Accy 1 – Fundamentals of Accounting
Lecture Notes–
Business Decisions and Financial Accounting
I.What is accounting and the accounting system
A.The accounting system is an ‘information system’ for financial information
B.Accounting is the set of rules and protocols that provides for
1.Clear, timely, and accurate financial information to the information users, and
2.Provides one set of checks and balances that facilitates the accuracy of that information
II.Why is accounting important?
A.Very simply put, because people use it, e.g. bankers, managers, investors, suppliers, and the “Taxman.”
B.Example: Toy-maker Mattel recently announced a $431 million net loss.
1.“What is a netloss?”
a.Where did the $431 million go?
b.How do we calculate a “net loss?”
2. “Suppose that you are a wealthy shareholder owning 100,000 shares of Mattel, valued at, say, $3,000,000.” Did you lose your share of those $431 MM dollars? How much money did you lose today?” As an investor your losses are measured by the effect of the financial statements on the price of your stock. How do we interpret the $431 mm loss in terms of effect on the price of the stock?
3.Further: “Suppose that you, the President of the company, are standing on the podium, announcing this loss. Stand up, and say, ‘I am the President. Your company, under my supervision, lost $431 million this year. Right after this meeting, I’ll pack up my things and go.”
4.See now that $431 million is not an abstract number rather, it carries tremendous ramifications for the company’s managers and shareholders.
5.But who else is affected?
6.But what is a net loss?
7.Those are questions this course will help you answer.
C.The purpose of the financial information reported by a company is to
1.Collect and present the financial health of the company
2.With the reports designed to maximize the usefulness of the information for the users
D.Users
1.External Users
a.This population is the focus of Financial Accounting
2.The users include
a.Investors
b.Creditors
c.Customers
d.Suppliers
e.Government (taxes, etc.)
E.Forms of doing business
1.There are several forms through which individuals may conduct their business operation, each has its advantages and disadvantages, as we will explain in a later discussion
2.The most common forms:
a.Proprietorship: where there is generally one owner and the business and the owner are not separate legal entities
b.Partnership: where there are at least 2 owners and the business and owners are, for most purposes, separate legal entities
c.Corporation: where there must be at least one owner (stockholder) and the business and the owner(s) are separate legal entities for ALL purposes.
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F.Forms of Financial Statements
1.There are two terms that are used in financial circles; the Financial Statements, and the Financial Report
2.They refer to
a.Financial Statements: the term refers to the four basic versions of presentations of financial information, as defined below,
b.Financial Reports: a body of work that includes
i.The financial statements
ii.Notes to the financial statements,
iii.The auditor’s report
iv.Other information as the company sees fit to include
3.There are generally four financial statements
a.The Balance Sheet which reflects what the business owns (resources) and what it owes to creditors (liabilities) and what is due to the owners (owners’ equity) at a specified point in time.
b.The Income Statement which reflects the results of the operations of the business reporting Sales (revenues from operational transactions), Expenses (costs incurred by the business in generating the Sales), and the net profit or loss (the difference between the Sales and Expenses (summary for a stated period of time)
c.The Statement of Retained Earnings which reconciles the beginning and ending balance of the balance sheet account (Retained Earnings) to show that the profit or loss as presented in the income statement has been accurately incorporated into the balance sheet.
d.The Statement of Cash Flows is derived from the information presented in the other financial statements and does two things:
i.It reconciles the beginning and ending cash balances of the balance sheet, and
ii.Details the sources and applications of cash stemming from the transactions to which the business was a party (generally for a stated period of time)
III. The Financial Statements and the Accounting (or Balance Sheet) Equation
A.To be useful, and to provide the ‘logic’ for the relationships between the different financial statements, they are designed around a financial equation
B.The equation states: Assets = Liabilities and Owners’ Equity.
1.This equation describes the presentation and relationship of the elements of the Balance Sheet, one of the four basic FS (Financial Statements)
2.If this equality does not exist, the financial statements are inaccurate and must be corrected
C.Define the Elements:
1.Assets – what a business owns
2.Liabilities – what it owes to outsiders
3.Owners’ Equity – What is left over for the owners of the company
D.This equation must always equal.
1.Manipulate the equation; under any form, an equality exists (this is useful)
a.Assets – Liabilities = Owners’ Equity
b.Assets - Owners’ Equity = Liabilities
2.No matter how the equation is phrased, the condition of equality persists, and this is crucial to understanding and managing the information reporting system, i.e. the accounting system
3.As a simple example
a.“My house in [expensive neighborhood], my Ferrari, my other Ferrari, and my investment portfolio are worth $10 million. I owed the bank $4 million on my mortgage. How much am I worth?”
b.the numbers fitted into the equation:
Assets / = / Liabilities / + / Net Worth$10 million / = / $4 million / + / ?
4.Here is the information for Mattel, Inc.,
Assets / = / Liabilities / + / Stockholders’ Equity$4,510 million / = / $2,294 million / + / $2,216 million
a.
b.Interpreted:
i.It is not uncommon for companies to report their information to the nearest million or hundred thousand
ii.$4,510 million means four thousand five hundred and ten million or four billion, five hundred and ten million
E.The Balance Sheet
1.The Balance Sheet presents the detail information behind the accounting equation at a given point in time.
a.It lists and totals the assets, liabilities and stockholders’ equity,
b.It shows that the accounting equation works.
c.It presents the financial position of the business at a point in time
2.Basic description of the Balance Sheet presentation, line-by-line.
a.Heading – “who, what, when, other”
i.who: what is the name of the reporting business
ii.what: what is the name of the statement, in this case it is the “Balance Sheet”
iii.when: for the balance sheet it is important to note that it is a snapshot of the fiscal status of the company at a specific point in time such as “As of December 31, 2008”
iv.other: sometimes the statement represents a consolidation of a number of companies or other variation
v.Emphasize the “when.” The Balance Sheet measures the company’s financial position at a specific point in time.
b.Assets – what a business owns: for example
i.Cash – money held by the company or in the bank
ii.Accounts Receivable – money the company expects to collect from customers for goods it has sold on credit.
iii.Inventories – the cost of goods made or bought to be sold in the future.
iv.Property, Plant, and Equipment – the cost of land, factories and production machinery used in the business
v.Other Assets – a catch-all
c.Liabilities – what a business owes to creditors: for example
i.Accounts Payable – amounts owed to other companies for purchases of goods or services on credit
ii.Notes Payable – similar to accounts payable, but:
a.Require interest,
b.Will usually be paid later than accounts payable, and
c.Were documented using formal contracts called “notes.”
d.Owners’ Equity – What is left over for owners of the company.
i.Common elements of this section of the Balance Sheet
a.Contributed Capital – money invested directly in the company by its owners.
b.Dividends – periodic payments to stockholders as return on their investment.
c.Retained Earnings – total income and losses less any dividends paid to stockholders, since the corporation was formed.
ii.We will revisit this later.
IV.The Income Statement
A.This financial statement presents the revenues generated and the expenses incurred by the business, that is the net profit or loss, for a specified period of time
B.“If Mattel makes one Hot Wheels car costing 60 cents, and sells it for a dollar, how much income did they earn?” – 40 cents:
Revenues / - / Expenses / = / Net income$1.00 / - / $0.60 / = / $0.40
C.“Now suppose that Mattel makes 1 million Hot Wheels cars costing 60 cents each, and sells each for a dollar. How much income did they earn?” - $400,000.
Revenues / - / Expenses / = / Net income$1.00 / - / $0.60 / = / $0.40
$1,000,000 / - / $600,000 / = / $400,000
D.Working line-by-line:
1.Heading: Who, What, When, Other.
a.who: what is the name of the reporting business
b.what: what is the name of the statement, in this case it is the “Income Statement” (or in a few cases businesses will call it the “Statement of Revenues and Expenses”)
c.when: for the balance sheet it is important to note that it is a snapshot of the fiscal status of the company for a specified period of time such as “For the Period Ending December 31, 2008”
d.other: sometimes the statement represents a consolidation of a number of companies or other variation
2.Revenues – increases in the company’s resources (e.g. cash, property, or promissory instruments such as accounts receivable),
arising primarily from its operating activities, but also from extraordinary transactions.
3.Sales – revenues from selling goods.
4.Expenses – the cost of doing business; decreases in a company’s resources arising primarily from its operating activities.
5.Cost of goods sold - usually the largest expense item. This is the cost of making the toys sold as for revenues.
6.Advertising and promotion expenses – Expense classes are usually self-explanatory, like Income tax expense.
7.Net income (Loss) = Revenues – expenses. Synonymous with Profit (Loss) and the often referred to as the “Bottom line.”
a.Profit: revenues > expenses
b.Loss: expenses > revenues
c.Conclude by reviewing Mattel’s income statement. What does it say?
d.The company sold $4.96 billion worth of toys in 2003, and earned $537 million in net income on those toys.
V.The Statement of Retained Earnings
A.What is it and why is it important?
B.Ask, “Where does net income go” within the financial statements?
1.One answer, “the bank” , while another answer is that it goes to the owners – net income belongs to the owners. The Statement of Retained Earnings shows how much income in total has been earned held by the enterprise for owners.
C.Define Dividends – in the discussion of accounting we have identified that one section of the balance sheet is the “Owners’ Equity” where the term owner is neutral, that is can assume any of many forms. This is a good time to orient the focus of what we are going to do in this class and that is to identify ‘owners’ as a specific type, that is owners of a corporation, whom we refer to as stockholders or shareholders. Hence, that is the form of the “Owners’ Equity” section we will demonstrate in the rest of the discussions in the class
1.payments to stockholders.
2.Can take the form of cash or property.
D.Net income could go in two directions:
1.Straight to stockholders, as Dividends.
2.‘Retained’ in the company, as Retained Earnings.
E.Retained Earnings (RE) Formula:
F.Exemplary numbers to demonstrate the above formula.
Beginning RE / + / Net Income / - / Dividends Declared / = / EndingRE
$341 / + / $537 / - / $171 / = / $707
1.Explanation:
a.Mattel has $341 in retained earnings on last year’s balance sheet.
b.The income statement added $547 (benefitting the owners).
c.The company distributed $171 to owners in the form of dividends.
d.This leaves $707 of earnings that has been retained by the business for various purposes which belongs to the owners.
2.Balance is adjusted annually
Beginning Retained Earnings / + / Net Income / - / Dividends Declared / = / Ending Retained Earnings$341 / + / $537 / - / $171 / = / $707
Balance Sheet, 12/31/2002 / Income Statement FYE Dec. 31, 2003 / Balance sheet, Dec. 31, 2003
VI.The Statement of Cash Flows (Not for Exam of Homework coverage in this class)
A.Now I again return to the opening discussion (“What is a loss?”) and ask the class, “Does a ‘loss’ cost you money?”
1.They will invariably respond that “of course it does,” or might even silently wonder why I would ask such an obvious question.
2.I argue that, “maybe, maybe not!”
a.Suppose that you consistently sell Hot Wheels cars costing 40 cents each for 25 cents. Will that cause you to lose money? Sure.
b.Now suppose that you have a giant factory in Kentucky, churning out Hot Wheels and Barbie Dolls. You decide to close the factory and shift production to China. The factory and all of the machinery was on your books for $50 million, and you sell it all for $10 million – a $40 million loss. Will that cost you $40 million in cash? No. In fact, at the same time as you record a $40 million loss, you will take in $10 million cash! Here, a loss brings in positive cash flow!
3.Lesson learned: income and cash flow may move independently. This is why we need the statement of cash flows. It explains why cash changed from the beginning of the year to the end. Where did cash come from? Where did it go?
B.Basic Formula:
Net Cash Flow from Operating Activities+/- / Net Cash Flow from Investing Activities
+/- / Net Cash Flow from Financing Activities
Net change in cash during the year
+ / Cash at beginning of the year
Cash at end of the year
C.Refer to the Mattel Exhibit 1.7, and fill in the numbers in the above table.
Net Cash Flow from Operating Activities / $372+/- / Net Cash Flow from Investing Activities / (181)
+/- / Net Cash Flow from Financing Activities / (305)
Net change in cash during the year / ($114)
+ / Cash at beginning of the year / 1,267
Cash at end of the year / $1,163
D.Explain each category:
1.Operating activities are cash flows directly related to earning income.
a.For Mattel, this would be cash received from customers buying toys, cash paid to suppliers and employees making toys, etc. Indicate that Mattel’s operations brought in $372 million in cash flow.
2.Investing activities are cash flows related to acquiring or selling long-term assets.
a.Here you can see that Mattel spent $206 million purchasing new equipment.
3.Financing activities are cash flows directly related to financing the company’s operations, including receipts from or payments to stockholders and creditors.
VII.Aspects of financial statements (Not for Exam of Homework coverage in this class)
A.Explain the usefulness of comparative financial statements.
1.Indicate how the company’s results progress from period to period.
B.Referring to textbook Exhibit 1.10, review the relationships between financial statements, and re-emphasize key financial statement formulas.
1.The Statement of Cash Flows, Statement of Retained Earnings and Income Statement explain changes in Balance Sheet numbers
a.Assets = Liabilities + Stockholders’ Equity
2.The Statement of Cash Flows explains why cash changed from the beginning-of-the-year balance sheet to the end.
a.Net operating cash flows + Net investing cash flows + Net financing cash flows = net increase in cash; Net increase in cash + beginning cash balance = ending cash balance
3.The Statement of Retained Earnings explains why retained earnings changed from the beginning-of-the-year balance sheet to the end.
a.Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings
b.The Statement of Retained Earnings uses net income, found on the Income Statement: Revenues – Expenses = Net Income
4.Refer students to text CD-Rom for a visual representation of how the financial statements link together.
C.Notes to the Financial Statements – are provided after the financial statements. They offer information about:
1.Accounting policies – accounting decisions made for preparing the financial statements
2.Contents included – provides more detail about certain account balances
3.Additional information – provides other important information not provided elsewhere. For example, the company may rent warehouse space.
D.Generally Accepted Accounting Principles
1.The basic rules of accounting. Set forth by:
a.Securities and Exchange Commission (“SEC”) – govt.t agency
b.Financial Accounting Standards Board (“FASB”) – has primary responsibility for setting rules, largely accounting professionals
c.Public Company Accounting Oversight Board (“PCAOB”) – oversees how accounting firms audit financial statements.
VIII.Why is Accounting Important, the question revisited –
A. “Why did Mattel lose $431 million?”
B.Background about the loss:
1.Mattel had previously purchased The Learning Company (“TLC”), and now decided to write-off its investment, causing this tremendous loss.
C.How would you explain the loss to the users? “What would you say?”
1.We regret having purchased The Learning Company
2.After this write-off, there will be no further losses from this bad investment
3.Our remaining operations are highly profitable.
D.Consider how the financial statements might support their arguments.
1.The income statement indicates that the company is profitable, except for TLC.
2.The balance sheet indicates that the company has more than enough assets to pay its liabilities.
3.The statement of retained earnings indicates that, even though the company showed a loss, it still paid dividends (perhaps).
4.The statement of cash flow indicates that the company has sufficient cash flow to cover the losses.
E.Put yourselves in the shoes of the stockholders and ask what would you do
1.Very common to say that they should sell their stock.
2.However, you might argue that now would be the time to buy more stock. Mattel just dumped its money-losing TLC and doesn’t have to absorb any more losses from it, and the chances are that many people took the action suggested in 1. and drove down the price.
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