Financial Accounting

John Shon

Financial Accounting

• Financial Accounting– Process by which the economic performance and financial position of

the company are recorded and communicated to decision-makers outside the company

– Benefits:• Helps decision-makers • Facilitates contracting between parties: Between management and ...?

• Managerial Accounting– Process by which information is communicated internally– Not covered in this course

Investors

Investment

ManagersValue creation

FINANCINGACTIVITIES

INVESTINGACTIVITIES

OPERATINGACTIVITIES

RETURNS

But how can investors be assured that managers:

- Choose the right projects/investments?

- Exert sufficient effort?

- Adequately disclose relevant information?

- Ultimately repay investors?

Investors

Investment

ManagersValue creation

FINANCINGACTIVITIES

INVESTINGACTIVITIES

OPERATINGACTIVITIES

RETURNS

“If you look at the history of the American capital markets, there’s probably no innovation more important than the idea of Generally Accepted Accounting Principles [GAAP].”

- Lawrence Summers, Former Secretary of the US Treasury & President of Harvard University

Financial Accounting serves anessential informational role for decision makers

Accounting is the language of business

• “Without a comprehension of [the fundamentals of Accounting], there can be no real understanding of the economics of enterprise.”– Paul Samuelson, 1970 Nobel Prize in Economic Sciences

• Who uses this information? – Decision makers:

• Individual investors, institutional investors (hedge funds, mutual funds)• Lenders/Creditors• Financial analysts, brokers, credit rating agencies, • Employees, customers, suppliers• Auditors, audit committee, board of directors• Competitors, labor unions• IRS, government regulators (e.g., SEC, PCAOB)• Compensation committee, potential employers

• A typical firm’s annual report contains:

– Financial statements (Form 10K)• Balance sheet• Income statement• Statement of cash flows• Statement of stockholders’ equity• Footnotes: The devil is in the details

– MD&A: Management discussion and analysis• Discusses key trends and provides important forward-looking information

– Letter to shareholders– Financial highlights, general description of business and risk factors

Annual report

• Auditor’s report, with audit opinion– Unqualified: “Clean”– Qualified or modified:

Explanatory language added to opinion*

Financial Accounting process

GAAP

Management’sincentives and

judgment

“Accrual”accounting

system

Economicevents

Financialstatements

• Financial Accounting is the process by which the economic performance and financial position of the firm are recorded and communicated to decision-makers outside the firm

Financial reporting standards( GAAP: Generally Accepted Accounting Principles )

• GAAP is not a science. The financial reporting system is a result of tradeoffs among these many constituencies (decision makers); it is a result of “social choice”– No consensus on what is “best”

Political climate

GAAPCongress

SECFASB

Public input*

Perceived economic consequences

* Public hearings, letters, exposure drafts, media, lobbying