INTRODUCTION TO FINANCIAL

STATEMENTS AND INTRODUCTION TO

THE BALANCE SHEET
FINANCIAL ACCOUNTING – LECTURE 1

ERIC FLOYD– FALL 2017

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COURSE MATERIALS
 Financial Accounting by Libby, Libby, Short Edition 9 (published
by McGraw-Hill).
 Class Handouts: Posted on TritonEd the week before class
 Homework: due every week Monday/Tuesday at 5pm. You need
to submit the homework using Connect.
 SmartBook/LearnSmart: Optional, but may be useful. Guided
reading and short quizzes to test your understanding.
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REVIEW SESSIONS AND OFFICE HOURS
 Review sessions:
 Weeks 5 and 10 before the midterm and final
 We will agree on the timing (and number) when we get closer
 Review sessions will focus on problems on the syllabus
 Please email problems to TA the day before review sessions
(see Syllabus)
 No new material is covered during review sessions

 Office hours:
 By appointment
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COURSE PERFORMANCE
Item Weight
Graded online homework 15%
Class Participation 10%
Midterm Exam (closed book) 25%
Final Exam (closed book) 50%

 The final exam will cover all of the material during the class.
 Midterm exam: Week 6
 Final exam: Week 11
 No changes to exam dates except in exceptional cases!!
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Introduction to Financial
Statements
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WHAT IS THE COURSE ABOUT?

 Understanding financial statements
• The course does not cover detailed accounting rules
• You will learn the basic principles behind bookkeeping
because this is essential in understanding financial
statements

 Developing experience in using financial statement data

• We will look at financial statements from the real world

 International differences
• Knowledge of US-GAAP is no longer enough
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COURSE THEMES
 Accounting is how the financial world keeps score. Financial
statements are the best starting point for obtaining information
about a company.

 However, accounting is not always objective:

• Accounting information is always based on assumptions.
Understand and question the assumptions before you use
the information.
• Accounting information is always subject to management
discretion. Important to understand motives and incentives
of preparers of information.
• Accounting information generally does not provide
answers, but it allows you to ask better questions.
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A BIT OF HISTORY
 First extensive use of accounting was by merchants
 First big capital intensive businesses in the US were railroads (4.6B
invested by 1880)
 19th century industrial firms disclosed little to outside investors.
 Initially raised money without financial disclosure or issued 2 page
prospectuses.
 Dividends were used to evaluate financial strength

 Railroads heavily relied on debt financing (bonds often sold to

European investors)
 Distant creditors demanded more information to monitor their
investments
 Financial reporting started to emerge
 Credit rating agencies emerged (S&P and Moody’s)
 First auditors were hired directly by creditors
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ACCOUNTING AND CRISIS

 October 28/29, 1929 DJIA index fell 23.1% followed by the Great
Depression
 Financial reporting received a portion of blame
 Resulting Securities Acts of 1933 and 1934 forever changed
financial accounting in US.

 Today, financial reporting also receives part of the blame for the
current crisis
 Shooting the messenger or are changes needed?
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INTRODUCTION TO FINANCIAL
STATEMENTS AND FINANCIAL REPORTING
 Financial Statements may be part of the annual report.

 Financial Accounting and Reporting: Process by which the financial

transactions, position, and results of a firm are recorded and
communicated to outside investors, potential investors, and other
external stakeholders.

 Uses of financial accounting information include:

• Valuation of the firm and its securities
• Contracting
o Debt contracts, labor contracts, management compensation
contracts, other contracts (e.g., royalties)
• Regulation (e.g., banks)
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INTRODUCTION TO FINANCIAL
STATEMENTS AND FINANCIAL REPORTING
 In the U.S., the Securities and Exchange Commission (SEC) governs
the process of the issuance of publicly traded securities (debt and
equity).
• The SEC oversees the establishment of accounting rules in the
U.S. for publicly traded firms.
• For the most part, the SEC has delegated the rule making process
to a private (i.e., non-governmental) organization: the Financial
Accounting Standards Board (FASB).
• The SEC is currently considering International Financial Reporting
Standards (IFRS) issued by the International Accounting Standard
Board (IASB) instead of FASB’s standards (IASB is a private
organization based in London, UK).
 External auditors (CPAs) annually assess whether corporations’
financial accounting and reporting are in compliance with GAAP.
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HIERARCHY OF GAAP
No single reference source exists for all generally accepted
accounting principles. The sources of GAAP are:
 Category A: Accounting Principles established by the Financial
Accounting Standards Board (FASB) (and Accounting Principles
Board and AICPA Technical Research Bulletins)
 Category B: FASB Technical Bulletins and AICPA Industry Audit and
Accounting Guides and AICPA Statements of Position
 Category C: AICPA Accounting Standards Executive Committee
Practice Bulletins and consensus bulletins of the FASB Emerging
Issues Task Force.
 Category D: AICPA accounting interpretations and implementation
guides published by the FASB staff, and practices that are widely
recognized either generally or in the industry
 IFRS is more based on principles (= fewer standards and
interpretations)
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QUALITIES OF ACCOUNTING INFORMATION
What makes accounting information useful?

Conceptual Framework:

ECONOMICS OF ACCOUNTING
INFORMATION
Demand for financial statements
1.Shareholders and investors
2.Managers and employees
3.Lenders and suppliers
4.Customers
5.Government and regulators
Information is valuable because:
1.Reduces uncertainty about a firm’s value
2.Helps to evaluate risks and expected
returns involved with investing
3.Helps price formation process
4.Enables to evaluate quality of managers
5.Helps evaluate ability to pay obligations
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Supply of financial statements
Companies trade off costs and benefits of
disclosing information
Disclosure benefits:
1.Information attracts investors
2.Transparency – “Sunlight is the best
disinfectant, electric light the most efficient
policeman”.
3.Lower cost of capital
Disclosure costs:
1.Collection, processing and dissemination
costs
2.Proprietary information costs
3.Litigation and Political costs
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THE NUMBERS GAME

 Managers often believe that reporting volatile earnings is detrimental to
firm’s value, while smooth, predictable earnings boost firm’s valuation
 This is despite the fact that finance theory (CAPM) says that
idiosyncratic risk is not priced by the market
 Volatility is a normal outcome of operating most businesses

 What’s more, managers may feel tempted to meet or beat analysts’

expectations all the time and often succeed in doing so
 A justification that one often hears is that managers can often “find”
and few pennies to beat the market (by managing earnings, i.e.,
borrowing form the future or shifting expenses forward).
 Not meeting earnings is like seeing a cockroach.
 If you see one cockroach, there must be hundreds cockroaches
around. Is it a good idea to hide it though?
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PRINCIPAL FINANCIAL STATEMENTS

 Balance Sheet (or statement of financial position)

 Income statement (or statement of profit and loss under IFRS)

 Statement of cash flows (or cash flow statement)

 Statement of shareholders’ equity (We will talk about this statement

later this quarter)

 Notes to the financial statements, including various supporting

schedules

 (Opinion of the independent certified public accountant)

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THE BALANCE SHEET

 What is the financial position of the firm?

 Snap shot in time, e.g., 31 December 2015

 The Basic Accounting Equation:

Resources = Sources of Resources
Assets = Liabilities + Shareholders’ Equity
• Assets (what you have): Measurable resources with the potential
to provide future economic benefits to a firm
• Liabilities (what you owe): Creditors’ claims for funds (i.e.,
obligations to sacrifice resources)
• Shareholders’ Equity (Net worth, what’s left over): Residual claims
by owners on assets after all liabilities have been satisfied
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THE INCOME STATEMENT
 Purpose is to report performance over a period of time, e.g., 2015
(between two balance sheets: 1 Jan. 2015 – 31 Dec. 2015).

 Report earnings (= net income/earnings/profit) for a period of time,

e.g.,
 One year for an annual report (10k)
 Portions of a year for a quarterly report (10q)

 Basic Income Equation:

Net Income = Revenues – Expenses
 Revenues (or sales/turnover) are the inflows of assets (or reductions
in liabilities) from selling goods and services
 Expenses are the outflows of assets (or increases in liabilities) used
in generating revenues
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STATEMENT OF CASH FLOWS

 Purpose is to explain the change in cash between two balance sheet
dates

 Receipts and payments, classified by type of activity:

• Operations: cash from customers less cash paid in carrying out
the firm’s operating activities.

• Investing: cash paid to acquire noncurrent assets less amounts

from any sale of noncurrent assets.

• Financing: cash from issues of long-term debt or new capital less

dividends.
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RELATION OF THE BALANCE SHEET TO
OTHER FINANCIAL STATEMENTS

Balance Sheet at December 31, 2014

Shareholders’ Equity
Cash + Noncash Assets = Liabilities + [Contributed Capital + Retained Earnings]

Statement of Cash Flows Income Statement

For year ended, 12/31/2015 For year ended, 12/31/2015
(Change in cash from (Change in retained earnings
Dec. 31, 2014 to from Dec. 31, 2014 to
Dec. 31, 2015) Dec. 31, 2015)

Cash + Noncash assets = Liabilities + [Contributed Capital + Retained Earnings]

Balance Sheet at December 31, 2015

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NOTES TO THE FINANCIAL STATEMENTS

 The balance sheet, income statement, and statements of cash
flows are condensed. The notes provide additional details.

 US-GAAP includes many choices. IFRS even more. The first

note usually explains the accounting policy.

 Other schedules, e.g., more detailed explanation on changes in

property, plant and equipment.
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AUDITOR’S OPINION
 Required when a firm is publicly traded.

 Assess the effectiveness of the firm’s internal control system for

measuring and reporting business transactions

 Assess whether the financial statements and notes present fairly

a firm’s financial position, results of operations, and cash flows
in accordance with GAAP

 The letter of opinion states the auditor’s opinion

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THE LETTER OF OPINION

 The first paragraph indicates the financial statements covered by the
opinion and that the responsibility for the statements rests with
management.
 Do auditors audit for fraud?
 The second paragraph states which accounting/auditing standards and
practices generally accepted by the accounting profession (reporting
system) were used by the auditor
 E.g., U.S. GAAP, UK-GAAP (prior to 2005), IFRS
 The third paragraph states auditor’s opinion: unqualified (clean) or
qualified.
 Qualified opinions are either a disclaimer of opinion (when auditor
cannot evaluate the appropriateness of financial statements) or an
adverse opinion.
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The Balance Sheet

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THE BALANCE SHEET: A CLOSER LOOK
The Accounting Equation:
Assets = Liabilities + Shareholders’ Equity

Learning objectives (of the balance sheet section):

 Understand the accounting concept of assets, liabilities and
shareholders’ equity
• Conditions when firms recognize such items (recognition
issues)
• Amounts (valuation issues)
• Where these items appear on the balance sheet
(classification issues)
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RECOGNITION OF ACCOUNTING ASSETS
 Asset: Probable future economic benefit that a firm controls because
of a past event or transactions.
• An asset is a future cash inflow to the firm!
 Recognize a resource as an asset only if:
1. The firm owns or controls the right to use the item.
2. The right to use the item arises as a result of a past transaction or
exchange.
3. The future benefit has a relevant measurement attribute that can be
quantified with sufficient reliability.
 Executory (uncompleted) contracts do not result in assets, unless the only
unexecuted part is the delivery of cash. Example: Purchase Order for
Inventory.
 Note: All assets are future benefits, but not all future benefits are
recognized as assets. Accounting assets ≠ economic assets.
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CAPITALIZING VS. EXPENSING FRAUD:
WORLDCOM
SEC enforcement actions information:
Line costs comprised the largest single expense item on WorldCom’s income statement. Line costs were the fees paid to third-
party telecommunications carriers under long term lease agreements for rights of access to their telecommunications
networks. These lease agreements required WorldCom to pay the fees whether or not WorldCom used all of the leased capacity.

During 2001 WorldCom’s line costs had increased, in large part due to its obligations under the long-term lease agreements it
had entered into based on its incorrect anticipation of growth in demand for telecommunications capacity.

U.S. GAAP required WorldCom to expense its line costs in the period they were incurred because they represented actual or
expected cash outflows from ongoing major operations. During 2001, WorldCom improperly removed approximately $3 billion in
its line cost expenses from its income statement, improperly and fraudulently characterizing these expenses as “assets” on its
balance sheet. This improper accounting was accomplished by manual journal entries to line cost and PP&E accounts.

The way company talks about fraudulent accounting:

In June 2002, the Company announced that, as a result of an internal audit of its capital expenditure accounting, it was
determined that certain transfers from line cost expenses (also referred to as access cost expenses) to capital accounts
during 2001 and the first quarter of 2002 were not made in accordance with GAAP. The Company promptly notified Arthur
Andersen LLP (“Andersen”), which had been the Company’s external auditor until May 2002, had audited its consolidated
financial statements for 2001 and 2000, and had reviewed its interim condensed financial statements for the first quarter of
2002. On June 24, 2002, Andersen advised the Company that in light of the inappropriate capitalization of access costs,
Andersen’s audit report on the consolidated financial statements for 2001 and its review of the Company’s interim
condensed consolidated financial statements for the first quarter of 2002 could not be relied upon.

…we have restated our previously reported consolidated financial statements for the fiscal years ended December 31,
2001 and 2000… These consolidated financial statements include restatements of earnings, write-downs of goodwill, other
intangible assets and property, plant and equipment and other adjustments...

The adjustments resulted in a cumulative net reduction to shareholders’ equity of $70.8 billion as of December 31, 2001…
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WHICH OF THE FOLLOWING ARE
ACCOUNTING ASSETS?
 Cash

 Accounts receivables

 Customers’ promises to buy products in the future

 Inventory

 Brand name

 Growth options (i.e., investment opportunities)

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ASSET: YES OR NO?
 $10m spent on researching new beverage (not yet feasible).

 $4m purchase order signed. $400K deposit delivered to vendor.

 $2m of advertising expenditures incurred.

 $2.5m worth of common stock issued to acquire another company.

 Is the company an assets even if cash was not paid?

 $800k spent on employees’ MBA educations.

 $150m mortgage signed to finance land acquisition.

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ASSETS (CONTINUED)
Valuation (the assignment of a monetary value)
 Theoretically, what basis could we use to value assets?
1. Acquisition or Historical Cost
2. Current Replacement Cost
3. Fair value (e.g., Net Realizable Value)
 Monetary asset : asset with value fixed in dollar terms by statue or
contract
• Use fair value (present value)
• Examples: cash, accounts receivable
 Nonmonetary assets generally use historical cost with adjustments
for usage if it is a noncurrent asset
• Examples: inventory, land, buildings
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ASSETS (CONTINUED)
Classification

 Current asset: asset that the firm expects to convert into cash
within one year or the operating cycle (whichever is longer)
• Examples: Cash, inventory, accounts receivable, marketable
securities

 All other assets are noncurrent assets

• Examples: PP&E, long term equity investments, intangible
assets
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RECOGNITION OF LIABILITIES
 Liability: Probable future sacrifices of economic benefits arising from
present obligations of a particular entity to transfer assets or provide
services to other entities in the future as a result of a past event or
transaction.
• A liability is a future cash outflow from the firm!
 Recognize a liability only if:
1. Represents a present obligation, not a potential future commitment
or intent.
2. Exist as a result of a past transaction or exchange.
3. Require a probable future economic resource that the firm has little
or no discretion to avoid.
4. Relevant measurement attribute that the firm can quantify with
sufficient reliability.
 Note: All liabilities are obligations but not all obligations are
recognized as liabilities.
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LIABILITY: YES OR NO?
 $10m received for newspaper subscriptions (we have to deliver
papers in the future).

 $4m invoice received for past advertising expenditures.

 $1m wages for last week of fiscal year not yet paid to employees

 $10m lawsuit where loss is “likely” (insurance will cover in full).

 $10m lawsuit where loss is “likely” (no insurance).

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LIABILITIES (CONTINUED)
Valuation (the assignment of a monetary value)

 Most liabilities are monetary (obligation fixed in dollar terms by

contract), thus use present value valuation base.

 Exceptions to this rule include “advances from customers” (use

amount received) and “warranty liability” (use estimated costs to
honor liability)

Classification
 Current and noncurrent definitions similar to assets
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SHAREHOLDERS’ EQUITY
Recognition
 Shareholders’ equity is the residual claim on assets after settling claims
of creditors.
 Shareholders’ equity is equal to total assets less total liabilities

Measurement
 Valuation derived based on how we valued assets and liabilities, thus
value is not based on only one valuation base

Question
 What is the relation between the market value of stockholders’
equity and book value of shareholders’ equity?
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SHAREHOLDERS’ EQUITY (CONTINUED)
Classification
 Contributed capital: investments made by shareholders in the firm.
Contributed Capital is divided into:
1. A par or stated value of the shares, which has a legal definition
2. The remaining amount, which is called Additional Paid-In Capital
(A.P.I.C.).
(This distinction may have no relation to any market value of the shares)
 Retained earnings (accumulated deficit): net accumulation of earnings
of the firm since its beginning
• Retained Earnings is increased by positive net income
• Is reduced by losses
• Is reduced by the payment of dividends to the shareholders or
owners
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ACCOUNTING IS A PUZZLE WITH MANY
PIECES THAT FIT TOGETHER
Resources = Claims to Resources
Balance Sheet: Schedule of
financial position as of a
particular date.
Assets = Liabilities + Shareholders' Equity

Assets = Liabilities + Contributed Capital + Retained Earnings

Assets = Liabilities + Contributed Capital + Retained Earnings

Retained Earnings = + Net Income  Dividends Statement of

Shareholders’ Equity:
Schedules that reconciles
changes with beginning and
ending balances.
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ACCOUNTING IS A PUZZLE WITH MANY
PIECES THAT FIT TOGETHER
Assets = Liabilities + Contributed Capital + Net Income  Dividends

Net Income = Assets  Liabilities  Contributed Capital + Dividends

Net Income = Revenue  Expense + Gains  Losses

Income Statement: Change in net assets during
the period between two balance sheet dates
from non-owner transactions and excluding
other equity transactions (i.e., excluding Paid-in
Capital and Dividends).

Cash + Non-cash Assets =Liabilities + Contributed Capital + Net

Income  Dividends

Cash = Liabilities + Contributed Capital + Net Income  Dividends 

Non-cash Assets

Statement of Cash Flows: Change

(inflow and outflow) in the cash
account during the period between
two balance sheet dates.
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LEARNING OBJECTIVES OF WEEK 1
Develop an understanding of:

 Basic uses of financial accounting information

 What Generally Accepted Accounting Practices (GAAP) is and

where it comes from

 The primary financial statements

 The balance sheet and its relation to other financial

statements
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Double-Entry Recordkeeping
Week 2 – Remember to bring this handout to class

Objective: Understand the dual-entry recording framework and learn

to use it to record a series of transactions, ending with the balance
sheet
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THE ACCOUNTING PROCESS AND
DOUBLE-ENTRY RECORDKEEPING
 We can use the Accounting Equation to record transactions:

Assets = Liabilities + Shareholders' Equity

 All transactions (i.e., recognized events) affect at least two accounts.

Four general combinations:
• Increase an asset and a liability or owners’ equity by the same
amount
• Decrease an asset and a liability or owners’ equity by the same
amount
• Increase an asset and decrease another by the same amount
• Increase a liability or owners’ equity and decrease another liability
or owners’ equity by the same amount.
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EXAMPLE
Transaction Assets = Liability + Equity

1. Issue 10,000 shares for

$100,000.
2. Purchase equipment for
$60,000 cash.
3. Purchase inventory for
$15,000 on account.
4. Pay supplier $8,000 cash of
the $15,000 owned
5. Issue 700 shares of stock to
supplier for balance due
6. Pay for one year insurance
policy, $600 in cash
7. Customer pays $3,000 for
merchandise to be delivered
in the future.
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DOUBLE-ENTRY RECORDKEEPING USING
T-ACCOUNTS
Debit/Credit Recordkeeping
 Use of the accounting equation to keep track of transactions is too
simplistic and does not provide enough information (also, expanding the
accounting equation would prove cumbersome)

 Instead we use “T-accounts”

• The T-accounts are just another way to use the accounting equation
(nothing is new except the way it is written)

 Rules of Debits and Credits

• No negative numbers are allowed. We use debit (Dr) and credit (Cr).
• Every transaction must have at least one debit and at least one credit.
• Debits must equal credits for all transactions
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THE ACCOUNTING PROCESS AND
DOUBLE-ENTRY RECORDKEEPING
Dr. Cr. Dr. Cr. Dr. Cr.

Assets = Liabilities + Shareholder’s

Equity
BB BB BB

+ - - + - +

EB EB EB

Dr. = Debit
**Notice that the sum of debits must equal the sum
Cr. = Credit
of credits for the accounting equation to hold!
BB = Beginning balance
EB = Ending balance
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THREE FUNDAMENTAL ACCOUNTING
EQUATIONS

 Assets = Liabilities + Shareholders’ Equity

 Beginning Balance + Increases – Decreases = Ending Balance
 Sum of Debits = Sum of Credits

These equations must be in balance at all times!

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Any Liability Account (L)
PURPOSE AND
USE OF BB  To accumulate the
transactions for specific
ACCOUNTS Decreases Increases financial statement
 + elements.
Dr. Cr.  To accumulate the
EB increases and decreases
Any Asset Account (A)
Contributed Capital (OE) (if any) of a specific item
during the period.
BB
BB
Decreases Increases
Increases Decreases
 +
+ 
Dr. Cr.
Dr. Cr. Normal or natural
EB
balance is on the
EB Retained Earnings (OE) credit side of the
account.

BB

Normal or Decreases Increases

natural balance
is on the debit  +
side of the Dr. Cr.
account.
EB
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EXAMPLE: OPENING BALANCE SHEET
(E.G., JANUARY 1ST)
1. A firm issues 20,000 shares of $5-par value stock for $12 cash per
share.
2. The firm acquires a building costing $500,000. It makes a cash
payment of $80,000 and assumes a long-term mortgage for the
balance of the purchase price.
3. The firm acquires on account equipment costing $20,000 and
merchandise costing $35,000.
4. The firm obtains a three-year fire insurance policy and pays the
$3,000 premium in advance.
5. The firm issues a 90-day, 6 percent note to the bank for a $20,000
loan.
6. The firm pays $22,000 to the suppliers in (3).
7. The firm receives an order for $6,000 of merchandise to be shipped
next month. The customer pays $600 at the time of placing the
order.
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Assets = Liabilities + Shareholders’ Equity:

A = L + SE
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JOURNAL ENTRIES:
Cash Merchandise Inventory Accounts Payable Common Stock - Par
BB BB BB BB

EB EB EB

Prepaid Insurance Note Payable Addtl. Paid in Capital

BB BB BB

EB EB EB

Buildings Advances from Cust.

BB BB BB

EB EB EB

Equipment Mortgage Payable

BB BB BB

EB EB EB EB
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BALANCE SHEET
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REVIEW
 Basic uses of financial accounting information
 GAAP and where it comes from
 The primary financial statements
 The balance sheet and its relation to other financial
statements
 The accounting process and double-entry bookkeeping