FIR 3410 1st Edition Lecture 5 Current Lecture o GAAP Generally Accepted Accounting Principles accounting rules and standards that companies are required to adhere to when they prepare financial statements and reports Established by the Financial Accounting Standards Board FASB and authorized by the SEC 5 Important Accounting Principles The Assumption of Arm s Length Transaction o Two parties involved in an economic transaction arrive at a decision independently and rationally The Cost Principle o Transactions are recorded at the historical cost at which they occurred The Realization Principle o Revenue is recognized when transaction is completed while cash may not be collected until a later time The Matching Principle o Expenses related to generating any revenue are matched with the related revenue during the period in which revenue arerecognized Going Concern Assumption o It is assumed that a company will continue to operate for the foreseeable future Advantages of US GAAP W O GAAP there would be no standardization of financial reports Makes it easier to compare results among different firms and across time periods Criticisms of US GAAP It is too complicated and detail oriented and leaves no room for accountants to use their judgment It can easily be circumvented by sharp financial managers and accountants Financial Statements Income Statement results of operation for a period of time movie o Method and expenses are located on the statement o Measures profitability of a firm over a period of time o Include both cash and credit sales value of products and services o Net Income Diff between the Firm s revenues and expenses Basic Structure is Revenues Expenses Net Income Includes some non cash items Revenue from making sales on credit Expenses from depreciation of property plant equipment PP E Amortization of some intangibles patents licenses Some common subtotals along the way Operating profit EBIT Revenue operating expenses Earnings before taxes operating interest Balance sheet company s financial position at a point in time snap shot o This financial statement identifies all the assets and liabilities of a firm at a point in time like a snapshot o Total Assets Total Liabilities Stockholders Equity Left side all assets the firm owns uses to generate revenues Right side shows how those assets are financed with money that the firm has borrowed from creditors liabilities and with shareholders investment equity Liquidity ability to convert to cash easily with min risk Equity is last entitled to residual Statement of Cash Flows Net Working Capital Current Assets Current Liabilities Net Operating Working capital NOWC Current Assets Current Liabilities Notes Payable