15.
516x Financial Accounting
Introduction to Course and to Accrual Accounting
John Core
MIT Sloan School of Management
What are our course objectives?
We are training you to be leaders
Understanding accounting at a big picture level will help you reach your career goals
Understand “Big Picture” of how accounting information is prepared
NOT to train you to prepare it
Inform decisions using accounting information
Introduce you to the rules, language, and techniques
Help you recognize when judgment is being used
Apply insights to real-world situations
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MIT Sloan Mission
The mission of MIT Sloan is to develop principled, innovative leaders who improve the
world
We will discuss examples in which firms/people manipulate accounting numbers
The purpose of these examples is to show the role of judgment in accounting systems
NOT to suggest the example behavior is appropriate
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Introductory Case: Shrek 2 DVD from Dreamworks
Economic Consequences of Accounting: Shrek 2
Case Facts (Wall Street Journal, May 31, 2005):
“Shrek 2” DVD made a killing over the 2004/2005 holiday season
At the beginning of 2005, DreamWorks put out a statement about the records it had
broken in the DVD market
As the first quarter ended, DreamWorks was shocked that retailers started returning
millions of unsold copies of the DVD
On May 10 2005, DreamWorks dropped a bombshell to the public when it disclosed that
it fell short of earnings forecasts by 25%
Timeline:
Nov/Dec Jan Feb March April May
Made a killing First quarter ends March 31
Statement about
records we broke
Retailers returning millions of
unsold copies of the DVD
Announce
bad earnings
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Economic Consequences of Accounting
Do you think investors are concerned with the earnings shortfall? Why?
Investors have a mental model in which Price = E[earnings],
where E[earnings] means discounted expected future earnings.
In your finance courses, you will learn that Price = E[cash flows]
Does the accounting for the sales of Shrek 2 DVD’s matter? Why?
Earnings help predict future cash flows
Earnings → future cash flows → price
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Economic Consequences of Accounting
What are the alternative approaches that can be used to account for the sale of a DVD?
Think about the value chain for a DVD:
Make → Ship → Retailer sells it; sends money to Dreamworks (in 60-90 days)
Retailer does not sell it; returns DVD to Dreamworks
Could account for sale in 3 places:
1. Make (build to order companies like Dell computer)
2. Ship Accrual accounting; what Dreamworks does
3. Wait for retailer to send cash or return Cash accounting
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Economic Consequences of Accounting
How do you think DreamWorks accounts for DVD sales and the related sales returns?
DreamWorks accounts for these when it ships the DVDs
This is more “relevant” – allows DreamWorks to get information to investors sooner
If it waited until the retailer sent cash, the accounting would be more “reliable”
What information is being estimated, and what factors affect the accuracy of those
estimates?
The main estimate is how many of the DVDs will be returned (not sold)
Using this estimate, DreamWorks can estimate sales and earnings
This estimate is more accurate when the market is stable, and the company has a
longer history
There have been big changes in DVD market. Dreamworks is a new company, and
only makes 2 movies / year.
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Economic Consequences of Accounting
What are the consequences of Dreamwork’s accounting choices?
Earnings performance
Stock price/volume/liquidity
Potential lawsuits
Managers’ reputations
Managers’ compensation
Job security
etc.
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The reaction of Dreamwork’s stock to lower than
expected earnings
Dreamworks daily closing stock price in May
2005
40
38
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Closing Price
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20 Closing prices
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Date
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The reaction of Dreamwork’s stock to lower than
expected earnings
Dreamworks daily volume may 2005
10,000,000
Shares Traded
8,000,000
6,000,000
daily volume
4,000,000
2,000,000
-
5/ 0 5
5/ 5
5/ 5
5/ 0 5
5/ 5
5/ 0 5
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05
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5/
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Date
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Economic Consequences of Accounting
On May 10/11 when the market learns of DreamWorks earnings shortfall:
-13.9% return
9,200,000 shares traded
Roughly 10% of the shares outstanding
5 times the normal share volume
A loss of $450,000,000 in market capitalization
Six subsequent shareholder lawsuits
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Takeaways from DreamWorks
The market considers earnings information to be important
Trade-off between relevance vs. reliability
Two types of accounting:
Cash flows (when the cash comes in)
Earnings (cash flows and accruals)
There are accounting rules and there is “accounting judgment”
The rules allow DreamWorks to record revenue for DVD sales
Management uses judgment to estimate how many DVDs will be returned
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Agenda for remainder of this class
Introduce the balance sheet equation approach
Way to analyze the effects of a transaction on firm’s financial statements
We will use the Balance Sheet Equation as our primary tool
Define some key concepts of Financial Accounting
Practice how to record transactions, and prepare financial statements
Introduce accrual accounting mechanics
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Introduction to Accounting
Accounting is the process of conveying information to the firm’s stakeholders
Who are the firm’s stakeholders?
Stockholders
Creditors
Suppliers
Employees
Customers
Others
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What types of information do stakeholders want?
(Terminology)
What does the company own?
“Assets”
How much does the company owe?
“Liabilities”
How much do shareholders own?
“Shareholders’ Equity”
How did the company perform?
“Net Income”
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The Balance Sheet Equation (“BSE”)
Assets = Liabilities + Shareholders’ Equity
“own” “owe” “owners’ share of the business”
(book value, net worth, residual claim)
Analogy to personal net worth:
Assets = Liabilities + Shareholders’ Equity
Your car Loan balance Net worth
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Assets and Liabilities – Definitions
Assets:
1. Right of ownership
2. Associated with future benefits
3. Measurable with reasonable accuracy
Liabilities:
1. Result of past transaction
2. Involves future obligation – cash, good or service
3. Measurable with reasonable accuracy
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Shareholders’ Equity – Definition
Shareholders’ Equity (SE = A – L)
Shareholders are the residual claimant to the firm’s assets
We divide their rights (or investment) into:
(a) contributed capital, and
(b) retained earnings
Contributed capital arises from the issuance of stock
Retained Earnings are profits that have not been distributed as dividends
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The Income Statement Equation
Net Income = Revenues – Expenses + Gains – Losses
Revenues are cash (or claims-to-cash) that are earned through the selling of goods or
services
Expenses are the outflows of cash (or claims-to-cash) that are incurred to generate
revenues
Gains are inflows of assets that are not generated through the ordinary course of
business
Losses are outflows of assets that are not generated through the ordinary course of
business
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The Income Statement Equation – simplified for now
Net Income = Revenues – Expenses + Gains – Losses
Revenues are cash (or claims-to-cash) that are earned through the selling of goods or
services
Expenses are the outflows of cash (or claims-to-cash) that are incurred to generate
revenues
Gains are inflows of assets that are not generated through the ordinary course of
business
Losses are outflows of assets that are not generated through the ordinary course of
business
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Net Income and Shareholders’ Equity
Remember shareholders’ equity on balance sheet reflects:
(a) contributed capital and (b) retained earnings
Retained earnings changes as follows:
End. Ret. Earn. = Beg. Ret. Earn. + Net income – Dividends
Recognizing revenues and expenses affect net income…
Revenues ultimately increase retained earnings
Expenses ultimately decrease retained earnings
The retained earnings equation links the balance sheet and the income statement
together
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Firm Performance and Shareholders’ Equity
We can expand the Balance Sheet Equation to look like this:
Assets (A) = Liabilities (L) + Shareholders’ Equity (S/E)
Cash + A/R + Inv. = A/P + Bonds + Contr. Capital + Ret. Earnings
Revenues Increase Retained Earnings
Expenses Decrease Retained Earnings
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Principles of Accrual Accounting
Accrual accounting attempts to measure firm performance in a particular period
regardless of when cash is exchanged
Revenue Recognition Intuition:
Earnings process substantially complete (Earned)
Cash collection reasonably assured (Collectible)
Matching Principle for Expenses:
Recognize expenses in same period as associated revenue
An accrual is the recognition of revenues and expenses, regardless of when cash is
received
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Exercise: The Peters Company
Peters Company was in business for two years, during which it entered into the following transactions:
Year 1: Year 2:
1. The owners contributed $24,000 cash 1. Shipped remaining inventory to Julies
2. At the beginning of the year, rented a Company, received additional $24,000
warehouse for two years with a prepaid 2. Paid the outstanding balance for the
rent payment of $12,000 inventory purchased in Year 1
3. Purchased $10,000 of inventory on 3. Paid the outstanding wages balance
account 4. Received full payment on the outstanding
4. Sold half the inventory for $24,000, accounts receivable
receiving $20,000 in cash and an account 5. Incurred and paid wages of $12,000
receivable of $4,000
6. Paid dividend of $9,000
5. Paid wages of $6,000. Accrued wages
payable of $4,000
6. Entered into a contract with Julies
Company to sell remaining inventory in
Year 2. Received a cash advance of
$6,000 from Julies Company
7. Paid dividend of $1,000
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Peters company, year 1
Assets = Liabilities + Stockholders Equity
Prepd Cont
Cash A/R Inv A/P DefRev WPay R/E
Rent Cap
1 24 24
2 -12 12
2A -6 -6 Rent Exp
3 10 10
4 20 4 24 Revenue
4A -5 -5 COGS
5 -6 4 - 10 Wage
6 6 exp
6
7 -1 -1 Dividend
EB 31 4 6 5 10 6 4 24 2
=
Total Assets = 46 Liabilities = 20 S/E = 26
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Balance Sheet (B/S), Year 1
Assets Liabilities
Cash 31 Accts Payable 10
A/R 4 Def Rev 6
Prepaid Rent 6 Wages Payable 4
Inventory 5
Tot Liabilities 20
Total Assets 46
Stockholders Equity
Cont. Capital 24
Retained Earn 2
Tot S/E 26
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Financial Statement Links
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Peters company, year 1
Assets = Liabilities + Stockholders Equity
Prepd Cont
Cash A/R Inv A/P DefRev WPay R/E
Rent Cap
1 24 24 Income
2 -12 12 Statement
2A -6 -6 Rent Exp
3 10 10
4 20 4 24 Revenue
4A -5 -5 COGS
5 -6 4 - 10 Wage
6 6 exp
6
7 -1 -1 Dividend
EB 31 4 6 5 10 6 4 24 2
Dividends are NOT part of the Income Statement
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Income Statement, Year 1 (Ignoring Taxes)
Revenue 24
Cost of Goods Sold -5
Gross Margin 19
Less Operating Expenses
Rent -6
Wage Expense -10
Total Operating expenses -16
Net Income 3
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Statement of Cash flows
There is a third financial statement that firms are required to prepare – the statement of
cash flows (SCF)
The statement reports the change from beginning of the period cash and end of the
period cash
There are three types of cash flows: (Discussed in a later class)
operating
investing
financing
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Peters company, year 1
Cash Flow
Assets = Liabilities + Stockholders Equity
Statement
Prepd Cont
Cash A/R Inv A/P DefRev WPay R/E
Rent Cap
1 24 Stock issue 24
2 -12 Prepaid rent 12
2A -6 -6 Rent Exp
3 10 10
4 20 Rev 4 24 Revenue
4A -5 -5 COGS
5 -6 Wages 4 - 10 Wage
6 Def Rev 6 exp
6
7 -1 Div -1 Dividend
EB 31 4 6 5 10 6 4 24 2
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Statement of Cash Flows (SCF), Year 1
Beginning Cash 0
Cash Flow from Operations
Cash rec. from cust. 26
Less rent paid -12
Less wages paid -6
Total CFO 8
Cash from Investing (CFI) 0
Cash From Financing
Cash from stock sale 24
Dividend -1
Total CFF 23
Ending Cash 31
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Summary of year 1
Performance Measure Year 1 Year 2 Total
Net Income 3
Minus: Cash Flow from Operations (CFO) 8
Accruals -5
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Concluding remarks
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Aside: Debits, credits, and journal entries
(Not on exam)
The BSE for “The owners contributed $24,000 cash” is:
Assets = Liabilities + Stockholders Equity
Prepd Cont
Cash A/R Inv A/P DefRev WPay R/E
Rent Cap
24,000 24,000
Historically, accountants have used a journal entry system with debits and credits.
The journal entry for “The owners contributed $24,000 cash” is:
Debit Credit
Cash 24,000
Contributed capital 24,000
Take Away Slide
We first discussed some basic accounting definitions
Introduced the three fundamental accounting equations:
BSE,
Net Income equation,
and RE equation.
Accrual accounting measures performance, regardless of when cash is affected
Use the BSE as a tool to analyze the impact of transactions on financial statements
At this point, you should
be able to identify assets, liabilities and shareholders equity items
be comfortable with accrual accounting and entering balance sheet equation entries
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Accrual accounting: revenue can be recognized at same
time, before, or after cash is collected
Current Period Subsequent Period
Cash received concurrent with Asset = Liab + S/E
earning revenue Cash = Ret Earn
+ +
Cash received before Asset = Liab + S/E Asset = Liab + S/E
earning revenue Cash = Def Rev Cash = Def Rev + Ret Earn
+ + – +
Cash received after Asset = Liab + S/E Asset = S/E
earning revenue Acct Rec = Ret Earn Cash + Acct Rec = Ret Earn
+ + + –
Revenue Recognition Intuition: Recognize revenues when…
Earnings process substantially complete (Earned)
Cash collection reasonably assured (Collectible)
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Accrual accounting: expense can be recognized at same
time, before, or after cash is collected
Current Period Subsequent Period
Cash paid concurrent with Asset = Liab + S/E
using resource to generate Cash = Ret Earn
revenue
– –
Cash paid before Asset = Liab + S/E Asset = Liab + S/E
using resource to generate Cash + Prepaid Asset Prepaid Asset = Ret Earn
revenue
– + – –
Cash paid after Asset = Liab + S/E Asset = Liab + S/E
using resource to generate Cash = Payable + Ret Earn Cash = Payable + Ret Earn
revenue
+ – – –
Matching Principle: Recognize expenses earnings when…
Matched to the same period as the associated revenue
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