Introduction to Accounting

1. Introduction to Accounting EMBA Summer 2007 ACCT 6322

2. Introduction to Accounting Focus of this class and our whole course course is “financial accounting”, and the “financial reporting” that firms do to parties external to the firm. We will focus first on how the financial statements are constructed and why, and then focus on issues of interpretation. The purpose of financial reporting is to provide information to shareholders and others to make informed investment decisions Much of financial reporting in this country and others is heavily regulated. Financial reporting is a critical element of efficient allocation of resources in the economy. Economic success depends on investment going to the areas of greatest return, and accounting/financial reporting provides important information to facilitate.

3. Accounting Provides Information about… • Firm’s operating activities • Purchase of raw materials, labor and other costs. • Selling products and services. • Firm’s investing activities • Long term assets such as plant and machinery, land, buildings, etc. • Investment in R&D and other intangible assets • Investment in other companies (M&A) • Firm’s financing activities • Issue or repurchase of securities, loans etc. • How the firm is financed. • The information is provided via following major financial statements • Balance Sheet • Income Statement • Statement of Cash Flows • Statement of Shareholders’ Equity

4. Regulatory Backdrop The role of government in the standard setting process. Financial Statements are prepared using Generally Accepted Accounting Principles (GAAP) “If you look at the history of the American capital market, there's probably no innovation more important than the idea of generally accepted accounting principles”. Prof. Larry Summers (Former Treasury Secretary and the former President of Harvard University) as quoted on PBS on 4/24/2001. The SEC (Securities and Exchange Commission, created in 1934). • Determines and enforces GAAP. • For the most part, the standard setting is left to Financial Accounting Standards Board (FASB)

5. The Components of the Financial Statements • Management Discussion & Analysis • Balance Sheet • Income Statement = Changes in Retained Earnings • Cash Flow Statement = Changes in Cash • Statement of Stockholder’s Equity – Details of changes in the accounts relating to shareholders • Footnotes • Auditor’s Report

6. Balance Sheet The balance sheet shows what the firm has (assets); what the firm owes (liabilities); and owners' claims on assets (stockholders' or owner's equity) Keep in mind: ASSETS = LIABILITIES + OWNER'S EQUITY Details: ASSETS - Resources that will provide a future economic benefit that can be 1) quantified; 2) were acquired in an exchange transaction.

7. Balance Sheet Assets: Subheadings for Assets Current Assets – Consumed or turned into cash within one year or operating cycle. Examples: Cash Accounts Receivable – amounts owed from product/services already delivered Inventory What is the operating cycle? Non-Current Assets – Assets that are expected to provide benefits over longer than one year Property, Plant & Equipment Investments Intangible Assets – Sizable intangible asset called goodwill for Tyson. Goodwill results from an acquisition

8. Tyson Foods Balance Sheet - Assets September 30, 2006, and October 1, 2005 in millions, except per share data 2006 2005 Assets Current Assets: Cash and cash equivalents $ 28 $ 40 Short-term investment 770 -- Accounts receivable, net 1,183 1,214 Inventories 2,057 2,062 Other current assets 149 169 Total Current Assets 4,187 3,485 Net Property, Plant and Equipment 3,945 4,007 Goodwill 2,512 2,502 Intangible Assets 136 142 Other Assets 341 368 Total Assets $ 11,121 10,504

9. Balance Sheet LIABILITIES: Fixed, unavoidable, obligations that must be settled at a definite time, that (in general) result from a transaction. SUBHEADINGS FOR LIABILITIES Current Liabilities – Discharged within one year Long Term Liabilities – Long term debt; long term liabilities related to environmental remediation

10. Balance Sheet OWNER'S EQUITY: Two categories of stockholders' equity, or owner's equity: 1) Contributed Capital = Amount paid for stock; 2) Retained Earnings = Accumulated earnings - dividends. SUBHEADINGS FOR OWNER'S EQUITY: Common stock at par value – Part of amount paid for stock Additional paid in capital – Part of amount paid for stock Retained Earnings – Firm’s accumulated earnings that haven’t been distributed Preferred Stock Treasury Stock – The firm’s own stock that has been repurchased.

11. Tyson Foods Balance Sheet - Liabilities in millions, except per share data 2006 2005 Current Liabilities: Current debt $ 992 $ 126 Trade accounts payable 942 961 Other current liabilities 912 1,070 Total Current Liabilities 2,846 2,157 Long-Term Debt 2,987 2,869 Deferred Income Taxes 495 657 Other Liabilities 353 169

12. Balance Sheet OWNER'S EQUITY: Two categories of stockholders' equity, or owner's equity: 1) Contributed Capital = Amount paid for stock; 2) Retained Earnings = Accumulated earnings - dividends. SUBHEADINGS FOR OWNER'S EQUITY: Common stock at par value – Part of amount paid for stock Additional paid in capital – Part of amount paid for stock Retained Earnings – Firm’s accumulated earnings that haven’t been distributed Preferred Stock Treasury Stock – The firm’s own stock that has been repurchased.

13. Tyson Foods Balance Sheet – Owner’s Equity 2006 2005 Shareholders' Equity: Common stock ($0.10 par value): Class A-authorized 900 million shares: issued 284 million shares in 2006 and 268 million shares in 2005 28 27 Class B-authorized 900 million shares: issued 86 million shares in 2006 and 102 million shares in 2005 9 10 Capital in excess of par value 1,835 1,867 Retained earnings 2,781 3,032 Accumulated other comprehensive income 17 28 4,670 4,964 Less treasury stock, at cost- 15 million shares in 2006 and 2005 230 238 Less unamortized deferred compensation -- 55 Total Shareholders' Equity 4,440 4,671 Total Liabilities and Shareholders' Equity $ 11,121 10,504

14. Income Statement Accountant's measure of profitability for the owner. Revenues -- Inflows of assets or reductions in liabilities from providing goods or services in the ordinary course of business Simple – sales value of goods and services delivered during the period Expenses - Resources consumed, or liabilities generated as a result of producing revenue Accrual accounting -- Revenues and Expenses are not necessarily measured when cash flows.

15. Income Statement Timing of cash flows causes problems as a potential measure of performance. “Accrual accounting” smooths these inflows and outflows to better reflect performance. “Accruals” refers to the way we separate the cash flow from the transaction recognition – e.g., when we use power to operate the lights, we “accrue” the expense in the period when we use the lights – not necessarily when we pay the light bill. Additional example: We buy a building. When do we recognize the cost on the income statement. We recognize “depreciation expense” over the life of the building.

16. Income Statement More on Expenses: Two expense categories: Product Costs or Product Expenses These are "matched" with sales -- e.g., COGS Period Costs - Difficult to match with a particular sale. Recognized when incurred.

17. Tyson Foods – Income Statement Three years ended September 30, 2006 in millions, except per share data 2006 2005 2004 Sales $ 25,559 26,014 $ 26,441 Cost of Sales 24,631 24,294 24,558 928 1,720 1,883 Operating Expenses: Selling, general and administrative 935 928 880 Other charges 70 47 86 Operating Income (Loss) (77) 745 917 Other (income) Expense: Interest income (30) (10) (5) Interest Expense 268 237 282 Other, Net (22) (10) 7 216 217 282 Income (Loss) before Income Taxes (293) 528 635 Income Tax Expense (Benefit) (102) 156 232 Income (Loss) before Cumulative Effect of Change in Accounting Principle (191) 372 403 Cumulative Effect of Change in Accounting Principle, Net of Tax (5) -- -- Net Income (Loss) $ (196) $ 372 $ 403 See accompanying notes.

18. Articulation of Balance Sheet and Income Statement Income Statement measures net inflow of assets from conducting business. Balance Sheet measures level of assets, liabilities and owner’s equity Beginning Owner’s Equity + Net Income – Dividends = Ending Retained Earnings Dividends -- Not an expense Distribution of Earnings Tyson: Beginning Retained Earnings 3032 (2005 End/2006 Beginning) (196) Net Loss (55) Dividends 2781 (2006 Ending)

19. Statement of Cash Flows Statement seeks to explain the sources of change in the cash balance over the period. Most analysts focus a great deal of attention on the Income Statement, but the accounting rulemakers felt that financial statement users should be able to examine the flows of cash in a statement. Three Sections: Operating -- Cash generated by day-to-day operations of the firm Investing -- How the firm invested or disinvested in fixed assets Financing -- Items that affected the capital structure --e.g. dividends, issues of stock Why do we need this statement?

20. Tyson Statement of Cash Flows Big Picture on the Tyson Cash Flow Statement 2006 2005 2004 Cash Provided by Operating Activities 287 999 932 Cash Used for Investing Activities (1,224) (561) (600) Cash Used for Financing Activities 929 (443) (326) Effect of Exchange Rate Change on Cash (4) 12 2 Increase (Decrease) in Cash and Cash Equivalents (12) 7 8 Cash and Cash Equivalents at Beginning of Year 40 33 25 Cash and Cash Equivalents at End of Year $ 28 $ 40 $ 33

21. Tyson – Operating Cash Flows Cash Flows From Operating Activities: 2006 2005 2004 Net income $ (196) $ 372 $ 403 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 481 465 458 Amortization 36 36 32 Plant closing related charges 51 10 28 Impairment and write-down of assets 18 25 46 Deferred taxes (130) (93 ) 8 Cumulative effect of change in accounting principle, before tax 9 -- -- Other (21) (2 ) 4 Decrease in accounts receivable 43 24 67 (Increase) decrease in inventories 8 13 (65) Increase in trade accounts payable (43) 11 109 Net change in other current assets and 31 138 (158) liabilities Cash Provided by Operating Activities 287 999 932

22. Tyson – Investing and Financing Cash Cash Flows From Investing Activities: Additions to property, plant and equipment (531) (571) (486) Proceeds from sale of assets 21 47 27 Purchases of marketable securities (191) (543) (99) Proceeds from marketable securities 214 504 - Purchase of short-term investment (750) - - Other, Net 13 2 (42) Cash Used for Investing Activities (1,224) (561) (600) Cash Flows From Financing Activities: Payments of debt, net (8) (720) (242) Net proceeds from borrowings of debt 992 353 - Purchase of treasury shares (42) (45) (72) Dividends (55) (55) (55) Stock options exercised and other 42 24 43 Cash Provided by (Used for) Financing Activities 929 (443) (326) Effect of Exchange Rate Change on Cash (4) 12 2 Increase (Decrease) in Cash and Cash Equivalents (12) 7 8 Cash and Cash Equivalents at Beginning of Year 40 33 25 Cash and Cash Equivalents at End of Year $ 28 $ 40 $ 33

23. Creating the Financial Statements First part of the course this fall will reinforce our introduction of the above statements. We will also learn about how to take basic transaction data and generate financial statements. We want to do a basic version of this today. “The Accounting Cycle” Steps: 1) The whole financial statement creation process is tied to transactions. In the actual process, each transaction will be entered into a source referred to as a “journal”. 2) These individual transactions are aggregated into “ledgers” for purposes of preparing the financial statements (T-accounts is another term for the aggregating places for the transactions.) 3) More in class during the semester, but a number of “adjusting entries” are required to get the books right – e.g., recording depreciation on a machine. Adjusting entries refer to entries that are made without a transaction. 4) Prepare the statements.

24. Creating the Financial Statements Some thoughts on financial statement preparation. 1) Assets – Non-Monetary -- Recorded at Acquisition Cost Monetary – Recorded at “Present Value” – What I would settle for in cash now Monetary – Specific Amount of Money Promised – Example: $100 to be paid in 5 years Non-Monetary – Inventory, Machines, etc. 2) Liabilities – At Present Value in General. Many times the “Present Value” Calculation is Trivial – If you borrow $100 million when you issue bonds, the present value of the bonds is the $100 million.

25. Creating the Financial Statements Some thoughts on financial statement preparation. Owner’s Equity Common Stock “Additional Paid in Capital” Together two accounts above represent the amounts paid by shareholders for stock. Retained Earnings – Recorded based on the amount of Income the firms has recognized, less any dividends that have been paid out

26. Creating the Financial Statements Some thoughts on financial statement preparation. Income Statement Revenues and Expenses Revenues – Sales value of goods or services delivered this period. Expenses – Assets consumed this period to deliver revenues; Examples: Cost of Sales, Operating Expenses, Depreciation Expense, etc.

27. Creating the Financial Statements An Example of the Process 1) Firm issues 10,000 shares of $1 par value common stock for $100,000. 2) Buy a building for $50,000. 3) Borrow $100,000 from a bank. Let’s call this a “Note Payable”. 4) Buy equipment for $40,000 5) Buy inventory for $40,000 “on account” from several suppliers. 6) Pay some of the suppliers in transaction 5 $15,000.

28. Creating the Financial Statements Record the transactions: 1) Firm issues 10,000 shares of $1 par value common stock for $100,000. Cash (an account we always see) increases by $100,000 Common Stock at Par (an account we almost always see) increases by $10,000. Additional Paid-in Capital increases by $90,000. If we were doing journal entries: Debit Cash $100,000 Credit Common Stock at Par $10,000 Credit Additional Paid in Capital $90,000

29. Creating the Financial Statements Record the transactions: 2) Buy a building for $50,000. Cash decreases by $50,000. An asset account increases by $50,000. A typical possibility is “Property, Plant, and Equipment”. If we were doing journal entries: Debit Property, Plant, and Equipment $50,000 Credit Cash $50,000

30. Creating the Financial Statements Record the transactions: 3) Borrow $100,000 as a note from the bank Cash increases by $100,000. Note Payable, a liability, increases by $100,000. If we were doing journal entries: Debit Cash $100,000 Credit Note Payable $100,000

31. Creating the Financial Statements Record the transactions: 4) Buy equipment for $40,000. Cash decreases by $40,000. Property, Plant and Equipment increases by $40,000 If we were doing journal entries: Debit Property, Plant, and Equipment $40,000 Credit Cash $40,000

32. Creating the Financial Statements Record the transactions: 5) Buy inventory on account for $40,000. Inventory increases by $40,000. Accounts Payable (a liability) increases by $40,000 If we were doing journal entries: Debit Inventory $40,000 Credit Accounts Payable $40,000

33. Creating the Financial Statements Record the transactions: 6) Pay some of the suppliers $15,000 Accounts Payable decreases by $15,000 Cash decreases by $15,000 If we were doing journal entries: Debit Accounts Payable $15,000 Credit Cash $15,000

34. Creating the Financial Statements Net effects of all of the above, shown in T-account form. Suppose we were going to prepare a balance sheet after above transactions. Cash ----------------- | (Beginning Balance 0) $100,000 | (Transaction 1 – Issue Stock) | $50,000 (Transaction 2 – Buy Building) $100,000 | (Transaction 3 – Borrow $100,000) | $40,000 (Transaction 4 – Buy Equipment $40,000) | $15,000 (Transaction 6 Pay Suppliers ----------------- $ 95,000 | (Ending Balance that would reported on the balance sheet.)

35. Creating the Financial Statements Net effects of all of the above, shown in T-account form. Suppose we were going to prepare a balance sheet after above transactions. Property, Plant, and Equipment ----------------- | (Beginning Balance 0) $ 50,000 | (Transaction 2 – Buy Building) $ 40,000 | (Transaction 4 – Buy Equipment 40,000) ----------------- $ 90,000 | (Ending Balance that would reported on the balance sheet.)

36. Creating the Financial Statements Net effects of all of the above, shown in T-account form. Suppose we were going to prepare a balance sheet after above transactions. Inventory ----------------- | (Beginning Balance 0) $ 40,000 | (Transaction 5 – Buy Inventory) ----------------- $ 40,000 | (Ending Balance that would reported on the balance sheet.)

37. Creating the Financial Statements Net effects of all of the above, shown in T-account form. Suppose we were going to prepare a balance sheet after above transactions. Accounts Payable ----------------- | (Beginning Balance 0) | $40,000 (Transaction 5 – Buy Inventory) $15,000| (Transaction 6 - Pay Suppliers) ----------------- | $25,000 (Ending Balance that would reported on the balance sheet.)

38. Creating the Financial Statements Net effects of all of the above, shown in T-account form. Suppose we were going to prepare a balance sheet after above transactions. Additional Paid In Capital ----------------- | (Beginning Balance 0) | $90,000 (Transaction 1 – Issue Stock) ----------------- | $90,000 (Ending Balance that would reported on the balance sheet.)

39. Creating the Financial Statements Finally, the Balance Sheet. Enter the ending balances from all the balance sheet account . Assets: Liabilities: Current: Current: Cash $ 95,000 Accounts Payable $ 25,000 Inventory 40,000 NonCurrent: NonCurrent: Note Payable 100,000 Property, Total Liabilities $125,000 Plant & Equipment 90,000 Owner’s Equity: Total Assets $225,000 Common Stock at Par 10,000 Additional Paid-In Capital 90,000 Owner’s Equity 100,000 Total “Equities” $225,000

40. Creating the Financial Statements Our example firm commences operations for a month: 1) Labor costs for the month are $10,000. 2) Pay the workers $8,000 by the end of the month. 3) Accrue but not pay $800 of interest on the note. 4) Sell inventory that originally cost $20,000 for $50,000. The $50,000 of sales are on credit. $40,000 collected by end of month. 5) Recognize depreciation on the Building and Equipment of $1,000.

41. Creating the Financial Statements Record the transactions: 1) Labor costs are $10,000. As we will discuss more in class, this transaction affects the income statement. Income statement accounts are “temporary accounts”, in that they are “closed” at the end of the accounting period. Ultimately, the expense represents a costs the owner’s bear to do business (it decreases retained earnings). So, in terms of recording, the labor cost decreases income (retained earnings). Act like for purposes of recording, wages are accrued and then paid later. Wage Expense is $10,000. This decreases net income (and therefore owner’s equity) by $10,000. Wages Payable (a liability) increases by $10,000 If we were doing journal entries: Debit Wage Expense $10,000 (Ultimately, retained earnings decreases) Credit Wages Payable $10,000. The liability “accrues” as the people work, independent of the pay schedule. Their costs are a cost of generating revenues this period.

42. Creating the Financial Statements Record the transactions: 2) We pay the workers $8,000 by the end of the month. We will wind up at the end of the month owing our workers $2,000 resulting in a payable on the ending balance sheet. Why? In accounting terms, workers did the work, but haven’t been paid at the end of the period for work already done. Paid wages decreases the wages we showed in the last slide by $8,000. So Wages Payable decreases by $8,000 Cash decreases by $8,000. If we were doing journal entries: Debit Wages Payable $8,000 Credit Cash $8,000

43. Creating the Financial Statements Record the transactions: 3) We accrue interest on the note. We used the money this period to generate revenue, so the cost of funds is an expense. Interest Expense of $800 (decreases net income and ultimately retained earnings). An Interest Payable (Liability) or “Accrued Expenses” account would be increases by $800. If we were doing journal entries: Debit Interest Expense $800 (Ultimately, retained earnings decreases) Credit Interest Payable Payable $800

44. Creating the Financial Statements Record the transactions: 4) We record sales, and the cost of these sales is $20,000. Income effects are the sale (revenue of $50,000) and the cost of the sale ($20,000). $40,000 is collected from customers. Sales increases net income (revenue – ultimately retained earnings) by $50,000, and firm would record an “Account Receivable” when the revenue is recognized. Collection would decrease the receivable by $40,000 and increase cash by $40,000. Cost of sales would decrease net income (expense- ultimately retained earnings) by $20,000, and would decrease inventory by $20,000. If we were doing journal entries: Debit Accounts Receivable $50,000 Credit Sales Revenue $50,000 (Retained Earnings Increases) Debit Cash $40,000 Credit Accounts Receivable $40,000 Debit Cost of Sales $20,000 (Retained Earnings Decreases) Credit Inventory $20,000

45. Creating the Financial Statements Record the transactions: 5) Record depreciation on the Building and Equipment. Equipment is used up. This is a cost of doing business that the owner’s will bear. The accounting term is depreciation (recording is maybe not obvious as discussed in class). The depreciation decreases net income, and simultaneously decreases assets Accumulated Depreciation of $1,000. This is an “offset” account (technical name “contra-asset”) that reduces the reported Property, Plant, and Equipment account on the balance sheet Depreciation Expense $1,000 reduces net income and ultimately retained earnings by $1,000. If we were doing journal entries: Debit Depreciation Expense $1,000 Credit Accumulated Depreciation $1,000

46. Creating the Financial Statements Producing a Finished Set of Financial Statements We can now prepare the financial statements (balance sheet and income statement). Here is how the process would proceed. We would start with the balances from the balance sheet we previously prepared (there would be a T-account for each account in the balance sheet). We would then record the new transactions, opening new accounts as necessary. We would have to open “temporary accounts” to record the income transactions. Starting Point: Prop, Plant Stock Add’l Paid Cash Inventory & Equip. Accts Pay Note Pay at Par in Cap. ------- -------- ---------- -------- -------- ------- --------- 95K| 40K| 90K| |25K |100K |10K |90K | | | | | | |

47. Creating the Financial Statements Net effects of all of the above, shown in T-account form. Suppose we were going to prepare a balance sheet after new transactions. Wage Expense (Temporary Account – Decreases Retained Earnings) ----------------- | (Beginning Balance 0) 10,000 | (Transaction 1 – Wages Recorded) ----------------- 10,000 | (Ending Balance would reflect this in retained earnings - This would be shown on Income Statement ) Wages Payable (New Liability Account) ----------------- | (Beginning Balance 0) | 10,000 (Transaction 1 – Wages Recorded) 8,000 | (Transaction 2 – Wages Paid) ----------------- | 2,000 (Ending Balance on Balance Sheet)

48. Creating the Financial Statements Net effects of all of the above, shown in T-account form. Suppose we were going to prepare a balance sheet and income statement after new transactions. Interest Expense (Temporary Account – Decreases Retained Earnings) ----------------- | (Beginning Balance 0) 800 | (Transaction 3 – Interest Recorded) ----------------- 800 | (Ending Balance would reflect this in retained earnings - This would be shown on Income Statement ) Interest Payable Payable (New Liability Account) ----------------- | (Beginning Balance 0) | 800 (Transaction 3 - Interest Recorded) | ----------------- | 800 (Ending Balance on Balance Sheet)

49. Creating the Financial Statements Net effects of all of the above, shown in T-account form. Suppose we were going to prepare a balance sheet after new transactions. Sales Revenue (Temporary Account – Increases Retained Earnings) ----------------- | (Beginning Balance 0) |$50,000 (Transaction 4 – Revenue Recorded) ----------------- | 50,000 (Ending Balance would reflect this in retained earnings - This would be shown on Income Statement ) Accounts Receivable (New Asset Account) ----------------- | (Beginning Balance 0) 50,000 | (Transaction 4 – Sales Recorded) | 40,000 (Transaction 4 – Cash Collected) ----------------- 10,000 | (Ending Balance on Balance Sheet)

50. Creating the Financial Statements Net effects of all of the above, shown in T-account form. Suppose we were going to prepare a balance sheet after new transactions. Cost of Sales (Temporary Account – Decreases Retained Earnings) ----------------- | (Beginning Balance 0) 20,000 | (Transaction 4 – Cost of Sales Recorded) ----------------- 20,000 | (Ending Balance would reflect this in retained earnings - This would be shown on Income Statement ) Inventory (Asset Account) ----------------- 40,000 | (Beginning Balance from Previous Balance Sheet) | 20,000 (Transaction 4 – Cost of Sales Recorded) | ----------------- 20,000 | (Ending Balance on Balance Sheet)