economics /management 4 financial...
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Economics /Management 4 Financial Accounting
Accounting Fundamentals, Terminology, and Conceptual
Foundations
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Accounting Firms Globals 1. Ernst & Young (E&Y). 2. Deloitte & Touche (D&T). 3. KPMG. 4. Price-Coopers (PwC). 5. Arthur Anderson Regionals 1. Moss Adams. 2. BDO Siedman 3. H&R Block-McGladry (Pullen). 4. Century
The Big Four
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Accounting – recording & processing commercial transactions to report business financial performance & financial position. a) Control (bookkeeping & internal controls); b) Financial reporting; c) Auditing; d) Tax-planning; e) Management & Information systems
consulting; f) Forensic accounting & litigation support.
Credentials: CPA, CIA, EA, CFE, CMA
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Accounting Terminology
• Terms of Art
– New words; Old words w/ new meanings
– Use online glossaries
• In order to
Expedite conversations
Avoid ambiguity
• Abbreviations [SG&A, EBITDA, AR’s, CAPEX]
Get used to it
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Financial Accounting
A highly-stylized Information System
Formulated as a system of Simultaneous Equations
Organized around the fundamental Accounting Equation
Assets = Liabilities + Equity
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The Fundamental Equation of Accounting
Assets = Liabilities + Equity
What we OWN “Assets” must have a Source =
Liabilities are what we owe to others Equity is what we owe to ourselves
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Firms Need Cash (to acquire Assets),
so they create Financial Capital
• Financial Capital represents the Cash raised when firms sell Financial Securities
1. Stocks – shares of the Firm sold to investors, also called Share-holders – Equity Capital
2. Bonds – loans from creditors, bond-holders – Debt
Capital
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Designed to provide Useful information to
Direct Providers of Financial Capital 1. Owners/Investors (who buy Stock) 2. Creditors / Lenders (who buy bonds) Indirect Providers of Financial Capital 3. Suppliers/Vendors 4. Customers 5. Government Tax & Regulatory Agencies
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What are the Characteristics of Useful?
a) Relevant – for decision-making
b) Reliable – consistent & comparable
c) Independent
d) Timely – result of recent activities How timely is publicly-reported financial accounting?
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Two Methods of Accounting
Cash-basis • Rules-oriented method. Only cash
receipts or disbursements matter. And there is only one bottom-line.
Accrual • Principles-based method. GAAP
accounting. More useful but opens the way for judgment, thus manipulation. There are many possible bottom-lines.
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Accounting Assumptions • One Entity. You are separate from your
company for accounting purposes.
• Record-keeping for a “Period” of time. Fiscal “FY” year comprised of 4 interim quarters of roughly 13 weeks each.
• In Dollar$.
• On-going concern. Change accounting methods for bankrupt companies or for discontinued operations w/in a company.
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Most companies Retailers 1st Quarter Jan-Mar Feb-Apr 2nd Quarter Apr-June May-July 3rd Quarter Jul-Sep Aug-Oct 4th Quarter Oct-Dec Nov-Jan
The Accounting Period is a 12 month fiscal year “FY”
With 4 Interim Periods, Quarters.
What is Nordstrom’s fiscal year? How about Starbucks?
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Accrual Accounting is a highly-stylized Information System
Basic Functions (all info systems):
1. Collection transactions’ data
2. Measurement in dollars $
3. Classification into 7-11 Elements
4. Presentation in 4 Reports
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Collection
Collect the quantitative information from commercial transactions with outsiders. No transaction, no record, no seat at the table..
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Measurement
Transactions are recorded in $’s, or a local currency. Not always easy. Think of trade-in’s. Often “estimates” are required.
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Classification
Transaction numbers are given a name, actually two names … and recorded twice. This preserves the fundamental equation. The fun begins with classification.
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Let’s be Candid
No one knows the truth. Facts are in dispute. But we need to communicate. So the issue is really, “what lies should we tolerate?”
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Classification is a Decision that starts a Process
• Amounts are recorded in two journals.
• Called double-entry book-keeping.
• Journals are individual accounts.
• Accounts are grouped by elements.
• There are five basic and two adjunct elements.
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Classification into the Elements of Accounting
1. Asset
2. Liability
3. Equity
4. Revenue
5. Expense
6. Gain
7. Loss
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Types of Assets
1. Cash
2. Inventory
3. FF&E
4. PP&E
5. Trademarks
6. Goodwill
Are all of the assets owned or controlled by a firm listed on its Balance Sheet?
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Types of Liabilities
1. Customer Advances
2. Payables
3. Accrued Expenses
4. Loans
5. Employee Pensions
Name the fundamental difference between Assets and Liabilities.
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Types of Expenses
1. Cost of Goods Sold
2. Wages & Salaries
3. Advertising
4. Parking
5. Depreciation
6. Interest
Name the three “generic’ types of Expenses and any other categorizations of Expenses..
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Generic Types of Expenses
1. Direct (COGS) 2. Indirect (Wages, Advertising,
Parking) 3. Periodic (Rent, Interest) Other categorizations of Expenses.
1. Operating & non-Operating 2. Financing 3. Recurring & non-Recurring
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Presentation
Into Financial Reports
1. Balance Sheet
2. Income Statement
3. Statement of Cash Flows
4. Statement of Shareholder’s Equity
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Simultaneous Equations To be explained & illustrated later
Cash0 + Inventory0 = Liabilities + PinK + RE0
Revenue + (COGS) = Earnings
Inventory0 + Purchases + (COGS) = Inventory1
Cash1 = Cash0 + Revenue - (Inventory1 - Inventory0)
Cash1 + Inv1 = Liabilities + PinK + RE0 + Earnings
Cash1 + Inventory1 = Liabilities + PinK + RE1
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Terminology is Critical
• (Earned) Revenue v. Unearned Revenue.
• Pre-paid Expense v. Expense.
• Expense v. Accrued Expense.
• Goods Sold v. Inventory on Hand.
• Wholesale COSTS v. Retail PRICES
ADJECTIVES MATTER
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Symmetry and Semantics
• Current vs. Non-Current
• Direct vs. Indirect
• Operating v. non-Operating
• Monetary vs. non-Monetary
• Right vs. Obligation
• Inflow vs. Outflow
• Primary vs. Adjunct
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TIMING
• Accrual is all about Time. The accounting period
matters ! It establishes when activities, and
subsequent results, stop.
• COSTS – what the firm pays for something.
• EXPENSES – what COSTS will become at some point in time.
• PRICES – what the firm receives for something.
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Turning Costs into Expenses
We purchase T-shirts @ $10 each - “wholesale” Cost.
We sell T-shirts @ $20 each - “retail” Price. Thus, we expect $10 per T-shirt sold as Profit.
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Cash
Receivables
Inventory
Pre Paid Expenses
Customer Advances
Payables
Accrued expenses
Paid in Capital
Retained earnings
The Balance Sheet
The Income Statement Revenue COGS Profit
TEMPLATES
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$ 100
$ 0
$ 0
$ 0
$ 0
$ 0
$ 0
$ 100
$ 0
Balance Sheet
We invest $100 cash in our T-shirt business.
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$ 0
$ 0
$ 100 $ 0
$ 0
$ 0
$ 0
$ 100
$ 0
Balance Sheet
We purchase ten T-shirts @ $10 each for a total of $100 in inventory consisting of 10 items.
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Income Statement $ 100 Revenue ($50) COGS $ 50 Profit
1. We sell five T-shirts @ $20 price each in-cash for a total of $100 in Revenue recognized. 2. We “expense” five T-shirt’s costs of $10 each for total expenses of $50 recognized. 3. Matching costs with revenues is called expense recognition. The net result is $ 50 in Profits.
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$ 100
$ 0
$ 50 $ 0
$ 0
$ 0
$ 0
$ 100
$ 50
Balance Sheet
We now have $ 50 cash and $ 50 in inventory . We have $ 50 in retained earnings.
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• Accrual concepts lead to Guidelines called GAAP.
• Fiction is permitted in accounting; it’s just not called fiction, it’s called interpretation.
• Occasionally, the line between truth and fiction is not a very bright one.
• Sometimes, a white lie gets a desired effect w/ little risk of harm.
Principle’s-Based Reporting
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The subjective meets the objective
• Opinion meets Evidence
• Quantitative meets Qualitative
• Romance meets Reality
• Form meets with Substance
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Profits ?
Profits are a construct, not a fact The “fact” is … a good accountant can make profits almost anything that he/she is directed that they be … Profits = Revenue & Gains less Expenses & Losses Thus, we will look very closely at what is meant by Revenue, Expenses, Gains, Losses.
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Accounting Principles
1. Cost
2. Realization
3. Matching
4. Disclosure
5. Objectivity
6. Materiality
7. Consistency
8. Conservatism
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Accounting Principles
1. Costs become expenses
2. Realization of Revenue
3. Matching Expenses to revenue
4. Disclosure qualitative reporting
5. Objectivity unrelated parties
6. Materiality significant
7. Consistency no flip-flopping
8. Conservatism no exaggerations
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What is the Goal of Financial Accounting (?)
USEFULNESS
… for what purpose?
COMPARABILITY