Financial Accounting
Fakhri Mammadov
Azerbaijan State Economic University
Overview
• Business activities and financial statements
• Users and uses of financial reports
• Purpose of financial reporting: alternative views
• Importance of understanding financial reports
• Accounting standards – need and source
• Financial statements
• Annual report
Business activities and
financial statements
• Business activities
– Operating
• Sell products or services to generate revenue1
• Incur expenses2 in generating revenue
– Investing
• Use (longer term) assets3 to operate the business
– Financing
• Borrow from creditors, creating a liability4
• Sell ownership interest (equity5) to shareholders
• Firms use financial statements to communicate
about these activities and their results
1-5: accounting elements
Users and uses of financial
statements
• Internal: direct access to information.
Statements = communication.
• External users of financial information:
– Investors
– Creditors
– Employees
– Suppliers
– Customers
– Governments and their agencies
– The public
Purpose of financial reporting:
some opinions
“The purpose
primary goal
of financial
in financial
reporting
reporting
is toisobtain
the
dissemination
cheap capital.”of financial statements that
accurately measure the profitability and financial
condition of a company.”
Schilit
Fridson and Alvarez
Purpose of financial reporting:
some opinions
“… to
accurately
obtain cheap
measure
capital.”
the profitability and
financial condition of a company.”
Best: most fully and fairly present
Best: produce the highest credit rating and market
multiple
Importance of understanding
financial reports
• Interpretations/ selective emphasis
– Facts & opinions
– Contradictions
• Judgments, estimates and choices of accounting
method
Example: selective emphasis
Headline of the company’s press release:
Taleo Announces Record First Quarter 2006
Financial Results; Q1 2006 revenue
increased by 22% year-over-year to over
$22 million
Bottom line of the company’s income statement:
($ 000’s) Three months ended
3/31/06 3/31/05
Loss from $(1,241) $ (581)
operations
Selective Emphasis
Example transactions:
YOUR GYM, INC.
At inception, YOUR GYM, INC., a company that personalizes
exercise equipment sets (yoga mats, hand weights) has
$100,000. During an accounting period, the company had
the following transactions:
• Purchased 100 sets of equipment
– Cost is $700 each
– Pay 50% on delivery and 50% in 180 days
• Personalized & sold 60 sets to customers for $1,200 each
– Customers to pay $57,000 now and $15,000 in 120 days
Assume no tax & no other expense, how did the company do
for the period?
Example: YOUR GYM, INC.
• Revenues (Sales)?
• Expenses?
• Income?
Example: YOUR GYM Inc.
Income Statement
Option A Option B Option C
Sales $72,000 $72,000 $72,000
Expenses $70,000 $35,000 $42,000
Income $2,000 $37,000 $30,000
Option D Option E Option F
Sales $57,000 $57,000 $57,000
Expenses $70,000 $35,000 $42,000
Income ($13,000) $22,000 $15,000
Accounting standards
• Sources of standards
– SEC (Securities and Exchange Commission)
– FASB (Financial Accounting Standards Board)
– IASB (International Accounting Standards Board)
• PCAOB (Public Companies Accounting
Oversight Board)
Purpose of financial reporting:
FASB
FASB: Objective of Financial Reporting
“Financial reporting should provide information that is
useful to present and potential investors and creditors
and other users in making rational investment, credit,
and similar decisions. The information should be
comprehensible to those who have a reasonable
understanding of business and economic activities and
are willing to study the information with reasonable
diligence.”
FASB concept statement 1.
Purpose of financial reporting:
IASB
IASB objective of Financial Statements
“The objective of financial statements is to provide
information about the financial position, performance and
changes in financial position of an entity that is useful to
a wide range of users in making economic decisions.”
IASB Framework
Assumptions Underlying
Financial Statements
• Financial statements are prepared on the
accrual basis of accounting.
– Effects of transactions and events recognized when
they occur (and not as cash is received or paid)
– Information not only about past transactions involving
the payment and receipt of cash but also about
obligations to pay cash in the future and resources
that represent cash to be received in the future.
• Financial statements assume an entity is a going
concern.
Qualitative characteristics of
useful financial statements
• Understandability
– Users assumed to have a reasonable knowledge of
business and economic activities and accounting and
a willingness to study the information with reasonable
diligence.
• Relevance
– Influences economic decisions of users; helps them
evaluate past, present or future events; material
• Reliability (free from material error and bias)
• Comparability (consistent throughout an entity, over time
for that entity and consistent across entities)
Constraints
• Constraints on achieving useful information
– Timeliness – report while information is relevant, but
may not have all the details thus limiting reliability
– Balance between benefit and cost
• Constraints on decision-usefulness of financial
statements
– largely portray the financial effects of past events
– do not necessarily provide non-financial information.
Financial Statements
Financial Statements:
4 plus the notes
1. Balance Sheet (a.k.a. Statement of Financial Position)
– Assets = Liabilities + Owners’ Equity
– Point in time
2. Income Statement (a.k.a. “Statement of Earnings” or “Profit and Loss
Statement”)
– Revenues – Expenses = Net Income
– Period of time
[Link] of Stockholders’ Equity (a.k.a. owners’ equity)
– All changes to stockholders’ equity (paid in & earned)
– Beginning Retained Earnings + Net Income – Dividends =
Ending RE
– Period of time
4. Statement of Cash Flows
– Inflows and outflows from operating, investing and financing
– Period of time
Example: Your Gym, Inc.
• Joe and Jan Doe form a company YOUR GYM, INC. to
personalize exercise equipment sets (yoga mats,
exercise balls, hand weights)
• Initial capital is $100,000
• In the first year of business, the company
– Purchased 100 sets of equipment for $700 each. Vendor
required cash on delivery ($70,000 total)
– Personalized and sold 60 sets for $1,200 each ($72,000 total).
To make the sales, they offered credit terms to many customers.
By year-end, $57,000 cash had been collected from customers
and, therefore, $15,000 remained outstanding from customers.
– Paid business expenses of $10,000
– Acquired office equipment for $9,000 in cash.
Example: Your Gym, Inc.
• Joe and Jan Doe form a company YOUR GYM, INC.
• Initial capital is $100,000. Beginning balance sheet.
Example: Your Gym, Inc.
– Purchased 100 sets of equipment for $700 each.
Vendor required cash on delivery ($70,000 total)
– Personalized and sold 60 sets for $1,200 each
($72,000 total). To make the sales, they offered credit
terms to many customers. By year-end, $57,000
cash had been collected from customers and,
therefore, $15,000 remained outstanding from
customers.
Your Gym, Inc.
Income Statement
For the year ended December 31, 2005
Revenue $ 72,000
Cost of goods sold 42,000
Gross profit $ 30,000
………
Example: Your Gym, Inc.
– Paid business expenses of $10,000
– Acquired office equipment for $9,000 in cash
[Will allocate the cost of this equipment over 3 years]
Your Gym, Inc.
Income Statement
For the year ended December 31, 2005
Revenue $ 72,000
Cost of goods sold 42,000
Gross profit $ 30,000
Miscellaneous business expenses 10,000
Office equipment depreciation
expense 3,000
Net Income $ 17,000
Your Gym, Inc.
Ending Balance Sheet
December 31, 2005
Assets
Cash $68,000
Accounts Receivable 15,000
Inventory 28,000
Equipment (Net of depreciation) 6,000
Total assets $117,000
Liabilities and Stockholders’ Equity
Liabilities $ 0
Stockholders’ equity
Common stock 100,000
Retained earnings 17,000
Total Stockholders’ equity 117,000
Total liabilities and stockholders’ equity $117,000
Financial Statement Linkages
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In teme
Sta
t es
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Cha E
in O i ng
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Ba et
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Your Gym, Inc.
Information for Statement of Cash
Flows
Beginning Cash $ 100,000
Less:
Purchase of inventory (100 sets @ $700 70,000
each)
Purchase of equipment 9,000
Miscellaneous office expense 10,000
Add: sale of exercise sets ($57,000 cash
collected) 57,000
Ending cash, Dec 31 $ 68,000
Change in cash $(32,000)
Financial Statements
1. Balance Sheet (a.k.a. Statement of Financial Position)
– Assets = Liabilities + Owners’ Equity
– Point in time
2. Income Statement (a.k.a. “Statement of Earnings” or “Profit and Loss
Statement”)
– Revenues – Expenses = Net Income
– Period of time
[Link] of Stockholders’ Equity (a.k.a. owners’ equity)
– All changes to stockholders’ equity (paid in & earned)
– Beginning Retained Earnings + Net Income – Dividends =
Ending RE
– Period of time
4. Statement of Cash Flows
– Inflows and outflows from operating, investing and financing
– Period of time
Typical content of annual
mailing to shareholders
• Annual report BUD example.
– Chairman’s letter
– Business description
– MD&A
– Auditors’ report
– Financial statements
– Notes to financial statements
– Information on board and management
• Proxy
– Information on management and management
– Compensation information Ref. Ch. 1, self-test 17.
On class problem solving
• Kenan and Arif form a company YOUR GYM, INC. to
personalize exercise equipment sets
• Initial capital is $100,000
• In the first year of business, the company
– Purchased 100 sets of equipment for $700 each. Vendor
required cash on delivery ($70,000 total)
– Personalized and sold 60 sets for $1,200 each ($72,000 total).
To make the sales, they offered credit terms to many customers.
By year-end, $57,000 cash had been collected from customers
and, therefore, $15,000 remained outstanding from customers.
– Paid business expenses of $10,000
– Acquired office equipment for $9,000 in cash with useful life of 3
years.
On class problem solving
• Construct a balance sheet for ASEU Inc., from
the following date and find the Stockholder’s
equity.
• Cash $500
• Long Term Debt 500
• Inventory 100
• Fixed Assets 700
• Accounts receivable 200
• Accounts Payable 300
• Accrued Expenses 100
• Total Assets = 1500
• Total Liabil = 900
• StockHolder’s Equity = 1500 - 900 = 600
