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Three Pillars

Accounting (Financial statements)


o Report on the financial position of an entity (e.g. a
business, organization, or person)
o Show how the entity has performed financially over a
particular period of time (an "accounting period")
Auditing
o Ensure that the entitys financial transactions are recorded
properly on entitys books
o Ensure that proper internal controls exist
Finance
o Valuation of entities, securities, and cash flows
o Understanding risk and returns
o Understanding capital markets
Objectives of Financial Accounting
Record all of an entitys transactions in a systematic way (double
entry system)
Prepare reports of an entitys financial performance and health
for its managers and/or outsiders
o Calculate an entitys income and cash flow
o Report the entitys assets and liabilities
Allow estimation of a companys future earnings and prospects of
the company.
Facilitate comparison of an entitys current performance to its
past performance or to competitors performance
Lawyers Uses of Accounting
Corporation law issues involving accounting
Other legal disputes/issues
o Contracts (e.g., what was the movies profit)
o Securities litigation
o Antitrust
Understand financial state of a business or other entity
Valuation of a business
Problem 1a An Introduction
Annie and Marta formed KFC (Hungary), Inc. (KFC) to
operate a Kentucky Fried Chicken franchise in Budapest.
During Year 1, KFC engaged in the following transactions:
Annie and Marta invest $600,000 in KFC in exchange for
common stock.
Is this income for KFC?

No, it is an equity investment in KFC:


o CASH $600,000 +
COMMON STOCK $600,000

Problem 1b An Introduction
Annie and Marta formed KFC (Hungary), Inc. (KFC) to
operate a Kentucky Fried Chicken franchise in Budapest.
During Year 1, KFC engaged in the following transactions:
KFC spends $50,000 training the staff to operate the
store.
Is this an asset, an expense in Year 1, or an expense to be
recognized over time?
Problem 1b An Introduction
Annie and Marta formed KFC (Hungary), Inc. (KFC) to
operate a Kentucky Fried Chicken franchise in Budapest.
During Year 1, KFC engaged in the following transactions:
An expense in Year 1:
o TRAINING EXPENSE $50,000 +
o CASH $50,000 Problem 1c An Introduction
Annie and Marta formed KFC (Hungary), Inc. (KFC) to
operate a Kentucky Fried Chicken franchise in Budapest.
During Year 1, KFC engaged in the following transactions:
KFC bought equipment for $150,000. By the time the
equipment was delivered its market value had increased
to $180,000 (due to exchange rates & inflation).
Should the equipment be listed at $150 K or $180 K ?
Problem 1c An Introduction
Annie and Marta formed KFC (Hungary), Inc. (KFC) to
operate a Kentucky Fried Chicken franchise in Budapest.
During Year 1, KFC engaged in the following transactions:
At cost: $150,000
o EQUIPMENT $150,000
+
CASH $150,000
Problem 1d An Introduction
Annie and Marta formed KFC (Hungary), Inc. (KFC) to
operate a Kentucky Fried Chicken franchise in Budapest.
During Year 1, KFC engaged in the following transactions:
KFCs bank added $40,000 to KFCs bank account for
interest earned by KFC on the account.
Should the interest be reported as ordinary income or as
a special type of income?

Problem 1d An Introduction
Annie and Marta formed KFC (Hungary), Inc. (KFC) to
operate a Kentucky Fried Chicken franchise in Budapest.
During Year 1, KFC engaged in the following transactions:
Special type of income:
CASH $40,000
+
INTEREST INCOME $40,000
+

Generally Accepted Accounting Principles (GAAP)


A set of accounting and financial reporting standards
Primarily created by the Financial Accounting Standards Board
(FASB), a private, independent organization of accounting
experts (CPAs, corporate executives, financial analysts,
academics) that establish and interpret GAAP
Because it is a private organization, FASBs promulgation of GAAP
doesnt officially legally bind accountants
In reality, GAAP is very important:
o Violating GAAP is generally the legal definition of
professional negligence for accountants
o The Securities and Exchange Commission (SEC)
generally strongly defers to GAAP
o Investors, lenders, and trade creditors oven insist on
receiving financial statements complying will GAAP before
investing, lending, or extending credit
Historical Sources of GAAP
FASB set forth GAAPs central organizing principles in a series of
Statements of Financial Accounting Concepts: broad
conceptual frameworks on which more particularized
pronouncements are built.
Particular pronouncements took the form of Statements of
Financial Accounting Standards.
Supplementing these were periodic Interpretations and
Technical Bulletins.
American Institute of Certified Public Accountants (AIPCA) was
main creator of GAAP before FASB was established in 1973. Even
after FASB, the AICPA publications continued to give opinions on
certain accounting issues.
Numerous other accounting organizations (e.g., American
Accounting Association, Financial Executives Institute) make
pronouncements on many accounting issues
Securities and Exchange Commission (SEC) has authority to
establish financial accounting and reporting standards for
publicly held companies. SEC has worked with FASB in
establishing these accounting principles and tends to sanction,
as a matter of law, the GAAP rules that FASB promulgates.

FASBs Accounting Standards Codification


Organizes GAAP into 90 topics, drawing on the scattered sources
that historically contributed to GAAP
Since 2009, FASB has said that its Accounting Standards
Codification is the single source of authoritative GAAP.
Everything else is non-authoritative.
In many cases, GAAP allow multiple ways of accounting
for certain financial events, as long as the chosen way is
fully disclosed in financial statements
SECs Role
SEC retains the power to establish financial accounting and
reporting standards for publicly held companies.
Sarbanes-Oxley Act of 2002 explicitly allows the SEC to recognize
as generally accepted those accounting principles established
by standard-setting bodies meeting certain criteria (primarily
independence)
SEC continues to work with FASB in establishing these accounting
principles and tends to sanction, as a matter of law, the GAAP
rules that FASB promulgates.
International Financial Reporting Standards (IFRS)
IFRS = A set of accounting standards promulgated by the
International Accounting Standards Board (IASB)
Primary accounting standards in over 100 countries
SEC and FASB has been working with IASB (with support of
Congress) to harmonize GAAP and IFRS
Most remaining differences between GAAP and IFRS involve
advanced accounting topics
Since 2008, SEC has allowed non-US companies to file financial
statements complying with IFRS
SEC had been pushing for a process to have U.S. switch from
GAAP to IFRS
Rumors are that the SEC is now instead seeking a convergence
(i.e. harmonizing GAAP and IFRS)
FASBs Objectives & Qualitative Characteristics
Objectives
o Provide useful information to outsiders (primarily investors
and creditors) regarding an entitys assets, liabilities,
owners equity, and cash flows
Characteristics of Accounting Information
o Relevant
(timely)

o Reliable

(free of error/misstatement; can be


verified by independent parties)
o Comparable
(to prior periods and to similar entities)
o Consistent
(same accounting methods from
period-toperiod; any changes must be justifiable
and disclosed)
GAAPs Assumptions/Foundations
Separate Entity Assumption Entity is distinct from its
owner(s)
Going Concern Assumption Entity will be continuing for an
indeterminate period
Time Period Assumption Entitys activities can be divided
into discrete time periods
Monetary Transactions Principle Reports entitys
transactions can be measured in monetary terms
Conservatism Principle It is preferable to understate rather
than overstate earnings, cash flow, and values
Realization Principle Recognize revenue only when the entity
has (virtually) completed the relevant exchange
Matching Principle Allocate expenses to the period in which
they contribute to generating revenue
Cost Principle Report asset values at their (historical) cost to
the entity, rather than at their current market value
Consistency Principle Apply accounting principles
consistently within a set of financial statements
Materiality Principle Information in financial statements
should be meaningful to users
Components of Financial Statements
Balance Sheet
Income Statement
Statement of Changes in Equity
Statement of Cash Flows
Footnotes
The Balance Sheet
ASSETS (What the entity owns)
o Cash, Accounts Receivable, Inventory, Equipment
LIABILITIES (What the entity owes)
o Accounts Payable, Notes Payable
EQUITY (Residual interest in assets, after subtracting liabilities)
o For businesses, Equity = Owners Stake

AssetsLiabilities=Equity
The

Income Statement
REVENUES (from delivering goods and services)
$ from selling sweaters or drafting wills
EXPENSES (from delivering goods and services)
Cost of sweaters sold, Secretarys salary, Rental cost of office
space
NET INCOME (Difference between Revenues and Expenses)
REVENUES EXPENSES = NET INCOME

The Statement of Changes in Equity


EQUITY AT BEGINNING OF PERIOD
o + NET INCOME
o + ADDITIONAL INVESTMENT DURING PERIOD
(stock issued)
o - WITHDRAWALS OF EQUITY DURING PERIOD
(stock bought back, dividends)
o = EQUITY AT END OF PERIOD
Also called Statement of Shareholders Equity or Statement of
Retained Earnings
Footnotes to Financial Statements
Presents additional or more detailed information than is in the
financial statements
Discloses which accounting convention was used in preparing
financial statements if GAAP permitted more than one method
o Inventory methods
o Depreciation methods
o Accounts Receivable write-offs
Purpose of footnotes is to explain information (not to hide it)
Balance Sheet
What is a Balance Sheet?
o A balance sheet is a summary of an entitys financial
resources and obligations.
o Also, a balance sheet is a snapshot of these
resources and obligations at a particular time. In
other words, a particular balance sheet exists at a
particular time (e.g., as of December 31, 2013).
A balance sheet reflects the Fundamental Accounting
Equation:
o ASSETS = LIABILITIES + EQUITY

DEFINITION OF ASSETS
What the Entity Owns
Formal Definition (according to FASB):
o Assets are resources with probable future economic
benefits obtained or controlled by an entity resulting from
past transactions or events.
DEFINITION OF LIABILITIES
What the Entity Owes
Formal Definition:
o Liabilities are probable future sacrifices of economic
benefits arising from present obligations to transfer assets
or render services in the future.
DEFINITION OF EQUITY
The residual interest in the assets of an entity after subtracting
its liabilities.
In a business enterprise, the equity is the ownership interest.
Equity is sometimes referred to as net assets or net
worth
THE FUNDAMENTAL EQUATION

Key Implication:
o Any change on one side of the equation must be matched
by a change on the other side.
o Otherwise, the equation wont hold and the balance sheet
wont balance.
o To keep the fundamental equation in balance: There must
be at least two entries for every transaction to be
accounted for.

REARRANGING THE FUNDAMENTAL EQUATION

What is
owed
What is
owed

Double-Entry Bookkeeping
Double-entry bookkeeping is implemented by two mechanisms:
debits and credits
Debit = left-side entry
Credit = right-side entry
KEY: For any transaction, the total $ amount of the debit
entries and the total $ amount of the credit entries must
be equal.
o i.e., the left-side entries always equal the right-side
entries;
Debits = Credits
T

ACCOUNTS
There is a ledger or T account for each asset, liability, and

equity.
Double-Entry Bookkeeping
To keep the fundamental equation in balance, there must
be at least two entries for every transaction to be
accounted for.
At least one entry must be a debit.
At least one entry must be a credit.
Types of Debits
o 1. Increase in an asset
o 2. Decrease in a liability

o 3. Decrease in equity
Types of Credits
o 1. Decrease in an asset
o 2. Increase in a liability
o 3. Increase in equity
KEY: For any transaction, the total $ amount of the debit
entries and the $ amount of the credit entries must be
equal.
o i.e., the left-side entries (debits) always equal the
right-side entries (credits)

First Example of Double Entries

Second Example of Double Entries

Third Example of Double Entries

More Examples of Double Entries

Sequence

JOURNAL ENTRIES
THE JOURNAL (DAILY BOOK)
o First book in the accounting system
o First record of each transaction
THE ENTRY
o DEBIT (To the left)

CREDIT (to the right)

To Make a JOURNAL ENTRY, ask . . .

3 Questions:
o What Happened?
(state the transaction)
o Which Accounts are Affected?
(type of asset , liability, equity)
o Which Direction do the Accounts Move?
(increase + or decrease -)
o Then use map of fundamental equation to make entries in
correct places.

Larrys Firm: JOURNAL ENTRIES


1. Larry opens a new law office and contributes $10,000
cash to it.

2. The Firm pays $500 cash to have legal stationary


printed for it

3. The Firm use a store credit card to buy a desk, chair,


and sofa for $3,000 at Barristers Department Store.

4. The Firm makes a $250 cash payment to the store to


pay part of its credit card bill.

5. The Firm gives Larry the $800 sofa for his personal use
at home.

6. The store terminates its credit card business and has


its accountholders instead issue promissory notes on the
remaining credit card balances.

7. To settle a dispute with a former client over its


handling of a lawsuit, the Firm agrees to pay the client
$500 in the future.

8. The former client forgives the $500 the Firm owes her.

Sequence: THE LEDGER


Ledger: the second book of accounting
Contains accounts by asset/liability/equity type (e.g., Cash, Land,
Loans, Owners Equity)
Daily journal entries are posted to the ledger accounts,
positioned as left-side or right-side entries as they appear in the
journal
The ledger accounts are called T-accounts to enable posting to
left and right sides, in turn to maintain equation and balance:

T-Accounts for Larrys Law Firm


How

to Close the Books


How to Close the Books
Larrys Firm: LEDGER
T-Accounts for Larrys Law Firm
How to Close the Books
Larrys Firm: LEDGER

Sequence: Statements
Balance Sheet
Sample Balance Sheets -- Assets
Current Assets
Defintion
Assets that are cash or are reasonably expected to be converted
into cash within one year in the normal course of business.
Examples
Cash
Marketable Securities
Accounts Receivable (A/R)
Inventory
Prepaid Expenses
Noncurrent Assets
Defintion
Non-cash assets that are not reasonably expected to be
converted into cash within one year in the normal course of
business.
Examples
Real Estate
Equipment
Computers

Sample Balance Sheets Liabilities & Owners Equity


Current Liabilities
Defintion
Obligations that are due within one year. Current liabilities
appear on the company's balance sheet and include short term
debt, accounts payable, accrued liabilities and other debts.
Examples
Short-term debt
Current portion of Long-term debt
Accounts Payable (A/P)

Income Taxes Payable


Accrued Expenses
Noncurrent Liabilities
Defintion
Obligations that are due in more than one year. Current liabilities
appear on the company's balance sheet and include short term
debt, accounts payable, accrued liabilities and other debts.
Examples
Long-term debt
Lease obligations