st session: Introduction to Accounting Objectives • • • Develop the ability to read, analyze and interpret financial statements Understand how financial accounting statements are constructed Provide you with tools for economic decision making – Where to find information – How the information got there Textbook • • Financial & Management Accounting, an Introduction by Pauline Weetman, 5th edition, available in two forms: – Softcover – E-book Register on Prentice Hall website for additional materials! (Process to be announced in class, next time.) Rules of the Game • • • • • Read the assigned material, the assigned problems before the lecture Come to class on time Do the assignments on a timely basis Turn off cell phones and other communication devices Ask questions and participate in class Course Website & e-mail I will use the schools e-learning portal to post information Make sure you log in at: http://sca.lisboa.ucp.pt/e-sca/esca.aspx Email: rireis@ucp.pt GRADING SCHEME Final grades will be determined by the following scheme: – Assignments – Midterm – Final: 10% 40% 50% FIRM OF THE DAY Today’s Class Overview of “Accounting” in general and “Financial Accounting” in particular Discussion of Accounting terminology Mandatory Financial Reporting (including the Financial Statements) Financial Accounting • Financial accounting is the language that translates economic events into uniform and comprehensive information, understandable by OUTSIDE observers • Unfortunately, this language has become extremely complex and heterogeneous… • This is naturally a bad thing for the outside observers In an ideal world… “In an ideal world, the user of financial statements could focus only on the bottom lines of financial reporting If financial statements were comparable among companies, consistent over time, and always fully reflecting the economic positions of the firms, financial statement analysis would be simple.” Adapted CFA Preparation Readings Risks and Uncertainties • Disclosure of Certain Significant Risks and Uncertainties require the following: – Nature of operations – Use of estimates – Certain significant estimates – Current vulnerability due to certain concentrations Supplementary Schedules • Special Cases for certain industries require these additional supplements – Oil and gas companies are required to provide additional data on their exploration activities, including the NPV of some of their projects – – Impact of changing prices Segment disclosure of sales revenue, operating income, according to geographical or business segments – Financial instruments and hedging activities Management Discussion and Analysis • Mandated by the SEC, the MD&A is required to discuss: – D&A of the management’s opinion on the current and prospective situation of the operations of the firm (trends in sales and expenses) – Same for the cash flow situation Where will the funding come from? Role of the Auditor • • Independent CPA, their role is to certify the financial statements in conformity with GAAP Must agree (or explain disagreement) with the management’s choices of accounting policies and estimates • Hired by the management, they are expected to be completely independent of it and a thorough analysis of the firm’s accounts, by verifying the internal control system through their own separate control systems Role of the Auditor • Audit Opinion: Summary of the audit results regarding the financial reports and an assessment of internal controls – Unqualified: Financial statements appear to be presented fairly and in accordance with Generally Accepted Accounting Principles (GAAP); internal controls appear to be adequate – Qualified: Generally, financial statements appear to be presented fairly and in accordance with Generally Accepted Accounting Principles (GAAP), but there is some material issue that needs to be addressed; there is an issue that needs to be addressed regarding internal controls – Adverse: There is a high probability of material errors within the financial statements; there are material weaknesses in internal controls Role of the Auditor • • • Auditors should be the main Agency Problem mitigators as they operate on behalf of the stockholders Commonly ignored, their reports should always be checked by an analyst, specially if it raises doubts about the firm’s financials Auditors are mandated to express not only their disagreements but also their doubts, mostly about: – – – The going concern assumption; Uncertainties related to the value of some assets or liabilities; Some contingencies Critical definitions of terms used throughout this course Assets: items owned by the firm Liabilities: items the firm owes to creditors (One source of funds available to purchase or create assets) Net Assets: Assets – Liabilities (the assets left over after paying off debt) Owners’ Equity: the owners’ claims to the assets Owners’ Equity = Net Assets Why? These are the fundamental concepts for the Balance Sheet Assets = (what is owned) Liabilities (what is owed) Provide funds for Owners’ Equity (owners’ claims) Critical definitions of terms used throughout this course (contd.) Accounting Equation: Assets = Liabilities + Owners’ Equity Cash + Other Assets Liabilities = (what is owned) (what is owed) Owners’ Equity (owners’ claims) Retained Earnings Contributed Capital (cumulative profits kept within (Stock Issues) (note this is a second source of funds the firm) for purchasing or creating assets) Revenues Expenses (inflows of resources) (outflows of resources) Critical definitions of terms used throughout this course (contd.) Revenues: inflows to the firm (from providing services or sales) Expenses: outflows by the firm that are generated to help create revenues Gains: increases in value of firm assets Losses: decreases in value of firm assets Net Income: “profit” earned during the period Revenues - Expenses + Gains - Losses = Net Income These are the fundamental concepts for the Note: the difference between these classifications is often subtle and confusing Generally, “revenues” and “expenses” are associated with fundamental operational transactions “Gains” and “losses” are associated with tangential transactions In N’ Out Burger’s sales of hamburgers would generate “revenues” Income Statement In N’ Out Burger’s sales of a delivery truck might generate a “gain” or a “loss” Critical definitions of terms used throughout this course (contd.) Income Statement: summary of revenues and expenses for the period Revenues − = Cost of Sales (Cost of Goods Sold) Gross Margin − = Selling and Administration Expenses Income from Operations − Interest Expense − Other Expenses or Losses + Other Revenues or Gains = Income before Taxes − Income Tax Expense = Non operations Section Income before Irregular Items −/+ −/+ Loss or Gain from Discontinued Operations (net of tax) Loss or Gain from Extraordinary Items (net of tax) −/+ = Operations Section Loss or Gain from Change in Accounting Principle (net of tax) Net Income Irregular Items Section We’ll cover this in more detail later… Revenues $152,866 Expenses $132,386 Net Income $16,819 Critical definitions of terms used throughout this course (contd.) Dividend: periodic payment back to the owners; a distribution of profits Now, let’s put this all together… The Big Picture Review The firm also borrows funds to purchase or create assets Assets Liabilities (what is owned) (what is owed) Owners’ Equity Owners’ funds are used to (owners’ claims) purchase or create firm assets Investors (owners) contribute funds to create a firm The Big Picture Review Assets Liabilities (what is owned) (what is owed) Assets are used up (expenses) to generate revenues Owners’ Equity (owners’ claims) which nets to Net Income Net Income (Revenues – Expenses) is collected within the firm (as Retained Earnings) Retained Earnings Back to Owners Some proportion of Retained Earnings is distributed to owners as a Dividend Next Class… Overview of the Financial Statements More detailed discussion of the Balance Sheet [...]... corporations must create and file financial reports Why do publicly-traded Corporations have to file financial reports? Monitoring Separation of ownership (shareholders) and control (hired managers) presents a classic principal-agent problem (agency theory) Agency theory suggests that, without proper monitoring and incentives, agents will extract perquisites (Jensen and Meckling, 1976) Financial reports are... inside the SE: – Preferred shares – Common shares – Additional paid-in capital – Retained earnings – Treasury shares – Employee stock ownership plan adjustments – Accumulated Other comprehensive income Footnotes • Mostly they serve the purpose of providing additional information to better interpret the numbers disclosed in the financial statements They refer to: – Accounting methods, assumptions, or estimates