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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