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).

Professor Lucile Faurel Principles of Financial Accounting Class 1: Introduction to Financial Accounting

Who Cares?
Accounting information is useful to anyone who needs to make a decision based upon the companys performance and potential.
For example:
Investors Owners Managers Creditors Legislators Etc.

Professor Lucile Faurel Principles of Financial Accounting Class 1: Introduction to Financial Accounting

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:
Accountants analysis and recording

Event

Financial statements

Users

Professor Lucile Faurel Principles of Financial Accounting Class 1: Introduction to Financial Accounting

Financial and Management Accounting

Major distinction between financial and management accounting = the users of the information.
Financial accounting serves external users (e.g. investors, creditors, and suppliers). Managerial accounting serves internal users (e.g. top executives, management, and administrators within organizations).

Professor Lucile Faurel Principles of Financial Accounting Class 1: Introduction to Financial Accounting

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

Professor Lucile Faurel Principles of Financial Accounting Class 1: Introduction to Financial Accounting

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
Professor Lucile Faurel Principles of Financial Accounting Class 1: Introduction to Financial Accounting

Xxx Total Liabilities and Owners Equity

Xxx

The Main Financial Statements

Income Statement:
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 Other expense (income) Income before Taxes Taxes Net Income Earnings Per Share
Professor Lucile Faurel Principles of Financial Accounting Class 1: Introduction to Financial Accounting

$ $

(xxx) (xxx) xxx (xxx) xxx x.xx

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The Main Financial Statements

Statement of Cash Flows:
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 Investing Activities: Sale of Noncurrent Assets $ Xxx Purchase of Noncurrent Assets Xxx Cash Flow from Investing Activities 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 NET CASH FLOW FOR 2005 $ (Ending cash Beginning cash)
Professor Lucile Faurel Principles of Financial Accounting Class 1: Introduction to Financial Accounting

Xxx

Xxx

Xxx Xxx

Annual Report
Prepared by management and distributed to current and potential investors providing information about the companys past performance and future prospects.
Includes the three main financial statements (BS, IS, SCF). Includes footnotes explaining in more detail many elements of the financial statements. Includes the Managements Discussion and Analysis (MD&A):
Should cover three financial aspects: liquidity, capital structure, and results from operations. 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 companys past performance and future prospects.
Usually ALSO includes:
Financial highlights Five-year financial data Letter from corporate management to stockholders Independent auditors report Managements responsibility for preparation of the financial statements Other information (description of company, business, products, etc.)

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Types of Firms
Three basic forms of ownership:
Sole proprietorships

Partnerships Private Corporations Public

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Corporations
Owners are called shareholders or stockholders. Publicly owned vs. privately owned corporations:
Private Shares in the ownership are owned by families, small groups of shareholders, or a single shareholder and are not sold to the public. Public Shares in the ownership are sold to the public on a stock exchange; the corporation may have many thousands of shareholders.
The shareholders elect a board of directors that essentially oversee the company.

Professor Lucile Faurel Principles of Financial Accounting Class 1: Introduction to Financial Accounting

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Stockholders & Board of Directors

Relationship among owners, managers, & the board of directors:
Stockholders elect Board of Directors appoint Managers

The board of directors is elected by the stockholders. Management is appointed by the board of directors. Often, top executives (president, vice presidents, etc.) are elected to the board of directors. Therefore, the interests of both the stockholders and management are usually represented on the board of directors. 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):
Statutory authority to establish financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. Delegates much rule-making power to the FASB.

Financial Accounting Standards Board (FASB)

Private sector organization designated since 1973 for establishing standards of financial accounting and reporting. Responsible for establishing the Generally Accepted Accounting Principles (GAAP).

International Accounting Standards Board (IASB)

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:
Each quarter (three 10-Qs) and each year (one 10-K). For a December 31 fiscal year-end company:
March 31: 10-Q June 30: 10-Q September 30: 10-Q December 31: 10-K

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.
In some cases, management may have incentives to make the companys 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.
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:
The American Institute of Certified Public Accountants (AICPA) prior to 2003. 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 independent audit reports.

An audit includes:

Tests of the accounting records. Tests of the internal control over the financial reporting system. Other audit procedures as deemed necessary.
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The Auditors Opinion

The audit is described in the auditors opinion (independent auditors report).
The auditors opinion is included with the financial statements in firms annual reports.

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Example of an independent auditors 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 Companys 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 Companys internal control over financial reporting as of November 30, 2004, based on the criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 11, 2005 expressed an unqualified opinion on managements assessment of the effectiveness of the Companys internal control over financial reporting and an unqualified opinion on the effectiveness of the Companys 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.
Public accountants accountants whose services are offered to the general public on a fee basis (auditing, tax return preparation). Private accountants all other accountants, including those who work for businesses, government agencies, and other nonprofit organizations.

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