An Introduction to Financial Accounting

2 - 1 - Video 1.1 Financial Reporting Overview (2116).txt

Hello, I'm professor Brian Bushee welcome 
to the first video in an introduction to 
financial accounting. 
What we're going to do in this video is 
first provide an overview of the 
financial reporting landscape. 
What's required in financial reporting, 
who makes the rules, who enforces the 
rules and then second, we're going to 
look at an extended example of what the 
financial statements can tell us. 
Which will introduce some concepts that 
we'll see again and again throughout the 
course. 
I hope you enjoy the video. 
Let's start with a definition. 
Accounting is a system for recording 
information about business transactions 
to provide summary statements of a 
company's financial position and 
performance to users who require such 
information. 
>>Wow. 
Please tell me the whole video won't be 
this boring. 
 >> [LAUGH] I hope not. 
but to spice things up a little bit, I 
will bring in some virtual students to 
ask questions or make pithy comments 
every now and then. 
Anyway, this definition has three parts. 
The first part is recording transactions. 
This part turns out to be a big deal as 
not everything a business does gets 
recorded in the financial statements. 
And sometimes it will seem like nothing's 
happening yet we'll need to record a 
transaction anyway. 
The second part is about providing 
summary statements. 
Large companies have billions and 
billions of transactions each year. 
If they made them all available to you in 
a gigantic database, your first question 
would be, how can I summarize all this 
into one or two summary numbers? 
And the third part focuses on users. 
As different user groups would want 
different types of summary numbers. 
So most companies keep at least three 
sets of books. 
Our focus in this course will be 
financial accounting. 
The standardized set of statements geared 
towards external users such as investors, 
creditors, customers, suppliers, 
competitors and any other stake holder. 
However these financial statements are 
not used to determine taxes. 
There's a separate set of books based on 
tax rules to compute how much taxes a 
company has to pay. 
These rules are often quite different 
from what we do in the financial 
statements. 
Finally, there's managerial accounting. 
Which provides customized reports for 
internal decision making. 
We won't cover this topic in this course, 
but you should be aware that the 
financial accounting we do cover is 
generally not used for internal decision 
making. 
So what are the financial reporting 
requirements? 
The Securities and Exchange commission, 
or SEC, requires periodic finiancial 
statement filings. 
Companies must file an annual report, or 
10-K, once a year. 
This includes a full set of financial 
statements with a substantial amount of 
additional disclosure. 
Generally running 200 to 300 pages. 
The other three quarters of the year, 
firms must file a quarterly report, or 
10-Q which is also a full set of 
financial statements but less required 
disclosure than in the annual report. 
If anything material happens between 
quarter ends, companies must file an 8-K 
or current report. 
Material information is generally viewed 
as anything important enough to move 
stock price, which means companies file 
these quite often. 
They don't require the financials just an 
update on whatever major corporate event 
has occurred. 
All of these filings have to be prepared 
in accordance with Generally Accepted 
Accounting Principles or GAAP. 
 >> Excuse me, does this [UNKNOWN] only 
apply to US companies? 
 >> That's a really good question. 
I should note at this point that this 
course will be very US-centric, because I 
am at a US business school. 
However, almost everything we cover is 
going to be applicable globally. 
So for example, even though I just gave 
you SEC filing requirements in the US, 
every country in the world that has a 
securities market also has filing 
requirements. 
Like an annual report. 
The only difference that you might see 
internationally is instead of a quarter 
report, some countries have some annual 
reports. 
Also none of this applies to private 
companies formally. 
But if a private company goes and borrows 
money from a bank, banks are so used to 
seeing reporting come in this kind of 
frequency. 
That invariably private companies will 
produce annual statements, in some kind 
of quarterly or semiannual statement in 
a, in addition. 
So this is a pretty universal set of 
financial reporting requirements. 
These periodic filing requirements create 
much of the tension in financial 
accounting that we're going to have to 
deal with in this course. 
For example, let's say you ship goods to 
a customer in one quarter, but collect 
the cash in the next quarter. 
When does the sale occur? 
Or let's say you buy equipment in one 
quarter and then use it for the next 23 
quarters. 
When does the expense occur? 
A lot of what we need to do is figure out 
what quarter to put these various 
business activities into. 
So who makes the rules? 
Generally accepted accounting principles, 
or GAAP, are established by the US 
Congress. 
But they're generally too busy doing 
things like investigating steroids in 
baseball or trying to figure out what's 
going on at the IRS that they don't have 
time to do accounting standards. 
So they delegate to the Securities and 
Exchange Commission. 
But they're often too busy trying to 
catch the bad guys. 
That they don't have time to make the 
rules. 
So they delegate to the Financial 
Accounting Standards Board, or FASB, a 
seven person board in Norock, Connecticut 
that has the authority to make accounting 
rules in the US. 
Now sometimes, they're even too busy to 
make all the rules. 
And so there's an emerging issues task 
force, or the AICPA, that can also have a 
hand in making accounting rules. 
That's just in the US. 
Internationally, there's International 
Financial Reporting Standards or IFRS 
that are established by the IASB or 
International Accounting Standard Board, 
and are now required in over 70 
countries, including the EU. 
But as of now, US GAAP is still required 
for US firms. 
So there's basically two big sets of 
standards out there in the world, but the 
good news is, for almost all of the intro 
accounting topics, there's a really high 
degree of overlap in the two standards. 
 >> Why doesn't the US just switch to 
IFRS? 
Do you think there will ever be one 
global accounting standard? 
 >> Actually, in the summer of 2008, the 
SEC came out with a road map to move U.S 
firms to IFRS by the middle of this 
decade. 
But then Lehman Brothers went bankrupt, 
the financial crisis hit, and this thing 
dropped way off of the SEC's radar 
screen. 
So for the foreseeable future, we will 
have two sets of standards in the world, 
U.S GAAP and IFRS. 
Although as I mentioned earlier the two 
standards are becoming closer to each 
other. 
The FASB and the ISB have been working 
together in any new standards. 
And so even though there are two 
standards, just about everything we talk 
about here in US GAAP would also be 
applicable under IFRS. 
So who's responsible for financial 
reporting? 
Management is responsible for preparing 
their own financial statements. 
>>Wait, what? 
That is like a professor allowing 
students to give themselves their own 
grade. 
Everyone gets an A plus. 
 >> Yes, that's correct. 
We, we allow managers to prepare their 
own financial statements because they 
have the most information about what 
happened at the company. 
And we hope that they use whatever 
discretion they have in finance reporting 
to better communicate their activities. 
But we do recognize that they may use 
this discretion to try to manipulate or 
obfuscate or be opportunistic in how they 
report. 
So there are a number of checks and 
balances that are there to try to curb 
manager's opportunistic behavior. 
First, the Audit Committee of the Board 
of Directors provides oversight of 
management's accounting process, however 
this is not a foolproof check on 
manager's opportunistic behavior. 
One of the biggest financial statement 
frauds ever was ENRON and the head of 
their audit committee was a guy whose 
full time job was accounting professor. 
Which means he could put someone like me 
on the board and still have these kinds 
of problems. 
So then auditors are hired by the board 
to express an opinion about whether the 
statements are prepared in conformity 
with GAAP. 
Again this is not a full proof check 
against managers being opportunistic in 
the case of ENRON, their auditor Arthur 
Anderson signed off on some of the more 
aggressive things they did and a lot of 
it was because they were being of the 
hired by the company and ENRON was the 
biggest client in Houston. 
If they lost ENRON they would've had to 
go to the second biggest company in 
Houston, which is, exactly. 
Who knows what the second biggest company 
in Houston is. 
And that's why they wanted to keep ENRON. 
The next line of defense is that the SEC 
and other regulators will take action 
against the firm if any violations of 
GAAP or other rules are found. 
Now these bodies tend to be very reactive 
instead of proactive. 
And it's really after someone else has 
brought the fraud to their attention that 
they most often then launch an 
investigation. 
So by and large it's information 
intermediaries like stock analysts, 
institutional investors, and the media, 
which provide the biggest check on 
manager's behavior. 
By either exposing or fleeing firms with 
questionable accounting. 
But again, by the time one of these 
parties gets involved, it's very public 
what is happening and the stock price 
drops and you're in bad shape if you're 
an investor. 
So the only people that are going to 
really look out for your interests in 
terms of making sure the financial 
reporting is high-quality is you. 
Which is why it's really important that 
you learn some basics in terms of reading 
financial statements. 
Next, what are the required financial 
statements. 
There's four of them. 
First, there's a balance sheet which 
gives the firms financial position, it's 
listing of resource and obligations on a 
specific date. 
Then there's an income statement which 
provides results of operations over a 
period of time using accrual accounting. 
In these cases we'll talk about 
recognition is tied to business 
activities not cash coming in or out. 
For that there's a statement of cash 
flows, which gives sources and uses of 
cash over a period of time and then the 
last statement is the statement of 
stockholders' equity which provides 
changes in stockholders' equity over a 
period of time. 
 >> Okay could we get an example. 
This is pretty abstract. 
 >> Yes in fact we'll go through an 
extended example right now. 
Well, we'll look at a very simple 
business, and see how the different 
financial statements can capture what's 
going on with that business. 
And since you're probably getting sick of 
my voice at this point, I'm going to turn 
it over to a narrator to give you the 
facts of the example. 
 >> Dave starts a business to export 
expensive cars. 
On December 1st, 2012 he receives $50,000 
cash from issuing common stock. 
He also borrows $80,000 from a bank and 
buys a $100,000 truck. 
It will be used for 48 months with a 
$4,000 salvage value. 
 >> Excuse me, Mr Narator what is 
salvage value? 
 >> We will explain that later. 
Dave also pays $12,000 cash upfront to 
rent office space for one year. 
During the month of December, Dave's 
company moves two cars. 
The clients will pay Dave $40,000 within 
30 days. 
Dave also pays his employees $10,000 of 
wages. 
On December 31, the bank wants to see 
financial statements. 
 >> The bank wants to see financial 
statements because they want an answer to 
the question, did the company make money 
during December? 
Well there's a number of different ways 
that we could try to provide evidence on 
whether the company made money or not. 
First way would be to just look at cash 
flows, so if we take the facts we got 
$50,000 from issuing stock, $80,000 from 
borrowing from a bank, we paid a $100,000 
to buy a truck, we paid rent. 
We paid wages. 
We didn't get anything from customers. 
And so we ended the month with $8,000 
cash. 
As it turns out this is a really bad way 
to try to figure out whether the 
company's made money or not. 
 >> Pardon me, what is wrong with that? 
Anytime I end the month with cash in the 
bank it is a great month. 
 >> Well, this is actually how a 
teenager would do accounting. 
You get an allowance from your parents, 
you borrow some money from your parents, 
you spend a bunch of money. 
If you have money in the bank at the end 
of the month, it was a great month. 
But it doesn't work so well for 
companies. 
Because all the company would have to do 
to post better performance would be to 
borrow more money or raise more stock. 
So a better way to look at cash flows 
would be to separate them into whether 
they came from running a business, 
investing in the long term, or financing 
the business. 
So for instance, our operating cash flows 
would be, we paid money for rent we paid 
money for wages. 
We didn't get anything from customers, 
and so our operations actually had a net 
outflow of cash of $22,000 during the 
month. 
In terms of investing for the future, we 
bought a $100,000 truck, which now we can 
use for four years. 
That's our cash flow from investing 
activities. 
And, for financing the business, we 
raised $50,000 from issuing common stock, 
and we borrowed $80,000 from the bank, 
giving us $130,000 cash inflow from 
financing activities. 
So this cash flow statement divides up 
the cash flows based on their source. 
Did they come from operating? 
Did they come from investing? 
Did they come from financing? 
Gives us the same bottom line of $8,000 
change in cash. 
So this is what the statement of cash 
flows is going to look like. 
It's going to report cash transactions 
over a period of time, split into whether 
they're operating, related to providing 
goods or services or other normal 
business activities, investing related to 
acquiring or disposing of long-lived 
producive assets, or financing, which are 
transactions related to our owners or 
creditors. 
Another way to try to answer the question 
of whether the company made money during 
December is to look at accounting income. 
Accounting income tries to look at 
business activities. 
Rather than just cash coming in or going 
out. 
For example, we actually move two cars 
during December. 
Even though we haven't gotten paid cash 
yet, we're likely to get paid cash. 
And so why not book revenue of $40,000? 
Recognize that we're going to eventually 
get cash coming in from doing the 
business activity. 
With the truck we paid $100,000 cash this 
period, but we're going to use it over 
four years. 
So why not allocate that cost over the 
period of time that we use the truck? 
For instance, $100,000 truck, salvage 
value of 4,000 is going to be what it's 
worth when we're done with it. 
So we're going to use up $96,000 of 
value. 
Over 48 months we're using up $2000 worth 
of the truck based on moving the cars 
this month. 
With the rent we paid $12000 cash up 
front, but that was for a year. 
We've only occupied the space for one 
month. 
So why not just recognized one 12th or 
$1000 as the cost of rent. 
All 10,000 we paid to employees was 
earned this month. 
And so we've recognized that as an 
expense. 
And so we come up with a number called 
net income which is a measure of did we 
price our service in this case moving 
cars. 
Did we price our service high enough to 
cover all the cost of running the 
business this period. 
All the cost of moving those cars. 
And what Menningham tells you is yeah, we 
did price our product or service high 
enough to cover all of those costs. 
This is what the income statement is 
going to show us. 
It's going to result, report the results 
of operations over a period of time using 
something called accrual accounting and, 
and we'll obviously talk about this a lot 
more as the course goes along. 
But in this case the recognition is tied 
to business activities where we have 
revenues which are going to be increases 
in something called owner's equity. 
Not necessarily cash from providing goods 
or services. 
Expenses are going to be decreases in 
owner's equity incurred in the process of 
generating these revenues. 
Again not neccessarily cash. 
And so we end up with net income which is 
also called earnings or net profit equal 
to these revenues minus expenses gives 
you a different picture than simply the 
change and cash. 
 >> This does not make any sense. 
How can we record revenue without getting 
any cash? 
What is this depreciation stuff? 
We didn't spend $2000 on a truck. 
We spent $100,000. 
>>Okay, just give me a few videos, it'll 
take a little bit for me to explain this 
to you. 
Hang in there. 
 >> Fine. 
So there are two different statements for 
this month's results. 
Which one's better? 
Which should we use? 
 >> I once heard that cash is king. 
I'm going to only use the cash flow 
statement. 
 >> No, no, no, no, we'll talk about 
this more but you definitely want to use 
both statements. 
Because they're giving you two different 
pictures of what happened with the 
company. 
For instance, revenue tells you how much 
you're going to get from customers based 
on actually moving cars. 
And the cash flow for customers tells you 
how much cash you got this period. 
For the truck, the cash flow tells you 
how much cash you spent to acquire the 
truck. 
The accounting income tells you how much 
of that truck was used this period. 
Rent expense, the cash flow tells you how 
much cash you spent for rent the rent 
expense tells you how much was actually 
used up this month. 
Sometimes the cash flow and the expense 
are the same. 
But you're really getting two different 
pictures. 
Cash flow from operations negative 22,000 
says this month you actually spent more 
cash than you had come in. 
But net income said that you actually 
priced your product enough to cover all 
the costs of delivering it which even 
though didn't get you cash now is going 
to lead to cash flow in the future. 
So just to hang with me for a few more 
videos and hopefully this will all make 
sense. 
We've got one more statement to do, and 
that's answer the question of what is the 
financial position at the end of the 
month. 
And here we're going to look at the 
Balance Sheet. 
So remember this is the listing of all 
the resources and obligations of the 
company. 
So resources we call assets. 
So we have cash of $8,000 that's cash in 
the bank at the end of the month. 
Accounts receivable of 40,000. 
This is the cash that's owed to us by the 
customers whose cars we moved. 
It's an asset because it's going to turn 
into cash. 
Either we're going to collect it from the 
customers or we could securitize it 
through a special purpose entity and get 
the cash immediately, which is sort of 
beyond the scope of what we're doing 
here. 
Prepaid rent is an asset. 
We paid 12 months in advance for rent. 
We have used up one of those months, but 
we still have prepaid 11 months of future 
space at the end of the, at the end of 
the month. 
That's an asset. 
The truck is an asset. 
That's something that we can use to run 
the business for the next 47 months. 
So we have a total of 150,000, 57,000 of 
assets. 
And then we look at all the obligations, 
these are the liabilities and 
stockholder's equity. 
So we owe $80,000 to the bank at the end 
of the month. 
That's a liability called bank debt. 
We got $50,000 of shareholder investment, 
that's the shareholder's claims on the 
assets. 
That's part of our obligation to our 
shareholders common stock of 50,000. 
And then we have something called 
retained earnings, which is how much 
accounting net income that we've 
recognized less any dividends that we 
payed out at the end of the month. 
And these are all the obligations against 
the resources of the company. 
 >> I am truly lost, when is this video 
going to end. 
 >> I'm sorry I, I know I've thrown a 
lot at you in this video, but just keep 
in mind that everything we've talked 
about we're going to talk about again in 
more detail. 
So just hang in there let me go through a 
couple more slides and then we'll wrap 
this up. 
So, as I was saying, this financial 
statement's called the balance sheet, 
which reports the financial position, the 
resources and obligations on a specific 
date, split up into assets, which are 
resources owned by a business expected to 
provide future economic benefits. 
Liabilities, which are claims on assets 
by creditors, non-owners, that represent 
an obligation to make future payment of 
cash, goods or services. 
And stockholders' equity or owners' 
equity which are claims on the assets by 
the owners of the business come from two 
sources contributed capital, which is 
when we sell shares, and retained 
earnings, which arise from operations. 
And again, we're going to go through all 
of these in much more detail in the next 
videos. 
The last statement is the statement of 
stockholders' equity. 
We're going to get to this later. 
Hopefully that gave you a good overview 
of what we're trying to accomplish with 
financial reporting. 
Now we're going to dive into all these 
concepts in more detail starting with the 
balance sheet. 
I'll see you in the next video. 
See you next video.