Introduction

15.501/516 Accounting
Spring 2004

Professor Sugata Roychowdhury

Sloan School of Management
Massachusetts Institute of Technology

Feb 4, 2004
1
Session 1:
Agenda
Administrative matters
Discussion of Accounting
Why is accounting interesting?
Why do we need accounting?
Course objective
Sophisticated financial statement
user
An overview of information in
financial statements
2
The required materials are:
5th Edition of Jamie Pratt
Financial Accounting In An Economic Context
Case Packet
Sloan Space
Syllabus
Schedule
Homework assignments
Textbook problem solutions
Sample exams

3
Few quick issues
Access to MITServer
MIT students
Non-MIT students

First point of contact: TAs

Best way to contact me: email

Syllabus:
Schedule conflict
April 26 material
4
Course Grading
Written Problem Sets 10%
Class participation 10
Midterm 1 20
Midterm 2 20
Final 40

5
Accounting Introduction
Discussion of Accounting
Why is accounting interesting?
Why do we need accounting?
Course objective
Sophisticated financial statement
user
An overview of financial
information

6
What is Accounting trying to do?
Demand for Information
Financial Accounting
provides information primarily to people outside the company
provides information that would be helpful in attracting capital
Equity and debt (useful in debt contracts)
Credit from suppliers
Customers
Employees

Managerial Accounting
provides information to people inside the company
Internal investment decisions
Performance evaluation

Tax Accounting
provides information to the tax authorities
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Why do We Need Financial Accounting?

Resources
Today
Outsiders
- investors
Company
- employees
- suppliers

Resources
Tomorrow 8
Why do We Need Financial Accounting?
Financial
Financialaccounting
accountingpromotes
promotesthe
theexchange
exchangeof
ofresources
resources

Resources
Today
Outsiders
- Investors
Company
Information - Suppliers
(e.g., financial - Creditors
statements)

Resources
Tomorrow 9
Nature of Financial Accounting
Information
Useful to those making investment and credit decisions,
who have a reasonable understanding of business and
economic activities.
Helpful to
present and potential investors
creditors
other users
in assessing the amount, timing, and uncertainty of future cash
flows.
Provides information about economic resources, the
claims to those resources, and the changes in them.

10
 How important is this information?
The Reaction of Walmart Stock to Announcement of 3rd Quarter Earnings
59.5

59

58.5

58

57.5
ST O C K PR IC E

57

56.5

56

55.5

55

54.5

54 11
1-Nov-03 3-Nov-03 5-Nov-03 7-Nov-03 9-Nov-03 11-Nov-03 13-Nov-03 15-Nov-03 17-Nov-03 19-Nov-03 21-Nov-03 23-Nov-03
DATE
Financial Accounting
Introduction
Discussion of Accounting
Why is accounting interesting?
Why do we need accounting?
Course objective
Sophisticated financial
statement user
An overview of financial
information 12
WHAT IS OUR COURSE
OBJECTIVE?
To become intelligent users of accounting
information
Be comfortable looking through an annual report
Learn the language and techniques
Begin to develop the ability to use financial
statements to assess a companys performance

Have a sense of the limitations of financial

statement data

What are not our objectives

to train you to be an accountant or bookkeeper
Financial Statement Analysis - take 15.535
13
World of a Sophisticated
Financial Statement User
Events are occurrences that affect the firm.

Examples include:
1) Microsoft sued by the Justice Department

2) McDonald's sells hamburgers

3) United Airlines workers go on strike

4) The GAP announces a new marketing strategy for

its Old Navy Clothing stores
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World of a Sophisticated Financial
Statement User
Events / Actions

Rules
&
Management
choices

Financial Statements
15
World of a Sophisticated Financial
Statement User
Financial Accounting = translates events
into financial statements
Events
Generally
Accepted
Accounting
Rules
& Principals (GAAP)
Management
choice Management selects
from alternative rules
and from allowable
Financial Statements estimates under GAAP
16
Three keys to becoming a sophisticated
financial statement user

Understand the rules and managements

discretion

Understand what explains the rules and

the type of management discretion
Incentives

Understand how events affect firm value

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Financial Accounting
Introduction
Discussion of Accounting
Why is accounting interesting?
Why do we need accounting?
Course objective
Sophisticated financial statement user
An overview of financial information

18
Accounting is complex and
interesting because
Diversity of businesses and events
Many different players
Diverse incentives
Economic
Other
Uncertainty
Many regulations

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Financial Accounting
Introduction
Discussion of Accounting
Why is accounting interesting
Why do we need accounting?
Course objective
Sophisticated financial statement
user
An overview of financial
information

20
Financial Reporting
Requirements
Audited Annual Report (10-K)
Unaudited Quarterly Reports (10-Q)
Current Reports (8-K)
within 10 days of the end of a month
containing a significant event (e.g.,
major asset sales, changes in
ownership, bankruptcy, changing the
auditor)
Foreign Companies (20-F)
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Focus: The Annual Report

The Management Letter

Management discussion on developments during the
year and current state of the company

The Financial Statements

The Auditors Report
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 Financial Reports:
The Auditor's Report
GAAS (Generally Accepted Auditing Standards)
Reasonable assurance that financial statements are free of
material misstatement
Assess the accounting principles used and significant
estimates made by management

Actual opinion
financial statements present fairly, in all material respects, the
financial position, the results of operations, etc.
are in conformity with GAAP (Generally Accepted Accounting
Principles).

23
 Financial Reports:
The Auditors Report
Management responsible for
the preparation and integrity of the financial statements, etc.
Statements prepared in accordance with GAAP.
Estimated amounts based on management's best estimates
and judgments.
Maintenance of an internal control system to ensure that
assets are safeguarded and transactions are properly
authorized, recorded and reported.

The Board has an Audit Committee composed

entirely of outside directors
This committee appoints the auditor who has direct access
to the Audit Committee.

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Financial Statements

Contain primarily historical Information

Balance Sheet
Assets, liabilities & owners equity
Income Statement
Revenue (-) Expenses = Net Income
Statement of retained earnings
Cumulative sum of undistributed profits
Statement of cash flows
Operating, Investing and Financing activities
Footnotes
Significant accounting policies, estimates, etc.

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Financial Statements: Balance Sheet

Balance sheet is a statement of the

financial position of a business as of a
certain date.
Assets, e.g., cash, accounts receivable,
equipment, land
Liabilities -- amounts/services owed by the
company, e.g., loans payable, accounts
payable, customer advances, etc.
Stockholders equity -- initial investment by
the owners (capital stock -- common and
preferred stocks) plus the sum of
undistributed profits (retained earnings)
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Financial Statements: Income Statement

Income statement measures the performance of a

company over a period of time
Revenues -- a measure of economic benefits generated by
the sale of products or providing of services over a period
of time
Expenses -- a measure of economic sacrifices incurred to
earn the revenues of a given period
Examples of expenses -- cost of inventory sold, salaries to
employees, rent and lighting,, advertising, .......
Net income = revenues (-) expenses

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Dividends

Are dividends paid to owners considered an

expense?
Owners are residual claimants
Dividends are distributions to the owners out of the
profits earned by the business
In determining accounting profits to the residual
owners, we only subtract the costs of all factors of
production, e.g., physical capital (depreciation),
human capital (salaries), debt capital (interest
cost), etc.
Dividends are not a factor of production
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Financial Statements: Retained
Earnings & Shareholders Equity

Retained earnings
A measure of undistributed profits of a business
Do not include capital contributed by owners
Retained earnings = Cumulative sum of profits
earned from the inception of business (-)
Cumulative sum of all dividends distributed to
the owners from the inception of business
Statement of shareholders equity describes the
change in retained earnings over a period of time
(e.g., a year)
Beginning balance in retained earnings
Add Net income earned during the period
Subtract Dividends distributed during the period
Ending balance in retained earnings 29
Summary

Accounting is a complex field contrary to

common perceptions.

Financial accounting information facilitates the

exchange of resources.

To become a sophisticated financial statement

user, you need to understand how the
information in financial statements is recorded.
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 Cost Allocation II
Death Spirals
15.501/516 Accounting
Spring 2004

Professor S. Roychowdhury
Sloan School of Management
Massachusetts Institute of
Technology 10

11

Allocation of Indirect Costs of a Cost Center

to Departments

Assume the following:

IT Department costs $100,000/month
5 Departments have equal access to IT services
Current allocation is $20,000/month to each

12

1
 Allocation of Indirect Costs of a Cost Center
to Departments
Outside
Dept. Cost Charge Result
A $ 18,000 $ 20,000 Unhappy, wants out
B $ 22,000 $ 20,000 Happy
C $ 30,000 $ 20,000 Happy
D $ 30,000 $ 20,000 Happy
E $ 30,000 $ 20,000 Happy

Total $130,000 $100,000

13

Allocation of Indirect Costs of a Cost Center

to Departments
Outside Charge Charge Charge Charge
Dept. Cost 1st Iteration 2nd Iteration 3rd Iteration 4th Iteration
A $ 18,000 $ 20,000 exits
B 22,000 20,000 25,000 exits
C 30,000 20,000 25,000 33,333 exits
D 30,000 20,000 25,000 33,333 exits
E 30,000 20,000 25,000 33,333 exits

Total $130,000 $100,000 $100,000 $100,000 ???

This is a death spiral -- a positive feedback loop.

14

Allocation of Indirect Costs of a Cost Center

to Departments
Outside
Dept. Cost Charge
A $ 18,000 $ 20,000
B $ 22,000 $ 20,000
C $ 30,000 $ 20,000
D $ 30,000 $ 20,000
E $ 30,000 $ 20,000
Total $130,000 $100,000

Why might departments C, D, and E have a higher outside

cost than department A? Should they pay more for IT
services than A?
15

2
 Allocating Costs to Departments
- General Points -
Charge cost center costs to departments based on % of cost
center products they use, so that these departments properly
incorporate cost center costs in their decisions.

Under-charging some departments for cost center use implies

that these under-charged departments are be subsidized by
other departments using the cost center

When a cost center is not operating at capacity, allocation of

the cost centers overhead costs may result in allocated costs
exceeding the cost of outside alternatives. Thus departments
purchase products from external parties.
Result in the firm overpaying for products.

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The Issue of Joint Costs

A joint cost is incurred to produce two or

more outputs from the same input.

Consider a firm that produces fillets,

drumsticks and wings from chickens.

The chicken and the initial processing of

separating it into various parts costs $2.00

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Joint costs - Split-Off Point

Split off point: the point beyond which further processing

has to take place for fillets, drumsticks and wings before they
can be sold.

Assume following data

Price Further Processing Cost NRV*
Fillets 2.40 (0.80) 1.60
Drumsticks 0.80 (0.04) 0.76
Wings 0.30 (0.16) 0.14

*Net Realizable Value

18

3
 Joints Costs How To Allocate?

By weight seems appropriate

Weight in oz
Total Fillets Drumsticks Wings
Weight 32 16 12 4
%age weight 100% 50% 37.5% 12.5%
Allocated
Cost 2.00 1.00 0.75 0.25

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Net Profits With Joint Cost Allocation

With weight-based allocation,

NRV Joint costs allocated Net Profit

Fillets 1.60 (1.00) 0.60
Drumsticks 0.76 (0.75) 0.01
Wings 0.14 (0.25) (0.11)
2.50 (2.00)

If input/output prices and yields are fixed, then it appears

optimal to drop wings

20

Joints Costs How To Allocate II?

Drop wings
Redistribute joint costs by weight across
fillets and drumsticks
Weight in oz
Total Fillets Drumsticks
Weight 28 16 12
%age weight 100% 57% 43%
Allocated
Cost 2.00 1.14 0.86

21

4
 Joint Cost Allocation Death Spiral?

With weight-based allocation,

NRV Joint costs allocated Net Profit
Fillets 1.60 (1.14) 0.46
Drumsticks 0.76 (0.86) (0.10)

If input/output prices and yields are fixed, then it appears optimal to drop
drumsticks
With only fillets, joint cost allocation is easy!

NRV Joint costs allocated Net Profit

Fillets 1.60 (2.00) (0.40)

If input/output prices and yields are fixed, then it now appears optimal to
drop fillets!
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Joints Costs & NRV

Allocate by proportion of NRV

Total Fillets Drumsticks Wings
NRV 2.50 1.60 0.76 0.14
%age NRV 100% 64% 30.4% 5.6%
Allocated
Cost 2.00 1.28 0.61 0.11

With above allocation,

NRV Joint costs allocated Net Profit
Fillets 1.60 (1.28) 0.32
Drumsticks 0.76 (0.61) 0.15
Wings 0.14 (0.11) 0.03

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Joint Costs & NRV

Proportion of NRV (Net Realizable Value) is the

only correct way to allocate joint costs

Why?
Once the joints costs are incurred, the company is going
to have fillets, drumsticks and wings anyway.
As long as the profit margins on each of those products
are positive, the joint costs are essentially irrelevant in
deciding the relative profitability of product lines.

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5
 Summary

Death Spirals result not just from overhead

allocations, but from cost-of-raw-material
allocations as well

In most or at least many cases, there are credible

alternate allocation methods to avoid death spirals.
Eg, joint costs should be allocated using NRVs

But one has to be careful!

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