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Hello, I'm professor Brian Bushee welcome

to the first video in an introduction to

financial accounting.

What we're going to do in this video is

first provide an overview of the

financial reporting landscape.What's required in financial reporting,

who makes the rules, who enforces the

rules and then second, we're going to

look at an extended example of what the

financial statements can tell us.

Which will introduce some concepts that

we'll see again and again throughout the

course.

I hope you enjoy the video.

Let's start with a definition.

Accounting is a system for recording

information about business transactions

to provide summary statements of a

company's financial position and

performance to users who require such

information.

>>Wow.

Please tell me the whole video won't be

this boring.

>> [LAUGH] I hope not.

but to spice things up a little bit, I

will bring in some virtual students to

ask questions or make pithy comments

every now and then.

Anyway, this definition has three parts.The first part is recording transactions.

This part turns out to be a big deal as

not everything a business does gets

recorded in the financial statements.

And sometimes it will seem like nothing's

happening yet we'll need to record a

transaction anyway.

The second part is about providing

summary statements.

Large companies have billions and

billions of transactions each year.

If they made them all available to you in

a gigantic database, your first question

would be, how can I summarize all this

into one or two summary numbers?

And the third part focuses on users.

As different user groups would want

different types of summary numbers.

So most companies keep at least three

sets of books.

Our focus in this course will be

financial accounting.

The standardized set of statements geared

towards external users such as investors,

creditors, customers, suppliers,competitors and any other stake holder.

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However these financial statements are

not used to determine taxes.

There's a separate set of books based on

tax rules to compute how much taxes a

company has to pay.

These rules are often quite different

from what we do in the financialstatements.

Finally, there's managerial accounting.

Which provides customized reports for

internal decision making.

We won't cover this topic in this course,

but you should be aware that the

financial accounting we do cover is

generally not used for internal decision

making.

So what are the financial reporting

requirements?

The Securities and Exchange commission,

or SEC, requires periodic finiancial

statement filings.

Companies must file an annual report, or

10-K, once a year.

This includes a full set of financial

statements with a substantial amount of

additional disclosure.

Generally running 200 to 300 pages.

The other three quarters of the year,

firms must file a quarterly report, or

10-Q which is also a full set of

financial statements but less required

disclosure than in the annual report.If anything material happens between

quarter ends, companies must file an 8-K

or current report.

Material information is generally viewed

as anything important enough to move

stock price, which means companies file

these quite often.

They don't require the financials just an

update on whatever major corporate event

has occurred.

All of these filings have to be prepared

in accordance with Generally Accepted

Accounting Principles or GAAP.

>> Excuse me, does this [UNKNOWN] only

apply to US companies?

>> That's a really good question.

I should note at this point that this

course will be very US-centric, because I

am at a US business school.

However, almost everything we cover is

going to be applicable globally.

So for example, even though I just gave

you SEC filing requirements in the US,

every country in the world that has a

securities market also has filingrequirements.

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Like an annual report.

The only difference that you might see

internationally is instead of a quarter

report, some countries have some annual

reports.

Also none of this applies to private

companies formally.But if a private company goes and borrows

money from a bank, banks are so used to

seeing reporting come in this kind of

frequency.

That invariably private companies will

produce annual statements, in some kind

of quarterly or semiannual statement in

a, in addition.

So this is a pretty universal set of

financial reporting requirements.

These periodic filing requirements create

much of the tension in financial

accounting that we're going to have to

deal with in this course.

For example, let's say you ship goods to

a customer in one quarter, but collect

the cash in the next quarter.

When does the sale occur?

Or let's say you buy equipment in one

quarter and then use it for the next 23

quarters.

When does the expense occur?

A lot of what we need to do is figure out

what quarter to put these various

business activities into.So who makes the rules?

Generally accepted accounting principles,

or GAAP, are established by the US

Congress.

But they're generally too busy doing

things like investigating steroids in

baseball or trying to figure out what's

going on at the IRS that they don't have

time to do accounting standards.

So they delegate to the Securities and

Exchange Commission.

But they're often too busy trying to

catch the bad guys.

That they don't have time to make the

rules.

So they delegate to the Financial

Accounting Standards Board, or FASB, a

seven person board in Norock, Connecticut

that has the authority to make accounting

rules in the US.

Now sometimes, they're even too busy to

make all the rules.

And so there's an emerging issues task

force, or the AICPA, that can also have a

hand in making accounting rules.That's just in the US.

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Internationally, there's International

Financial Reporting Standards or IFRS

that are established by the IASB or

International Accounting Standard Board,

and are now required in over 70

countries, including the EU.

But as of now, US GAAP is still requiredfor US firms.

So there's basically two big sets of

standards out there in the world, but the

good news is, for almost all of the intro

accounting topics, there's a really high

degree of overlap in the two standards.

>> Why doesn't the US just switch to

IFRS?

Do you think there will ever be one

global accounting standard?

>> Actually, in the summer of 2008, the

SEC came out with a road map to move U.S

firms to IFRS by the middle of this

decade.

But then Lehman Brothers went bankrupt,

the financial crisis hit, and this thing

dropped way off of the SEC's radar

screen.

So for the foreseeable future, we will

have two sets of standards in the world,

U.S GAAP and IFRS.

Although as I mentioned earlier the two

standards are becoming closer to each

other.

The FASB and the ISB have been workingtogether in any new standards.

And so even though there are two

standards, just about everything we talk

about here in US GAAP would also be

applicable under IFRS.

So who's responsible for financial

reporting?

Management is responsible for preparing

their own financial statements.

>>Wait, what?

That is like a professor allowing

students to give themselves their own

grade.

Everyone gets an A plus.

>> Yes, that's correct.

We, we allow managers to prepare their

own financial statements because they

have the most information about what

happened at the company.

And we hope that they use whatever

discretion they have in finance reporting

to better communicate their activities.

But we do recognize that they may use

this discretion to try to manipulate or

obfuscate or be opportunistic in how theyreport.

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So there are a number of checks and

balances that are there to try to curb

manager's opportunistic behavior.

First, the Audit Committee of the Board

of Directors provides oversight of

management's accounting process, however

this is not a foolproof check onmanager's opportunistic behavior.

One of the biggest financial statement

frauds ever was ENRON and the head of

their audit committee was a guy whose

full time job was accounting professor.

Which means he could put someone like me

on the board and still have these kinds

of problems.

So then auditors are hired by the board

to express an opinion about whether the

statements are prepared in conformity

with GAAP.

Again this is not a full proof check

against managers being opportunistic in

the case of ENRON, their auditor Arthur

Anderson signed off on some of the more

aggressive things they did and a lot of

it was because they were being of the

hired by the company and ENRON was the

biggest client in Houston.

If they lost ENRON they would've had to

go to the second biggest company in

Houston, which is, exactly.

Who knows what the second biggest company

in Houston is.And that's why they wanted to keep ENRON.

The next line of defense is that the SEC

and other regulators will take action

against the firm if any violations of

GAAP or other rules are found.

Now these bodies tend to be very reactive

instead of proactive.

And it's really after someone else has

brought the fraud to their attention that

they most often then launch an

investigation.

So by and large it's information

intermediaries like stock analysts,

institutional investors, and the media,

which provide the biggest check on

manager's behavior.

By either exposing or fleeing firms with

questionable accounting.

But again, by the time one of these

parties gets involved, it's very public

what is happening and the stock price

drops and you're in bad shape if you're

an investor.

So the only people that are going to

really look out for your interests interms of making sure the financial

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reporting is high-quality is you.

Which is why it's really important that

you learn some basics in terms of reading

financial statements.

Next, what are the required financial

statements.

There's four of them.First, there's a balance sheet which

gives the firms financial position, it's

listing of resource and obligations on a

specific date.

Then there's an income statement which

provides results of operations over a

period of time using accrual accounting.

In these cases we'll talk about

recognition is tied to business

activities not cash coming in or out.

For that there's a statement of cash

flows, which gives sources and uses of

cash over a period of time and then the

last statement is the statement of

stockholders' equity which provides

changes in stockholders' equity over a

period of time.

>> Okay could we get an example.

This is pretty abstract.

>> Yes in fact we'll go through an

extended example right now.

Well, we'll look at a very simple

business, and see how the different

financial statements can capture what's

going on with that business.And since you're probably getting sick of

my voice at this point, I'm going to turn

it over to a narrator to give you the

facts of the example.

>> Dave starts a business to export

expensive cars.

On December 1st, 2012 he receives $50,000

cash from issuing common stock.

He also borrows $80,000 from a bank and

buys a $100,000 truck.

It will be used for 48 months with a

$4,000 salvage value.

>> Excuse me, Mr Narator what is

salvage value?

>> We will explain that later.

Dave also pays $12,000 cash upfront to

rent office space for one year.

During the month of December, Dave's

company moves two cars.

The clients will pay Dave $40,000 within

30 days.

Dave also pays his employees $10,000 of

wages.

On December 31, the bank wants to see

financial statements.>> The bank wants to see financial

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statements because they want an answer to

the question, did the company make money

during December?

Well there's a number of different ways

that we could try to provide evidence on

whether the company made money or not.

First way would be to just look at cashflows, so if we take the facts we got

$50,000 from issuing stock, $80,000 from

borrowing from a bank, we paid a $100,000

to buy a truck, we paid rent.

We paid wages.

We didn't get anything from customers.

And so we ended the month with $8,000

cash.

As it turns out this is a really bad way

to try to figure out whether the

company's made money or not.

>> Pardon me, what is wrong with that?

Anytime I end the month with cash in the

bank it is a great month.

>> Well, this is actually how a

teenager would do accounting.

You get an allowance from your parents,

you borrow some money from your parents,

you spend a bunch of money.

If you have money in the bank at the end

of the month, it was a great month.

But it doesn't work so well for

companies.

Because all the company would have to do

to post better performance would be toborrow more money or raise more stock.

So a better way to look at cash flows

would be to separate them into whether

they came from running a business,

investing in the long term, or financing

the business.

So for instance, our operating cash flows

would be, we paid money for rent we paid

money for wages.

We didn't get anything from customers,

and so our operations actually had a net

outflow of cash of $22,000 during the

month.

In terms of investing for the future, we

bought a $100,000 truck, which now we can

use for four years.

That's our cash flow from investing

activities.

And, for financing the business, we

raised $50,000 from issuing common stock,

and we borrowed $80,000 from the bank,

giving us $130,000 cash inflow from

financing activities.

So this cash flow statement divides up

the cash flows based on their source.Did they come from operating?

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Did they come from investing?

Did they come from financing?

Gives us the same bottom line of $8,000

change in cash.

So this is what the statement of cash

flows is going to look like.

It's going to report cash transactionsover a period of time, split into whether

they're operating, related to providing

goods or services or other normal

business activities, investing related to

acquiring or disposing of long-lived

producive assets, or financing, which are

transactions related to our owners or

creditors.

Another way to try to answer the question

of whether the company made money during

December is to look at accounting income.

Accounting income tries to look at

business activities.

Rather than just cash coming in or going

out.

For example, we actually move two cars

during December.

Even though we haven't gotten paid cash

yet, we're likely to get paid cash.

And so why not book revenue of $40,000?

Recognize that we're going to eventually

get cash coming in from doing the

business activity.

With the truck we paid $100,000 cash this

period, but we're going to use it overfour years.

So why not allocate that cost over the

period of time that we use the truck?

For instance, $100,000 truck, salvage

value of 4,000 is going to be what it's

worth when we're done with it.

So we're going to use up $96,000 of

value.

Over 48 months we're using up $2000 worth

of the truck based on moving the cars

this month.

With the rent we paid $12000 cash up

front, but that was for a year.

We've only occupied the space for one

month.

So why not just recognized one 12th or

$1000 as the cost of rent.

All 10,000 we paid to employees was

earned this month.

And so we've recognized that as an

expense.

And so we come up with a number called

net income which is a measure of did we

price our service in this case moving

cars.Did we price our service high enough to

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cover all the cost of running the

business this period.

All the cost of moving those cars.

And what Menningham tells you is yeah, we

did price our product or service high

enough to cover all of those costs.

This is what the income statement isgoing to show us.

It's going to result, report the results

of operations over a period of time using

something called accrual accounting and,

and we'll obviously talk about this a lot

more as the course goes along.

But in this case the recognition is tied

to business activities where we have

revenues which are going to be increases

in something called owner's equity.

Not necessarily cash from providing goods

or services.

Expenses are going to be decreases in

owner's equity incurred in the process of

generating these revenues.

Again not neccessarily cash.

And so we end up with net income which is

also called earnings or net profit equal

to these revenues minus expenses gives

you a different picture than simply the

change and cash.

>> This does not make any sense.

How can we record revenue without getting

any cash?

What is this depreciation stuff?We didn't spend $2000 on a truck.

We spent $100,000.

>>Okay, just give me a few videos, it'll

take a little bit for me to explain this

to you.

Hang in there.

>> Fine.

So there are two different statements for

this month's results.

Which one's better?

Which should we use?

>> I once heard that cash is king.

I'm going to only use the cash flow

statement.

>> No, no, no, no, we'll talk about

this more but you definitely want to use

both statements.

Because they're giving you two different

pictures of what happened with the

company.

For instance, revenue tells you how much

you're going to get from customers based

on actually moving cars.

And the cash flow for customers tells you

how much cash you got this period.For the truck, the cash flow tells you

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how much cash you spent to acquire the

truck.

The accounting income tells you how much

of that truck was used this period.

Rent expense, the cash flow tells you how

much cash you spent for rent the rent

expense tells you how much was actuallyused up this month.

Sometimes the cash flow and the expense

are the same.

But you're really getting two different

pictures.

Cash flow from operations negative 22,000

says this month you actually spent more

cash than you had come in.

But net income said that you actually

priced your product enough to cover all

the costs of delivering it which even

though didn't get you cash now is going

to lead to cash flow in the future.

So just to hang with me for a few more

videos and hopefully this will all make

sense.

We've got one more statement to do, and

that's answer the question of what is the

financial position at the end of the

month.

And here we're going to look at the

Balance Sheet.

So remember this is the listing of all

the resources and obligations of the

company.So resources we call assets.

So we have cash of $8,000 that's cash in

the bank at the end of the month.

Accounts receivable of 40,000.

This is the cash that's owed to us by the

customers whose cars we moved.

It's an asset because it's going to turn

into cash.

Either we're going to collect it from the

customers or we could securitize it

through a special purpose entity and get

the cash immediately, which is sort of

beyond the scope of what we're doing

here.

Prepaid rent is an asset.

We paid 12 months in advance for rent.

We have used up one of those months, but

we still have prepaid 11 months of future

space at the end of the, at the end of

the month.

That's an asset.

The truck is an asset.

That's something that we can use to run

the business for the next 47 months.

So we have a total of 150,000, 57,000 ofassets.

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And then we look at all the obligations,

these are the liabilities and

stockholder's equity.

So we owe $80,000 to the bank at the end

of the month.

That's a liability called bank debt.

We got $50,000 of shareholder investment,that's the shareholder's claims on the

assets.

That's part of our obligation to our

shareholders common stock of 50,000.

And then we have something called

retained earnings, which is how much

accounting net income that we've

recognized less any dividends that we

payed out at the end of the month.

And these are all the obligations against

the resources of the company.

>> I am truly lost, when is this video

going to end.

>> I'm sorry I, I know I've thrown a

lot at you in this video, but just keep

in mind that everything we've talked

about we're going to talk about again in

more detail.

So just hang in there let me go through a

couple more slides and then we'll wrap

this up.

So, as I was saying, this financial

statement's called the balance sheet,

which reports the financial position, the

resources and obligations on a specificdate, split up into assets, which are

resources owned by a business expected to

provide future economic benefits.

Liabilities, which are claims on assets

by creditors, non-owners, that represent

an obligation to make future payment of

cash, goods or services.

And stockholders' equity or owners'

equity which are claims on the assets by

the owners of the business come from two

sources contributed capital, which is

when we sell shares, and retained

earnings, which arise from operations.

And again, we're going to go through all

of these in much more detail in the next

videos.

The last statement is the statement of

stockholders' equity.

We're going to get to this later.

Hopefully that gave you a good overview

of what we're trying to accomplish with

financial reporting.

Now we're going to dive into all these

concepts in more detail starting with the

balance sheet.I'll see you in the next video.

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See you next video.