Welcome to Financial Accounting

Chapter 1
INTRODUCTION TO
FINANCIAL
Accounting Acct
6201
@Cambridge Business Publishers, 2013
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What is Financial Accounting?
The preparation and use of accounting
information
Provided in a companys financial
statements
Often available to the public
Enables users to make informed decisions
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Users of Financial Accounting Information
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Own the company through
purchased shares
Management
Investment
Professionals
Government
Agencies
Shareholders
Debtholders
Such as regulators
and taxing authorities
Who provide financial
advice about the company
Have loaned money
to the company
In charge of the
company
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What is Managerial Accounting?
Accounting information that is internal to a
firm
Helpful in deciding operational questions
How much inventory to produce
What price to charge customers
Helpful in measuring performance of
managers and employees
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The Accounting Equation
A businesss assets must equal the sum of
liabilities and shareholders equity
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A L + SE
Shareholders
Equity
Liabilities
Assets
=
Financial Statements
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Balance
Sheet
Income
Statement
Statement of
Shareholders
Equity
Statement
of Cash
Flow
Historical
Performance
Summaries
The End
Product of
Financial
Accounting
The Balance Sheet
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Based on the accounting equation
Indicates a companys financial position
At a point in time (i.e. a particular date)

Assets = Liabilities + Shareholders Equity

Assets Liabilities = Shareholders Equity
The Companys
Net Worth
What a
company owes
What a
company owns
With a little algebra we get..
Google, Inc.s
Balance Sheet
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December 31 2012 2011
Assets
Current Assets
Cash and cash equivalents $14,778 $ 9,983
Short term investments 33,310 34,643
Net receivables 9,729 6,387
Other current assets 2,637 1,745
Total Current Assets 60,454 52,758
Long term investments 1,469 790
Property, plant and equipment 11,854 9,603
Intangible assets 18,010 8,924
Other long term assets 2,011 499
Total Assets $93,798 $72,574
Liabilities
Current Liabilities
Accounts payable $10,893 $ 7,148
Other current liabilities 3,444 1,765
Total Current Liabilities 14,337 8,913
Long-term liabilities 7,746 5,516
Total Liabilities 22,083 14,429
Stockholders' Equity
Common stock 23,373 20,540
Retained earnings 48,342 37,605
Total Stockholders' Equity 71,715 58,145
Total Liab. & Stockholders' Equity $93,798 $72,574
All numbers in millions
Income Statement
Covers a period of time
Usually one year
Shows the financial performance of a company
Reports how much sales the company earned
less the expenses the company used in earning
that revenue
Also known as profit and the bottom line

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Revenue Expenses = Net Income
If expenses > revenue, a net loss occurs.

Google, Inc.s
Income Statement
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All numbers in millions
Years Ending December 31 2012 2011
Total Revenue $50,175 $37,905
Cost of Revenue 20,634 13,188
Gross Profit 29,541 24,717
Operating Expenses
Research Development 6,793 5,162
Selling General and Administrative 9,988 7,813
Total Operating Expenses 16,781 12,975
Income from Operations 12,760 11,742
Total Other Income/(Expense) 710 642
Earnings Before Interest and Taxes 13,470 12,384
Interest Expense 84 58
Income Before Tax 13,386 12,326
Income Tax Expense 2,598 2,589
Income from Continuing Operations 10,788 9,737
Discontinued Operations (51)
Net income $ 10,737 $ 9,737
Statement of Cash Flow
Tells how much cash a company received
and where the company used its cash for
each of three business activities
Operating activities
Cash from/for normal business operations
Investing activities
Cash to buy or sell assets used in business
Financing activities
Cash borrowed from or paid to debtholders
Cash received from or paid to shareholders for
stock
Cash paid to shareholders for dividends
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Google, Inc.s
Statement of Cash Flow
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All numbers in millions
Years Ending December 31 2012 2011
Operating Activities
Net Income $10,737 $9,737
Depreciation 2,962 1,854
Adjustments To Net Income 2,022 2,347
Changes In Accounts Receivables (787) (1,156)
Changes In Liabilities 2,217 2,048
Changes In Other Operating Activities (532) (262)
Net Cash Flow From Operating Activities 16,619 14,565
Investing Activities
Capital Expenditures (3,273) (3,438)
Investments 785 (13,703)
Other Cashflows from Investing Activities (10,568) (1,900)
Net Cash Flow From Investing Activities (13,056) (19,041)
Financing Activities
Net Borrowings 1,328 726
Other Cash Flows from Financing Activities (99) 81
Net Cash Flow From Financing Activities 1,229 807
Effect Of Exchange Rate Changes 3 22
Change In Cash and Cash Equivalents $ 4,795 $(3,647)
Google, Inc.s
Statement of Shareholders Equity
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Reveals how the shareholders investment
in a business changed during the period



Net income retained in the business
Becomes Retained Earnings
New share sales or repurchases
Distribution as dividends to owners

Relation Among Financial Statements
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Relation Between Income Statement
and Balance Sheet
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Which Basis of Accounting is Used?
Cash basis
Financial effects are recorded in financial
statements when cash is received or paid
Accrual basis
Financial effects are recorded without
regard to the timing of the cash flows
Accounts that exist under accrual basis
Accounts receivable
Amounts customers owe for items purchased
Accounts payable
Amount the company owes for credit purchases
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Going Concern Concept
A notion underlying the basic financial
statements
Assumes that a business will continue
operating in the future
Unless substantial evidence to the contrary

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Investors Focus
Going Concern
Focus is on revenue
and net income
Desire to forecast
future operating
performance
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Ceasing of Operations
Focus is on
shareholders equity
on the balance sheet
Need to determine
what an investor
might receive upon
liquidation
Accounting Information Has Decision Usefulness
Provides information for users to make
economic decisions
Two attributes that make it useful
Relevance
Has the capacity to impact a decision
Is timely
Possesses feedback and/or predictive value
Faithful representation
Is free from error or bias
Is objective
Is verifiable

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Materiality
A criterion used by companies
Helps decide what, and how much
information should be provided in financial
statements
Common threshold
Five percent of revenues
Five percent of assets
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The Independent Audit
Performed by an external independent
company
Financial statements are prepared by the company
being audited
Audited statements provides some assurance
that they are free materials errors and biases.
Auditors only provide an opinion, not a
guarantee
Auditors follow generally accepted auditing
standards as prescribed by the Public
Companies Accounting Oversight Board
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Lemons
Problem
GAAP
Generally Accepted Accounting Principles
(GAAP)
The guidance U.S. companies currently use to
measure and report performance
Is very flexible
Allows management judgment
Different methods of measurement allowed
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Who prepares
a companys
financial
statements?
Management
GAAP FAQs
Why did GAAP arise?
To mutually benefit the capital market
participants who use financial statements
To help evaluate risk and return
To give confidence to users that information
helps make better decisions
Created by Financial Accounting Standards
Board (FASB)
Overseen by the Securities and Exchange
Commission (SEC)
SEC has the ultimate power to set accounting
standards
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Economic Environment of Accounting Information
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International Accounting Standards
Attempt to harmonize accounting standards
through creation of International Financial
Reporting Standards (IFRS)
Some countries are using IFRS
European Union converted in 2005
Recent impact on U.S.
Late 2007, U. S. SEC voted to allow foreign
registrants to file financial statements with the
U.S. using IFRS
Previously required to use or reconcile to U.S.
GAAP

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Capital Markets
Capital market
A marketplace in which funds are traded
between suppliers and those in need of
capital
Efficient capital market
A market in which security prices correctly
reflect all publicly available information

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Investment Decisions
Supply of
Capital
Demand
for
Capital
Capital
Market
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Investors with
funds available to
invest
Companies
with
opportunities
to invest
Raising Capital and Investors Return
1. Issue shares of stock
to shareholders
2. Borrow from creditors
such as financial
institutions and bond
investors

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1. Receipt of dividends
and stock appreciation
2. Receipt of interest and
repayment of amount
borrowed
Return on Stock Investments
Return =
Change in share price + dividends received
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Where P
t
= Share price at end of period,
D
t
= Dividends received during the period
P
t-1
= Share price at beginning of period

Information Role of Accounting
For equity investors
Provides better assessments of
Expected return, and
Expected risk of individual securities
Allows investor to make best possible decisions
For debtholders
Help debtholders assess financial risk
I.e., the risk that a company may not pay
Debt service charge (interest), and
Principal payments
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Changes in U.S. Corporate Regulation
Brought on by multiple financial scandals
over the years
Sarbanes-Oxley Act
Established Public Company Accounting
Oversight Board (PCAOB)
To regulate accounting profession
Mandated an investigation by SEC of using
principles rather than rules as a basis for U.S.
GAAP

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Corporations
Owned by shareholders
Organized under state laws
Corporate charter required
By-laws governing board of directors rights
and responsibilities to shareholders
Corporate governance
Board of directors
Elected by shareholders
Oversight of day-to-day management
Recommend independent auditors to
shareholders


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Appendix 1A
Agency Costs
Costs associated with divergent self-
interests of shareholders
Borne by the companys shareholders
How? Ownership
Monitoring and contracting role of
accounting information
Helps control and reduce conflicts between
shareholders, managers, and creditors
Example:
Financial information included in employment
contacts
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Appendix 1A
Conflicts
Between managers and shareholders
Due to self-interests resulting from separation of
management and firm ownership
Possible solution
Incentive contracts
Between debtholders and shareholders
Shareholders divert funds for dividends rather
than paying for borrowed funds
Possible solution
Loan contract with shareholder restrictions
Debt covenants
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Appendix 1A
Financial Accounting Concepts
Issued by the Financial Accounting Standards
Board (FASB)
Serve as foundation for Statement of Financial
Accounting Standards (SFAS), i.e., the
accounting rules
Contain
Objectives of financial reporting
Qualities of accounting information
Elements of accounting

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Appendix 1B
Objectives of Financial Reporting
1. Aids the creation of information useful in
making economic decisions
2. Provides information to aid in predicting cash
flows
3. Provides relevant information regarding a
businesss economic resources
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Appendix 1B
PURPOSE
To facilitate the
measurement
and reporting of
business activity
Accounting Assumptions
Economic entity
A business activity can be identified with a
particular business unit of accountability
Going concern
Entity will continue for the foreseeable future
Fiscal period
Segmented into reportable periods
To provide users timely, relevant information
Monetary unit
Only items that can be expressed in monetary
amounts are included in financial statements
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Appendix 1B
Qualities of Accounting Information
Relevance
Is timely
Possesses feedback and/or predictive value
Faithful representation
Is free from error or bias, objective, verifiable
Comparability
Comparisons between entities
Consistency
Comparisons across time

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Appendix 1B
Accounting Information Constraints
Materiality
GAAP applies only to economic events significant
enough to affect a users decision
Conservatism
Applied when trade-offs between qualities are
needed
A reaction to uncertainty
When in doubt, financial statements should
Understate assets
Overstate liabilities
Delay recognition of revenues
Accelerate recognition of expenses
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Appendix 1B
Accounting Elements
Assets
Liabilities
Equity

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Revenue
Expenses
Gains
Losses
Comprehensive income

Investments by owners
Distributions to owners

Balance
Sheet
Elements
Income
Statement
Elements
Transfers
Between a
Company and
its Owners
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END OF CHAPTER 1