Three Pillars Accounting (Financial statements) Report on the financial position of an entity (e.g. a business, organization, or person) Show how the entity has performed financially over a particular period of time (an "accounting period") Auditing Ensure that the entitys financial transactions are recorded properly on entitys books Ensure that proper internal controls exist Finance Valuation of entities, securities, and cash flows Understanding risk and returns Understanding capital markets

Objectives of Financial Accounting Record all of an entitys transactions in a systematic way (double entry system) Prepare reports of an entitys financial performance and health for its managers and/or outsiders Calculate an entitys income and cash flow Report the entitys assets and liabilities Allow estimation of a companys future earnings and prospects of the company. Facilitate comparison of an entitys current performance to its past performance or to competitors performance

Lawyers Uses of Accounting Corporation law issues involving accounting Other legal disputes/issues Contracts (e.g., what was the movies profit) Securities litigation Antitrust Understand financial state of a business or other entity Valuation of a business

Problem 1a An Introduction Annie and Marta formed KFC (Hungary), Inc. (KFC) to operate a Kentucky Fried Chicken franchise in Budapest. During Year 1, KFC engaged in the following transactions: Annie and Marta invest $600,000 in KFC in exchange for common stock. Is this income for KFC? No, it is an equity investment in KFC: CASH $600,000 + COMMON STOCK $600,000 +

Problem 1b An Introduction Annie and Marta formed KFC (Hungary), Inc. (KFC) to operate a Kentucky Fried Chicken franchise in Budapest. During Year 1, KFC engaged in the following transactions: KFC spends $50,000 training the staff to operate the store. Is this an asset, an expense in Year 1, or an expense to be recognized over time? Problem 1b An Introduction Annie and Marta formed KFC (Hungary), Inc. (KFC) to operate a Kentucky Fried Chicken franchise in Budapest. During Year 1, KFC engaged in the following transactions: An expense in Year 1: TRAINING EXPENSE $50,000+ CASH $50,000-

Problem 1c An Introduction Annie and Marta formed KFC (Hungary), Inc. (KFC) to operate a Kentucky Fried Chicken franchise in Budapest. During Year 1, KFC engaged in the following transactions: KFC bought equipment for $150,000. By the time the equipment was delivered its market value had increased to $180,000 (due to exchange rates & inflation). Should the equipment be listed at $150 K or $180 K ? Problem 1c An Introduction Annie and Marta formed KFC (Hungary), Inc. (KFC) to operate a Kentucky Fried Chicken franchise in Budapest. During Year 1, KFC engaged in the following transactions: At cost: $150,000 EQUIPMENT $150,000+ CASH $150,000-

Problem 1d An Introduction Annie and Marta formed KFC (Hungary), Inc. (KFC) to operate a Kentucky Fried Chicken franchise in Budapest. During Year 1, KFC engaged in the following transactions: KFCs bank added $40,000 to KFCs bank account for interest earned by KFC on the account. Should the interest be reported as ordinary income or as a special type of income? Problem 1d An Introduction Annie and Marta formed KFC (Hungary), Inc. (KFC) to operate a Kentucky Fried Chicken franchise in Budapest. During Year 1, KFC engaged in the following transactions: Special type of income: CASH $40,000 + INTEREST INCOME $40,000+

Generally Accepted Accounting Principles (GAAP) A set of accounting and financial reporting standards Primarily created by the Financial Accounting Standards Board (FASB), a private, independent organization of accounting experts (CPAs, corporate executives, financial analysts, academics) that establish and interpret GAAP Because it is a private organization, FASBs promulgation of GAAP doesnt officially legally bind accountants In reality, GAAP is very important: Violating GAAP is generally the legal definition of professional negligence for accountants The Securities and Exchange Commission (SEC) generally strongly defers to GAAP Investors, lenders, and trade creditors oven insist on receiving financial statements complying will GAAP before investing, lending, or extending credit

Historical Sources of GAAP FASB set forth GAAPs central organizing principles in a series of Statements of Financial Accounting Concepts: broad conceptual frameworks on which more particularized pronouncements are built. Particular pronouncements took the form of Statements of Financial Accounting Standards. Supplementing these were periodic Interpretations and Technical Bulletins. American Institute of Certified Public Accountants (AIPCA) was main creator of GAAP before FASB was established in 1973. Even after FASB, the AICPA publications continued to give opinions on certain accounting issues. Numerous other accounting organizations (e.g., American Accounting Association, Financial Executives Institute) make pronouncements on many accounting issues Securities and Exchange Commission (SEC) has authority to establish financial accounting and reporting standards for publicly held companies. SEC has worked with FASB in establishing these accounting principles and tends to sanction, as a matter of law, the GAAP rules that FASB promulgates.

FASBs Accounting Standards Codification Organizes GAAP into 90 topics, drawing on the scattered sources that historically contributed to GAAP Since 2009, FASB has said that its Accounting Standards Codification is the single source of authoritative GAAP. Everything else is non-authoritative. In many cases, GAAP allow multiple ways of accounting for certain financial events, as long as the chosen way is fully disclosed in financial statements

SECs Role SEC retains the power to establish financial accounting and reporting standards for publicly held companies. Sarbanes-Oxley Act of 2002 explicitly allows the SEC to recognize as generally accepted those accounting principles established by standard-setting bodies meeting certain criteria (primarily independence) SEC continues to work with FASB in establishing these accounting principles and tends to sanction, as a matter of law, the GAAP rules that FASB promulgates.

International Financial Reporting Standards (IFRS) IFRS = A set of accounting standards promulgated by the International Accounting Standards Board (IASB) Primary accounting standards in over 100 countries SEC and FASB has been working with IASB (with support of Congress) to harmonize GAAP and IFRS Most remaining differences between GAAP and IFRS involve advanced accounting topics Since 2008, SEC has allowed non-US companies to file financial statements complying with IFRS SEC had been pushing for a process to have U.S. switch from GAAP to IFRS Rumors are that the SEC is now instead seeking a convergence (i.e. harmonizing GAAP and IFRS)

FASBs Objectives & Qualitative Characteristics Objectives Provide useful information to outsiders (primarily investors and creditors) regarding an entitys assets, liabilities, owners equity, and cash flows Characteristics of Accounting Information Relevant (timely) Reliable (free of error/misstatement; can be verified by independent parties) Comparable (to prior periods and to similar entities) Consistent (same accounting methods from period-to- period; any changes must be justifiable and disclosed)

GAAPs Assumptions/Foundations Separate Entity Assumption Entity is distinct from its owner(s) Going Concern Assumption Entity will be continuing for an indeterminate period Time Period Assumption Entitys activities can be divided into discrete time periods Monetary Transactions Principle Reports entitys transactions can be measured in monetary terms Conservatism Principle It is preferable to understate rather than overstate earnings, cash flow, and values Realization Principle Recognize revenue only when the entity has (virtually) completed the relevant exchange Matching Principle Allocate expenses to the period in which they contribute to generating revenue Cost Principle Report asset values at their (historical) cost to the entity, rather than at their current market value Consistency Principle Apply accounting principles consistently within a set of financial statements Materiality Principle Information in financial statements should be meaningful to users

Components of Financial Statements Balance Sheet Income Statement Statement of Changes in Equity Statement of Cash Flows Footnotes

The Balance Sheet ASSETS (What the entity owns) Cash, Accounts Receivable, Inventory, Equipment LIABILITIES (What the entity owes) Accounts Payable, Notes Payable EQUITY (Residual interest in assets, after subtracting liabilities) For businesses, Equity = Owners StakeAssets Liabilities = Equityor ASSETS = LIABILITIES + EQUITY

The Income Statement REVENUES (from delivering goods and services) $ from selling sweaters or drafting wills EXPENSES (from delivering goods and services) Cost of sweaters sold, Secretarys salary, Rental cost of office space NET INCOME (Difference between Revenues and Expenses)REVENUES EXPENSES = NET INCOME

The Statement of Changes in Equity EQUITY AT BEGINNING OF PERIOD + NET INCOME + ADDITIONAL INVESTMENT DURING PERIOD (stock issued) - WITHDRAWALS OF EQUITY DURING PERIOD (stock bought back, dividends) = EQUITY AT END OF PERIOD Also called Statement of Shareholders Equity or Statement of Retained Earnings

Footnotes to Financial Statements Presents additional or more detailed information than is in the financial statements Discloses which accounting convention was used in preparing financial statements if GAAP permitted more than one method Inventory methods Depreciation methods Accounts Receivable write-offs Purpose of footnotes is to explain information (not to hide it)

Balance Sheet What is a Balance Sheet? A balance sheet is a summary of an entitys financial resources and obligations. Also, a balance sheet is a snapshot of these resources and obligations at a particular time. In other words, a particular balance sheet exists at a particular time (e.g., as of December 31, 2013). A balance sheet reflects the Fundamental Accounting Equation: ASSETS = LIABILITIES + EQUITY

DEFINITION OF ASSETS What the Entity Owns Formal Definition (according to FASB): Assets are resources with probable future economic benefits obtained or controlled by an entity resulting from past transactions or events.

DEFINITION OF LIABILITIES What the Entity Owes Formal Definition: Liabilities are probable future sacrifices of economic benefits arising from present obligations to transfer assets or render services in the future.

DEFINITION OF EQUITY The residual interest in the assets of an entity after subtracting its liabilities. In a business enterprise, the equity is the ownership interest. Equity is sometimes referred to as net assets or net worth

THE FUNDAMENTAL EQUATION

Key Implication: Any change on one side of the equation must be matched by a change on the other side. Otherwise, the equation wont hold and the balance sheet wont balance. To keep the fundamental equation in balance: There must be at least two entries for every transaction to be accounted for.

REARRANGING THE FUNDAMENTAL EQUATION

What is owed

What is owed

Double-Entry Bookkeeping Double-entry bookkeeping is implemented by two mechanisms: debits and credits Debit = left-side entry Credit = right-side entry KEY: For any transaction, the total $ amount of the debit entries and the total $ amount of the credit entries must be equal. i.e., the left-side entries always equal the right-side entries; Debits = Credits

T ACCOUNTS There is a ledger or T account for each asset, liability, and equity.

Double-Entry Bookkeeping To keep the fundamental equation in balance, there must be at least two entries for every transaction to be accounted for. At least one entry must be a debit. At least one entry must be a credit. Types of Debits 1. Increase in an asset 2. Decrease in a liability 3. Decrease in equity Types of Credits 1. Decrease in an asset 2. Increase in a liability 3. Increase in equity KEY: For any transaction, the total $ amount of the debit entries and the $ amount of the credit entries must be equal. i.e., the left-side entries (debits) always equal the right-side entries (credits)

First Example of Double Entries

Second Example of Double Entries

Third Example of Double Entries

More Examples of Double Entries

Sequence

JOURNAL ENTRIES THE JOURNAL (DAILY BOOK) First book in the accounting system First record of each transaction THE ENTRY DEBIT (To the left)

CREDIT (to the right)

To Make a JOURNAL ENTRY, ask . . . 3 Questions: What Happened? (state the transaction) Which Accounts are Affected? (type of asset , liability, equity) Which Direction do the Accounts Move? (increase + or decrease -) Then use map of fundamental equation to make entries in correct places.

Larrys Firm: JOURNAL ENTRIES 1. Larry opens a new law office and contributes $10,000 cash to it.

2. The Firm pays $500 cash to have legal stationary printed for it

3. The Firm use a store credit card to buy a desk, chair, and sofa for $3,000 at Barristers Department Store.

4. The Firm makes a $250 cash payment to the store to pay part of its credit card bill.

5. The Firm gives Larry the $800 sofa for his personal use at home.

6. The store terminates its credit card business and has its accountholders instead issue promissory notes on the remaining credit card balances.

7. To settle a dispute with a former client over its handling of a lawsuit, the Firm agrees to pay the client $500 in the future.

8. The former client forgives the $500 the Firm owes her.

Sequence: THE LEDGER Ledger: the second book of accounting Contains accounts by asset/liability/equity type (e.g., Cash, Land, Loans, Owners Equity) Daily journal entries are posted to the ledger accounts, positioned as left-side or right-side entries as they appear in the journal The ledger accounts are called T-accounts to enable posting to left and right sides, in turn to maintain equation and balance:

T-Accounts for Larrys Law Firm

How to Close the Books How to Close the Books Larrys Firm: LEDGER T-Accounts for Larrys Law Firm How to Close the Books Larrys Firm: LEDGER

Sequence: Statements Balance Sheet Sample Balance Sheets -- Assets Current Assets Defintion Assets that are cash or are reasonably expected to be converted into cash within one year in the normal course of business. Examples Cash Marketable Securities Accounts Receivable (A/R) Inventory Prepaid Expenses Noncurrent Assets Defintion Non-cash assets that are not reasonably expected to be converted into cash within one year in the normal course of business. Examples Real Estate Equipment Computers Sample Balance Sheets Liabilities & Owners Equity Current Liabilities Defintion Obligations that are due within one year. Current liabilities appear onthe company's balance sheet andinclude short term debt, accounts payable, accrued liabilities and other debts. Examples Short-term debt Current portion of Long-term debt Accounts Payable (A/P) Income Taxes Payable Accrued Expenses Noncurrent Liabilities Defintion Obligations that are due in more than one year. Current liabilities appear onthe company's balance sheet andinclude short term debt, accounts payable, accrued liabilities and other debts. Examples Long-term debt Lease obligations