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    Introduction

    15.511 Corporate Accounting

    Summer 2004

    Professor SP KothariSloan School of ManagementMassachusetts Institute of Technology

    June 7, 2004

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    Session 1:

    Agenda Administrative matters

    Discussion of AccountingWhy is accounting interesting?

    Why do we need accounting?Course objective

    Sophisticated financial statementuser

    An overview of information infinancial statements

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    The required materials are:10th Edition of Stickney and Weil

    Financial Accounting: An Introduction to Concepts,Methods, and Uses

    Case Packet

    Class web server SyllabusSchedule

    Homework assignmentsSample exams

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    Course GradingWritten Problem Sets 25%

    Midterm 30%Final 45%

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    Accounting IntroductionDiscussion of Accounting

    Why is accounting interesting?Why do we need accounting?

    Course objectiveSophisticated financial statementuser

    An overview of financialinformation

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    What is Accounting trying to do?

    Demand for InformationFinancial Accounting

    Provides information primarily to people outside the company

    Provides information that would be helpful in attracting capitalEquity and debt (useful in debt contracts)Credit from suppliersCustomersEmployees

    Provides information helpful in monitoring and evaluatingmanagement performance

    Managerial Accounting

    Provides information to people inside the companyInternal investment decisionsPerformance evaluation

    Tax AccountingProvides information to the tax authoritiesLegal to prepare separate books for tax and financial purposes

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    Why do We Need Financial Accounting?

    Company

    Outsiders

    - investors- employees- suppliers

    ResourcesToday

    ResourcesTomorrow

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    Why do We Need Financial Accounting?

    Company

    Outsiders

    - Investors- Suppliers- Creditors

    ResourcesToday

    ResourcesTomorrow

    Information(e.g., financial

    statements)

    Financial accounting promotes the exchange of resourcesFinancial accounting promotes the exchange of resources

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    Nature of Financial Accounting

    InformationUseful to those making investment and credit decisions,who have a reasonable understanding of business andeconomic activities.Helpful to

    present and potential investorscreditorsother usersin assessing the amount, timing, and uncertainty of future cash

    flows.Provides information about economic resources, theclaims to those resources, and the changes in them.

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    How important is this information?

    The Reaction of Wal-Mart Stock to Announcement of 3rd Quarter Earnings

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    59.5

    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

    S T O C K P R I C

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    Financial Accounting

    IntroductionDiscussion of Accounting

    Why is accounting interesting?Why do we need accounting?

    Course objective

    Sophisticated financialstatement user

    An overview of financialinformation

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    WHAT IS OUR COURSE

    OBJECTIVE?To become intelligent users of accounting

    information. Examples:Managers use accounting information in makinginvestment decisionsInvestors use accounting information in valuingstocksBankers rely on accounting information indeciding whether to lend money to a businessand in assessing the risk of the loan

    Accounting information is crucial in evaluatingthe performance of employees at various levels

    in an organization

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    WHAT IS OUR COURSE

    OBJECTIVE?To become intelligent users of accountinginformationBe comfortable looking through an annual report

    Learn the language and techniquesBegin to develop the ability to use financialstatements to assess a companys performance

    Have a sense of the limitations of financialstatement data

    What are not our objectivesto train you to be an accountant or bookkeeper Financial Statement Analysis - take 15.535

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    World of a Sophisticated Financial

    Statement User Events / Actions

    Rules&

    Managementchoices

    Financial Statements

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    World of a Sophisticated Financial

    Statement User

    Rules&

    Managementchoice

    Financial Statements

    Events

    Financial Accounting = translates eventsinto financial statements

    GenerallyAccepted

    AccountingPrinciples (GAAP)

    Management selectsfrom alternative rulesand from allowableestimates under GAAP

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    Three keys to becoming a sophisticatedfinancial statement user

    Understand the rules and managements

    discretion

    Understand what explains the rules andthe type of management discretionIncentives

    Understand how events affect firm value

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    Understanding the genesis of

    the rulesDemand for independence: Accounting enters

    objective, verifiable information into accountingrecordsInformation produced by managers alone is not

    believable. Outside investors demandindependently audited financial informationIn the process, accounting misses out on forward-

    looking information that might be valuable, but lacksobjective evidence (e.g., research in progress)

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    Understanding the genesis of

    the rules Asymmetry

    Asymmetric treatment of good and bad newsFaced with uncertain bad news, accountingtends to enter it into the recordsFaced with uncertain good news, tendency toignore itWhy?

    Demand for bad newsCreditors with no upside, but all the downside

    Investors believe bad news disclosed bymanagement, but skeptical of good news unless

    supported by objective evidenceManagement incentives affect believability of theirdisclosures

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    Financial Accounting

    IntroductionDiscussion of Accounting

    Why is accounting interesting?Why do we need accounting?

    Course objectiveSophisticated financial statement user An overview of financial information

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    Accounting is complex and

    interesting becauseDiversity of businesses and events

    Many different playersDiverse incentives

    EconomicOther

    Uncertainty

    Many regulations

    l

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    Financial Accounting

    IntroductionDiscussion of Accounting

    Why is accounting interestingWhy do we need accounting?

    Course objectiveSophisticated financial statementuser

    An overview of financialinformation

    Fi i l R i

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    Financial Reporting

    RequirementsAudited Annual Report (10-K)

    Unaudited Quarterly Reports (10-Q)Current Reports (8-K)within 10 days of the end of a monthcontaining a significant event (e.g.,major asset sales, changes inownership, bankruptcy, changing theauditor)

    Foreign Companies (20-F)

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    Focus: The Annual Report

    The Management Letter Management discussion on developments during theyear and current state of the company

    The Financial Statements

    The Auditors Report

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    Financial Reports:

    The Auditors ReportGAAS (Generally Accepted Auditing Standards)

    Reasonable assurance that financial statements are free ofmaterial misstatement Assess the accounting principles used and significantestimates made by management

    Actual opinionfinancial statements present fairly, in all material respects, thefinancial position, the results of operations, etc.are in conformity with GAAP (Generally Accepted AccountingPrinciples).

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    Financial Reports:

    The Auditors ReportManagement responsible for

    the preparation and integrity of the financial statements, etc.Statements prepared in accordance with GAAP.Estimated amounts based on management's best estimatesand judgments.

    Maintenance of an internal control system to ensure that

    assets are safeguarded and transactions are properlyauthorized, recorded and reported.

    The Board has an Audit Committee composed

    entirely of outside directorsThis committee appoints the auditor who has direct accessto the Audit Committee.

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    Financial Statements

    Contain primarily historical InformationBalance Sheet

    Assets, liabilities & owners equityIncome Statement

    Revenue (-) Expenses = Net Income

    Statement of retained earningsCumulative sum of undistributed profitsStatement of cash flows

    Operating, Investing and Financing activities

    FootnotesSignificant accounting policies, estimates, etc.

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    Financial Statements: Income Statement

    Income statement measures the performance of acompany over a period of timeRevenues -- a measure of economic benefits generated bythe sale of products or providing of services over a period

    of timeExpenses -- a measure of economic sacrifices incurred toearn the revenues of a given period

    Examples of expenses -- cost of inventory sold, salaries toemployees, rent and lighting, advertising, .......Net income = revenues (-) expenses

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    Dividends

    Are dividends paid to owners considered an

    expense?Owners are residual claimantsDividends are distributions to the owners out of the

    profits earned by the businessIn determining accounting profits to the residualowners, we only subtract the costs of all factors of

    production , e.g., physical capital (depreciation),human capital (salaries), debt capital (interestcost), etc.

    Dividends are not a factor of production

    Financial Statements: Retained

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    Financial Statements: RetainedEarnings & Shareholders Equity

    Retained earnings A measure of undistributed profits of a businessDo not include capital contributed by owners

    Retained earnings = Cumulative sum of profitsearned from the inception of business (-)

    Cumulative sum of all dividends distributed tothe owners from the inception of businessStatement of shareholders equity describes thechange in retained earnings over a period of time(e.g., a year)

    Beginning balance in retained earnings Add Net income earned during the periodSubtract Dividends distributed during the periodEnding balance in retained earnings

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    Summary

    Accounting is a complex field contrary tocommon perceptions.

    Financial accounting information facilitates theexchange of resources.

    To become a sophisticated financial statementuser, you need to understand how theinformation in financial statements is recorded.