 Environmental Factors
                                   GAAP
            Generally Accepted Accounting Principles

                      FASB                  APB                AICPA(CAP)
Level I          Standards and            Opinions             Accounting
(Most            Interpretations                            Research Bulletins
authoritative)
                     FASB                  AICPA                    AICPA
Level II           Technical          Industry Audit &          Statement of
                   Bulletins        Accounting Guidelines         Position

                             FASB                             AICPA
Level III          Emerging Issues Task                 Practice Bulletins
                          Force

                      FASB                 AICPA             Recognized and
Level IV
                  Implementatio       Interpretations          Widely Used
(Least
                    n Guides                                Industry Practices
authoritative)
             Environmental Factors
                 Unions          AICPA                 Lenders

Securities and
  Exchange         Investors
                       vestors           Politicians

 Commission
                          Accountants                  Others

                  Provide input to

  Financial Accounting Standards Board
                      Help set
Generally Accepted Accounting Principles
              Environmental Factors

  Securities and Exchange Commission (SEC)



 Independent, quasi-judicial government agency
 Administer securities regulations & disclosures
 Can modify & set GAAP, if necessary
 Rarely directly challenges FASB
 Major player in global accounting
        Environmental Factors


International Accounting Standards (IAS)
 Set by International Accounting
  Standards Board
 Not currently accepted in U.S.
 SEC under pressure to accept IAS
  The Business Cycle
                            Cash: Start. Company           Cash: End. Customer
                             pays for raw materials       pays for product or service

            Purchases                      1              9
                                                                                   Collections
                   2
Materials
                                                 Current Assets                   8
Inventory


      3

                                                                                        7
                                  Operating Cycle                                           Accounts
                                                                                            Receivable
     Production         4
                                                                   6
                                                5                       Sales
                                    Finished
                                   Inventory
Core Concepts Accounting


Managerial versus Financial Accounting
 Managerial
       Provides information to internal decision makers

   Financial
       Communicates information to external decision makers,
        especially to shareholders and creditors

                 We are concerned with
                 Financial Accounting
   Accounting Concepts
Entity Concept         Accounts are kept and reports are issued for a
                         specified accounting entity, which could be a
                         single person, two or more partners, a company
                         or group of associated companies.

Money Unit Principle   Transactions must be quantifiable in monetary terms.


                       Information reflects the original cost of assets.
Historical Cost


Matching Principle     Costs are recorded as expenses in the same period
(Income Statement)        as the associated revenue



Conservatism           Accounting should not overstate assets or under-
                          state liabilities.
Annual Report Structure

   Management's Discussion and Analysis
   The Four Primary Financial Statements
       Balance Sheet
       Income Statement
       Cash Flow Statement
       Statement of Shareholders’ Equity
   Footnotes
   Auditor's Opinion
Kimberly Clark - First Page of MD&A
Core Concepts Accounting

     The balance sheet must always balance




                             Liabilities
                                 +
         Assets
                           Stockholder’s
                               Equity
Core Concepts Accounting

       Assets
                               Liabilities and
                             Stockholders’ Equity
Shown on the left-hand    Shown on the right-hand
   side of the balance       side of the balance
          sheet                     sheet



 Assets = Liabilities + Stockholder’s Equity
Core Concepts Accounting


   The balance sheet reports a company's financial
    position “as of” a set date
       Think of the balance sheet as a snap shot of a company

   There are three main balance sheet components
    Assets: what the company owns
    Liabilities: what the company owes
    Stockholders’ equity: what belongs to the owners
Core Concepts Accounting

Ordering of the balance sheet
 Assets

       Current Assets (most liquid)
       Long-term Assets
       Intangible Assets (least liquid)

   Liabilities
       List in order in which they become due

   Stockholders’ Equity
       Paid-in Capital (Common Stock)
       Additional Paid-in Capital (or Capital in excess of par value)
       Retained Earnings
Balance Sheet – Current Assets
Assets are divided into Current (less than one year) or Long-Term.

                       Current Assets
Cash and cash equivalents:     Cash or government bills (less
                               than 90 days);
Marketable securities:         Traded securities, either equity or
                               debt;
Accounts receivable:           Amounts owed by customers from
                               sales made on credit;
Notes receivable:              Amounts due from other non-trade
                               activities;
Inventory:                     The total of costs allocated to
                               inventory;
Prepaid expenses:              Prepayments of future expenses.
Balance Sheet – Long Term Assets
                              Long Term Assets

 Property, Plant & Equipment:       PP&E is valued at historic cost
                                    and other capitalized costs,
                                    less accumulated depreciation and
                                    impairments.

 Investments in affiliates:         Investments in and advances to
                                    affiliates using the equity method
                                    of accounting.

 Intangible assets:                 Includes Goodwill, trademarks,
                                    patents, and other assts without a
                                    physical shape
Current Liabilities
Liabilities due within one year are classified as current.

                           Current Liabilities
Notes payable:           Amounts owed to financial creditors;

Accounts payable:        Amounts owed to trade creditors;

Income taxes payable: Income taxes accrued during the past year
                      that are not yet paid;

Current portion of       The part of long-term debt due within one LTD:
                         year;

Current portion of       The part of capital leases due within one
  capital leases         year.
Long Term Liabilities
                         Long Term Liabilities

Long term debt:                   Financial obligations (borrowings)
                                  due in more than one year.
Capital lease obligations:        The present value of leases that
                                  have the characteristics of debt;
Post-retirement benefit costs:    The present value of future
                                  pension and other benefit costs;
Deferred income taxes:            Cumulative differences between
                                  accounting tax expense and taxes
                                  payable on the tax return;
Minority interests:               Equity of outsiders in the assets of
                                  the company.
Balance Sheet – Stockholders’ Equity
                          Stockholders’ Equity

 Preferred stock:                 Usually non-voting stock with
                                  restricted dividend rights;

 Common stock:                    The total par value of outstanding
                                  common stock;
 Additional paid in capital:      Amounts above par received from
                                  sale of stock;
 Retained earnings:               The accumulation of company’s
                                  earnings less dividends paid;
 (Treasury stock):                Repurchased stock;
Core Concepts Accounting

     Classroom Question 1
     If a company has a balance sheet which records
     $10,000 of assets and $8,000 of equity, then the
     recorded value of liabilities will be:

A.    -$2,000.
B.     $2,000.
C.    $10,000.
D.    $12,000.
Core Concepts Accounting

     Classroom Question 2
     If a company has a balance sheet which records
     $10,000 of assets and $12,000 of liabilities, then the
     recorded value of equity will be:

A.    -$2,000.
B.     $2,000.
C.    $10,000.
D.    $12,000.
Core Concepts Accounting

   There are several ways to increase Stockholders’ Equity:
     Increase the value of assets

     Decrease the value of liabilities

     Retain profits

     Issue new equity



   The balance sheet account values are based on assumptions
    made by the company’s management
     The balance sheet is subject to manipulation by changing
      assumptions
Core Concepts Accounting

    Classroom exercise: building a balance sheet
    We shall build basic balance sheets for Tiny Company, a
    fictitious firm, using only four accounts
   Asset accounts
     Cash

     Other assets

   Liability and Stockholders’ Equity
     Liabilities

     Common stock
Core Concepts Accounting


Building a balance sheet: transaction 1

On January 1, 20X4, Tiny Company issued $10,000
of stock and deposited the proceeds into a bank
account.

Assume opening balances of $0 for every item.
 Core Concepts Accounting

                          Tiny Company
                 Balance Sheet as at January 1, 20X4

              Assets                   Liabilities and Stockholders’
                                                    Equity
Cash              $10,000             Common stock $10,000
Total             $10,000             Total            $10,000

    “Cash” is the proper name for money on hand and in bank
     accounts
    Every transaction must have at least two financial statement
     entries
       This is called a double-entry system
Core Concepts Accounting

 Building a balance sheet: transaction 2
 On February 1, 20X4, Tiny Company received a
 bank loan for $5,000, with which it bought new
 machinery worth $5,000.

 Prepare Tiny Company’s balance sheet as at
 February 1, 20X4.
Core Concepts Accounting



        Assets         Liabilities +
                  Stockholders’ Equity



Total             Total
Core Concepts Accounting


 Building a balance sheet: transaction 3
 On March 1, 20X4, Tiny Company purchases a plot
 of land by writing a check for $3,000. (The check
 clears the bank immediately.)

 Prepare Tiny Company’s balance sheet as at
 March 1, 20X4.
    Core Concepts Accounting


         Assets               Liabilities and
                        Stockholders’ Equity



Total                   Total
Core Concepts Accounting


 Building a balance sheet: transaction 4
 On April 1, 20X4, Tiny Company obtains another bank loan for
 $6,000. With the proceeds, Tiny deposits $2,000 into its bank
 account and purchases another $4,000 of new machinery.

 Prepare Tiny Company’s balance sheet as at
 April 1, 20X4.
    Core Concepts Accounting

                   Tiny Company
           Balance Sheet as at April 1, 20X4

        Assets                        Liabilities and
                                 Stockholders’ Equity



Total                             Total
Core Concepts Accounting

 Building a balance sheet: transaction 5
 On May 1, 20X4, Tiny Company writes a cheque
 to repay $4,000 of its bank loan.


 Prepare Tiny Company’s balance sheet as at
 May 1, 20X4.
   Core Concepts Accounting

                    Tiny Company
            Balance Sheet as at May 1, 20X4

        Assets                        Liabilities and
                                 Stockholders’ Equity



Total                            Total
Core Concepts Accounting

   In reality, new balance sheets are not created whenever new
    transactions occur
     Handling a large number of transactions would be

       impractical

   Instead, we change the balance sheet only periodically
     Between balance sheet changes, we record each
       transaction in a T-account
       There is one T-account for every item appearing on the
        balance sheet
Core Concepts Accounting

       T-account properties

       Left-hand side is   Right-hand side is
       called a debit      called a credit
       (Dr.)               (Cr.)
Core Concepts Accounting

                                               Liabilities and
        Asset accounts
                                        Stockholders’ Equity accounts
            (Dr.)   (Cr.)                               (Dr.)   (Cr.)
    Increases in    Decreases in             Decreases in       Increases in
assets are called   assets are called     liabilities and/or    liabilities and/or
           debits   credits              equity are called      equity are called
                                                      debits    credits
Core Concepts Accounting


How to use a T-account                           Cash

Assume that the opening                       (Dr.) (Cr.)
balance for cash is $0

The company receives $400           Opening bal. 0
in cash from a customer                               250

The company pays $250                          400
in cash to a supplier
                                   Closing bal. 150
What is the closing cash balance
at the end of the period?
Core Concepts Accounting
                               Tiny Company
                       Balance Sheet as at May 1, 20X4
                   Assets                  Liabilities and Stockholders’
                                                        Equity
    Cash              $5,000             Liabilities        $7,000
    Other assets      12,000             Common stock       10,000
               Total $17,000                           Total $17,000


   Closing balances in the T-accounts are posted to the
    corresponding balance sheet items
      This balance sheet is identical to the one built in five

        separate steps
   Closing balances in the T-accounts now become the opening
    balances for next period’s transactions
Core Concepts Accounting
 Let’s now consider some transactions for Tiny
 Company during the month of June, 20X4
  These will help link the Balance Sheet with the

   Income Statement and Statement of Cash Flows

 Building a balance sheet: transaction 6
 On June 1, 20X4, Tiny Co. pays $4,000 cash for
 inventory.
 Core Concepts Accounting
                            Tiny Company
                    Balance Sheet as at June 1, 20X4
               Assets                      Liabilities and Stockholders’
                                                        Equity
Cash                $1,000               Bank debt           $7,000
Inventory           4,000
Machinery           9,000                Common stock        10,000
Land                3,000
             Total $17,000                            Total $17,000

    Note: Accounts have been disaggregated
       List the most liquid asset, then work down to the least liquid asset
       The purchase of inventory is an Operating Activity
Core Concepts Accounting

 Building a balance sheet: transaction 7
 On June 15, 20X4, Tiny Co. issues a 2-year note
 (debt) to finance future expansion. The proceeds of
 $8,000 are deposited into the bank account. (Note
 that Tiny Co.’s bank loans are due at the end of
 2004.)

 Prepare Tiny Company’s balance sheet as at
 June 15, 20X4.
Core Concepts Accounting



     Assets            Liabilities and
                   Stockholders’ Equity




    Total          Total
Core Concepts Accounting

 Building a balance sheet: transaction 8
 On June 20, 20X4, Tiny Co. sold $1,000 worth of
 goods for $3,000 in cash.

 Prepare Tiny Company’s balance sheet as at
 June 20, 20X4. All unaffected accounts have
 been left for you.

 Remember: the balance sheet must balance
 Core Concepts Accounting

                        Tiny Company
               Balance Sheet as at June 20, 20X4

            Assets                 Liabilities and Stockholders’
                                                Equity
Cash                             Bank debt                 $7,000
Inventory                        Note due                   8,000
Machinery                9,000 Common stock                10,000
Land                     3,000
Total                            Total
Core Concepts Accounting

 Building a balance sheet: transaction 9
 On June 29, 20X4, Tiny Co. paid a $1,500 cash
 dividend to its shareholders.

 Prepare Tiny Company’s balance sheet as at
 June 29, 20X4. All unaffected accounts have
 been left for you.
 Core Concepts Accounting

                        Tiny Company
               Balance Sheet as at June 29, 20X4

            Assets               Liabilities and Stockholders’
                                              Equity
Cash                           Bank debt                 $7,000
Inventory                3,000 Note due                   8,000
Machinery                9,000 Common stock              10,000
Land                     3,000 Retained Earnings
Total                          Total
Core Concepts Accounting

 Building a balance sheet: transaction 10
 On June 30, 20X4, Tiny Co. purchases another piece
 of machinery in cash worth $2,000.
Core Concepts Accounting
      How the Balance Sheet links to the Income Statement

                  Retained Earnings
                   (Balance Sheet)




                      Statement of
                  Retained Earnings
                  (intermediate step)




                     Net Income
                 (Income Statement)
 Core Concepts Accounting

                                    Retained Earnings
Retained Earnings T-Account

The opening balance is $0               (Dr.) (Cr.)

The company sells $1,000
                                                0 Opening bal.
worth of goods for $3,000

The company pays $1,500        Expense 1,000 3,000 Revenue
cash dividend
                              Dividends 1,500
What is the closing balance
at the end of the period?
                                                500 Closing bal.
Core Concepts Accounting

         The Income Statement

               Revenues
                Minus
               Expenses
                Equals
              Net Income
   Core Concepts Accounting
         Tiny Company                       Tiny Company
       Income Statement            Statement of Retained Earnings
 for the month ending June 30,      for the month ending June 30,
              20X4                               20X4

Revenues                 $3,000   Opening Balance              $0

Less: Expenses           $1,000   Net Income                2,000

Net Income               $2,000   Subtotal                 $2,000

                                  Less: Dividends           1,500

                                  Closing Bal.               $500
Core Concepts Accounting
Cash T-account
                                            Cash
Opening balance is $5,000

Company buys $4,000                      (Dr.) (Cr.)
of inventory (operating)

Company receives $8,000     Opening bal. 5,000 4,000
from note (financing)

Company receives $3,000                 8,000 1,500
from sales (operating)
                                        3,000 2,000
Company pays $1,500 in
dividends (financing)
                            Closing bal. 8,500
Company pays $2,000 for
new machinery (investing)
Section 2


            Accrual Accounting
                 and the
            Matching Principle
Section 2 Outline


   Cash versus Accrual Accounting
   The Matching Principle
   Examples of Accruals
Cash versus Accrual

Cash Basis: Recognize revenue when the firm
 receives cash and recognize expenses when
 the firm pays cash.

Accrual Basis: Recognize revenue when it is
 “earned.” Recognize expenses at the same
 time the firm recognizes associated revenue.
The Matching Principle

 Recognize expenses in the same period you
      recognize the associated revenue

Accruals: Accruals arise when costs or
 benefits are recognized without cash being
 exchanged at the same time.
Example 1: Schwarzenegger

The California Doll Company sold $100 million of “Arnold
  Schwarzenegger for Governor” dolls for $60 million cash and $40
  million on account.


   What is the journal entry when the sale is made?


   What is the journal entry when the
    cash is collected?
    Example 1 Solution
The California Doll Company sold $100 million of “Arnold
  Schwarzenegger for Governor” dolls for $60 million cash and
  $40 million on account.

   What is the journal entry when the sale is made?

    Cash +60            A/R +40          Revenue (RE) +100

   What is the journal entry when the
    remaining cash is collected?

        Cash    +40             A/R      -40
Example 2: AT&T

AT&T sells $500,000 in prepaid phone cards.

   What is the journal entry when the sale is made?

   What is the journal entry at year-end when AT&T
    knows that 40 percent of the minutes on the
    cards have been used?
Example 3: Bonds

On January 1st, the company issues $200,000 of 10-
 year bonds that pay 10 percent simple interest. The
 interest payments take place twice a year, on July
 1st and January 1st.

   What is the journal entry on January 1st when the
    company issues the bonds?
   What is the journal entry on July 1st?
   What other entries might there be for the current
    year?
    Accounting Analysis

         Process to evaluate and adjust financial
      statements to better reflect economic reality



Comparability problems — across firms and across time

                      Manager estimation error
                                                 Accounting
Distortion problems   Earnings management
                                                    Risk
                      Distortion of business
 Accounting Analysis
        Sources of Accounting Distortions
 Accounting Standards – attributed to (1) political
  process of standard-setting, (2) accounting principles and
  assumptions, and (3) conservatism
 Estimation Errors – attributed to estimation errors
  inherent in accrual accounting
 Reliability vs Relevance – attributed to over-emphasis
  on reliability at the loss of relevance
 Earnings Management – attributed to window-
  dressing of financial statements by managers to achieve
  personal benefits
 Accounting Analysis
     Earnings Management –Source of Distortion

Three common strategies:
 Increasing Income   – managers adjust accruals
                      to increase reported
                      income
 Big Bath            – managers record huge
                      write-offs in one period to
                      relieve other periods of
                      expenses
 Income Smoothing – managers decrease or
                      increase reported income
                      to reduce its volatility
  Accounting Analysis
          Earnings Management – Motivations

 Contracting Incentives -- managers adjust numbers used
  in contracts that affect their wealth (e.g., compensation
  contracts)
 Stock Prices – managers adjust numbers to influence stock
  prices for personal benefits (e.g., mergers, option or stock
  offering)
 Government Favors – managers adjust numbers to affect
  political actions (e.g., antitrust actions, IRS pressures,
  government subsidies)
 Other Reasons -- managers adjust numbers to impact (1)
  labor demands, (2) management changes, and (3) societal
  views
  Accounting Analysis
        Earnings Management – Mechanics

 Incoming Shifting   – Accelerate or delay
                      recognition of revenues or
                      expenses to shift income from
                      one period to another

 Classification      – Selectively classify revenues
                      and expenses in certain parts
                      of the income statement to
                      affect analysis inferences
                      regarding the recurring nature
                      of these items
  Accounting Analysis
            Process of Accounting Analysis

Accounting analysis involves several inter-related processes
   and tasks that can be grouped into two broad areas:
 Evaluating Earning Quality –
1. Identify and assess key accounting policies
2. Identify and assess red flags
Adjusting Financial Statements --
1. Identify, measure, and make necessary adjustments
   to financial statements to better serve one’s analysis objectives
Any Questions?

				
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