Objectives and Game Plan - Understand some key concepts of Financial Accounting - Appreciate the differences between cash basis and accrual accounting - Develop a mental model for classifying types of accruals - Practice the basic bookkeeping model 15.514 2003 Session 2Important Financial Accounting Concepts - Conservatism: not the same as pessimism - Materiality: Benefit/cost trade-off - Consistency: Contrast with uniformity - Comparability - Verifiability - Revenue Recognition - Matching Principle: Matching Efforts (costs) with Benefits (revenue) • Further, we will make assumptions about the Economic Entity, its ability to survive as a Going Concern, and the Fiscal Period (which need not be the calendar year) 15.514 2003 Session 2Key Conflict: Relevance v. Reliability - Example: How should we value one-of-a-kind assets, like one of Intel’s wafer fabrication plants? 15.514 2003 Session 2Key Conflict: Relevance v. Reliability - Example: How to value one-of-a-kind assets? • Financial accounting stresses Objectivity: Verifiable and reliable information. • Does not mean accounting is “cut and dried.” • Still ample room for managerial judgment when estimating future effects under “objective rules.” 15.514 2003 Session 2The Balance Sheet Equation Assets = Liabilities + Shareholders’ Equity Assets - Liabilities = Shareholders’ Equity “own” “owe” “owners’ share of the business” (book value, residual claim) 15.514 2003 Session 2Accounting in a Single-Period Word is “Easy” - Cash + Cash Invested Returned 0 1 - Example: Shipping Expeditions in the 15th Century • Ship sold at end of voyage: finite project life • No information available until ship returns • Income is simply difference between cash out and cash in 15.514 2003 Session 2Accounting in a Multiperiod World is “Difficult” Cash Invested 0 1 2 3 4 5 6 … Cash Returned - No pre-determined end to firm's life - going concern - Cash invested and generated at multiple points in time - Subsequent actions affected by prior results - feedback - Monitoring by external investors: evaluate investment, retain/reward management - Accrual accounting: focus on measuring performance in a given time period, independent of cash effects. 15.514 2003 Session 2Principals of Accrual Accounting - An attempt to measure firm performance regardless of when cash is exchanged - Revenue Recognition: • Earnings process substantially complete • Cash collection reasonably assured - The Matching Principle for Expenses: • Match efforts to the benefits generated • Capitalize expenditures that will benefit future periods, expense as benefits are realized • Recognize liabilities when efforts benefiting the current period require cash payment in the future 15.514 2003 Session 2Cash Collection v. Revenue Recognition Prior Period Current Period Subsequent Period Cash received + Cash (A) = concurrent + Revenue (SE) � with earning Income Statement revenue Cash received + Cash (A) = 0 = before earning + Deferred - Deferred Revenue (L) revenue Revenue (L) + Revenue (SE) � Income Statement Cash received + Accounts Receivable (A) = + Cash (A) after + Revenue (SE) � - A/R (A) = 0 earning Income Statement revenue Note: Deferred Revenue can also be called Advances from Customers. Both names signify that cash has been received for a service or product that hasn't been delivered. 15.514 2003 Session 2Cash Payment v Expense Recognition Prior Period Current Period Subsequent Period Cash paid concurrent with using resource to generate revenue - Cash (-A) = + Expense (-SE) � Income Statement Cash paid - Cash (-A) - Productive Asset (-A) = before + Productive + Expense (-SE) � using resource to Asset (A) = 0 Income Statement generate revenue Cash paid 0 = - Cash (-A) = after + Accrued Liability (L) - - Accrued using resource to + Expense (-SE) � Liability (-L) generate revenue Income Statement Note: The "Productive Asset" could be inventory, Prepaid Insurance, PP&E, etc. In the case of PP&E, we would reduce the value of the asset through the contra-asset Accumulated Depreciation. The"Accrued Liability" could be Accounts Payable, Accrued Wage Expense, Interest Payable, etc 15.514 2003 Session 2Temporary v Permanent Accounts - Permanent Accounts: • Appear on the Balance Sheet • Start each period with the ending balance from the prior period - Temporary Accounts: • Appear on the Income Statement • Start each period with a balance of $0 • Are closed at the end of the period to the Income Summary to compute Net Income for the period 15.514 2003 Session 2Handling Temporary Accounts in the Balance Sheet Equation (BSE) Format Net Income = Revenues - Expenses + Gains - Losses End. Ret. Earn. = Beg. Ret. Earn. + NI - Div Therefore... - Revenues and Gains ultimately Increase Ret. Earn. - Expenses and Losses ultimately Decrease Ret. Earn. - We’ll record Income Statement components directly to the Permanent Account, Retained Earnings, with a note about the reason and recognize that this is a short-cut around the use of Temporary Accounts 15.514 2003 Session 2Exercise E5-18: Peters Company See Example E4-19: Peters Company on pages 163-4 in the course textbook. 15.514 2003 Session 21 Exercise E5-18: Peters Company, Year 1 Cash + AR + PPRent + INV = AP + WgsPble + CC + RE BB Total Assets = Liab + SE = 15.514 2003 Session 21 Exercise E5-18: Peters Company, Year 2 Cash + AR + PPRent + INV = AP + WgsPble + CC + RE BB Balance Sheet 26 4 6 5 10 4 24 3 15.514 2003 Session 2Exercise E5-18: Peters Company (continued) Performance Measure Year 1 Year 2 Total Net Income…………… Net Cash Flow from Operations……………. 15.514 2003 Session 2Key Points - Relevance of Accounting Measures depends on the decision context - Most relevant measures are sometimes the least reliable: a major trade-off in accounting - Accrual Accounting attempts to measure performance, regardless of when cash is affected • Tables on slides 8 and 9 provide a framework for thinking about the accrual process - Balance Sheet Equation (BSE) as a tool for understanding events' impacts on the Financial Statements 15.514 2003 Session