Principles of Financial Accounting

Class 1
Introduction

What is Accounting?

„ Accounting – a process of identifying, analyzing, recording,

summarizing, and reporting economic information to decision
makers in the form of financial statements.

„ Financial accounting – focuses on the specific needs of

decision makers external to the organization (e.g. stockholders,
suppliers, banks, and government agencies).

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 Who Cares?

„ Accounting information is useful to anyone who needs to make a

decision based upon the company’s performance and potential.

Í For example:
9 Investors
9 Owners
9 Managers
9 Creditors
9 Legislators
9 Etc.

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How Does It Work?

„ Accounting helps in decision making by showing where and

when money has been spent, by evaluating performance, and
by showing the implications of choosing one plan instead of
another.

„ Fundamental relationships in the decision-making process:

Accountant’s
Financial
Event analysis and Users
statements
recording

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 Financial and Management Accounting

„ Major distinction between financial and management accounting

= the users of the information.

Í Financial accounting serves external users (e.g. investors,

creditors, and suppliers).

Í Managerial accounting serves internal users (e.g. top executives,

management, and administrators within organizations).

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Financial Accounting

„ What might we want to know about an organization as an external

user of financial statements?

„ Accountants answer many of these questions with three major

financial statements.
Í Balance sheet – shows financial picture on a given day.
Í Income statement – shows financial performance over a given period.
Í Statement of cash flows – shows cash inflows and outflows over a
given period.

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 The Main Financial Statements
„ Balance Sheet: Snapshot of assets and liabilities at a given point in time.
The ABC Company, Inc.
Balance Sheet
As Of December 31, 1997
Assets Liabilities and Owners’ Equity
Liabilities
Current Assets Current Liabilities
Cash Xxx Accounts Payable Xxx
Short –Term Investments Xxx Expenses Payable Xxx
Accounts Receivable Xxx Bank Loans Xxx
Inventory Xxx Xxx
Pre-paid Expenses Xxx Noncurrent
Liabilities
Xxx Bank Loans Xxx
Noncurrent Assets Bonds Payable Xxx
Machinery and Equipment Xxx Xxx
Buildings Xxx
Land Xxx Owners’ Equity
Xxx Contributed Capital Xxx
Investments and Other Assets Xxx Retained Earnings Xxx
Xxx
Total Assets Xxx Total Liabilities and Xxx
Owners’ Equity
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The Main Financial Statements

„ Income Statement:
Í Flow of revenues and expenses during a period of time.
The ABC Company, Inc.
Income Statement
For The Year Ended December 31, 2005
Revenues $ xxx
Less: Cost of Goods Sold (xxx)
Gross Income $ xxx

Operating Expenses:
General and Administrative Expense xxx
Selling (Marketing) Expense xxx (xxx)
Income from Operations $ xxx

Interest expense (xxx)

Other expense (income) (xxx)
Income before Taxes xxx
Taxes (xxx)
Net Income $ xxx

Earnings Per Share $ x.xx

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 The Main Financial Statements
„ Statement of Cash Flows:
Í Cash receipts and cash payments during a period of time.
The ABC Company, Inc.
Statement of Cash Flows
For The Year Ended December 31, 2005
Operations:
Revenues Providing Cash $ Xxx
Expenses Paid with Cash Xxx
Cash Flow from Operations Xxx
Investing Activities:
Sale of Noncurrent Assets $ Xxx
Purchase of Noncurrent Assets Xxx
Cash Flow from Investing Activities Xxx
Financing Activities:
Cash Provided by Borrowing $ Xxx
Cash Provided by Issuing Equity Xxx
Cash Used to Repay Debt Xxx
Cash Used to Pay Dividends Xxx
Cash Flow from Financing Activities Xxx
NET CASH FLOW FOR 2005 $ Xxx
(Ending cash – Beginning cash)

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Annual Report
„ Prepared by management and distributed to current and potential
investors providing information about the company’s past
performance and future prospects.
Í Includes the three main financial statements (BS, IS, SCF).

Í Includes footnotes explaining in more detail many elements of the

financial statements.

Í Includes the Management’s Discussion and Analysis (MD&A):

9 Should cover three financial aspects: liquidity, capital structure, and
results from operations.
9 Should highlight favorable and unfavorable trends and identify significant
event and uncertainties that affect these three factors.

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 Annual Report
„ Prepared by management and distributed to current and potential
investors providing information about the company’s past
performance and future prospects.
Í Usually ALSO includes:
9 Financial highlights
9 Five-year financial data
9 Letter from corporate management to stockholders
9 Independent auditor’s report
9 Management’s responsibility for preparation of the financial statements
9 Other information (description of company, business, products, etc.)

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Types of Firms

„ Three basic forms of ownership:

Í Sole proprietorships

Í Partnerships

Private

Í Corporations
Public

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 Corporations

„ Owners are called shareholders or stockholders.

„ Publicly owned vs. privately owned corporations:

Í Private – Shares in the ownership are owned by families, small
groups of shareholders, or a single shareholder and are not sold to
the public.
Í Public – Shares in the ownership are sold to the public on a stock
exchange; the corporation may have many thousands of
shareholders.
9 The shareholders elect a board of directors that essentially “oversee”
the company.

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Stockholders & Board of Directors

„ Relationship among owners, managers, & the board of directors:

Stockholders elect Board of Directors appoint Managers

Í The board of directors is elected by the stockholders.

Í Management is appointed by the board of directors.
Í Often, top executives (president, vice presidents, etc.) are elected to
the board of directors.
Í Therefore, the interests of both the stockholders and management
are usually represented on the board of directors.
Í The separation between ownership and management creates
demand for information from investors.
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 Financial Reporting
Regulation & Standard Setting
„ Securities and Exchange Commission (SEC):
Í Statutory authority to establish financial accounting and reporting
standards for publicly held companies under the Securities Exchange
Act of 1934.
Í Delegates much rule-making power to the FASB.
„ Financial Accounting Standards Board (FASB)
Í Private sector organization designated since 1973 for establishing
standards of financial accounting and reporting.
Í Responsible for establishing the Generally Accepted Accounting
Principles (GAAP).
„ International Accounting Standards Board (IASB)
Í International body responsible for establishing the International
Financial Reporting Standards (IFRS).
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Financial Reporting
„ Public firms are required to file financial reports with the SEC
four times a year:
Í Each quarter (three 10-Qs) and each year (one 10-K).
Í For a December 31 fiscal year-end company:
9 March 31: 10-Q
9 June 30: 10-Q
9 September 30: 10-Q
9 December 31: 10-K
Í Note: Fiscal year-end can be on any date.

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 Credibility and the Role of Auditing

„ Corporate management prepares the financial statements.

Í In some cases, management may have incentives to make the
company’s performance look better than it actually is.

„ Investors must be able to rely on the financial statements to

show an accurate picture of the company.

„ One way to ensure that the financial statements are credible is to

introduce an independent, expert third party.
Í The auditor examines the information used by managers to prepare
the financial statements and attests to the credibility of the
statements.

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Auditing
„ Audit – an examination of transactions and financial statements
made in accordance with generally accepted auditing standards
(GAAS) developed primarily by:
Í The American Institute of Certified Public Accountants (AICPA)
prior to 2003.
Í The Public Company Accounting Oversight Board (PCAOB)
since 2003.
The PCAOB is a private-sector, non-profit corporation
created by the Sarbanes-Oxley Act (a 2002 United States
federal law) to oversee the auditors of public companies in
order to ‘protect the interests of investors and further the
public interest in the preparation of informative, fair, and
„ An audit includes: independent audit reports’.

Í Tests of the accounting records.

Í Tests of the internal control over the financial reporting system.
Í Other audit procedures as deemed necessary.
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 The Auditor’s Opinion

„ The audit is described in the auditor’s opinion (independent

auditor’s report).
Í The auditor’s opinion is included with the financial statements in
firms’ annual reports.

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Example of an independent auditor’s report:

To the Board of Directors and Stockholders of Lennar Corporation
We have audited the accompanying consolidated balance sheets of Lennar Corporation and subsidiaries (the “Company”)
as of November 30, 2004 and 2003, and the related consolidated statements of earnings, stockholders’ equity, and cash
flows for each of the three years in the period ended November 30, 2004. These financial statements are the responsibility
of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our
audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the
Company as of November 30, 2004 and 2003, and the results of its operations and its cash flows for each of the three
years in the period ended November 30, 2004, in conformity with accounting principles generally accepted in the
United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United
States), the effectiveness of the Company’s internal control over financial reporting as of November 30, 2004, based
on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission and our report dated February 11, 2005 expressed an unqualified
opinion on management’s assessment of the effectiveness of the Company’s internal control over financial
reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial
reporting.
/s/ DELOITTE & TOUCHE LLP
Certified Public Accountants
February 11, 2005
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 The Accounting Profession

„ The most common way to classify accountants is to divide them

into public accountants and private accountants.
Í Public accountants – accountants whose services are offered to
the general public on a fee basis (auditing, tax return preparation).
Í Private accountants – all other accountants, including those who
work for businesses, government agencies, and other nonprofit
organizations.

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