Econ 4 - Part 1

Economics 4 Lecture 1.1

Accounting, Business Professions, And a Reporting

Illustration

Michael Willoughby, Ph.D., CFA

© Michael G Willoughby 2008

The Context

Scarcity: We want more than we have, or

… we need what we don’t have – a chunk of ca$h. Life Cycle: Time changes everything

… needs, wants, resources, and prices.Risk: Shit happens plus

…we seldom never know exactly what kind of shit it is - so CERTAINTY is more desirable than uncertainty.

Information helps! … unless it’s bad information.

Money-related Professions (broadly)

Economics: decisions about the use of resources – what do we want most?

Finance: decisions about the inter-temporal allocation of money: lending & borrowing.

Risk-management: decisions about the management – purchase or sale – of risk.

Accounting – an information system for recording and reporting business financial performance & position.

Money-related Professions (narrowly)

Economics: a) policy pro/prescriptions;b) purchasing of commodities (i.e., the SWAL fuel

futures);

c) production management. Finance: a) Banking - financial intermediation;b) Investment management (valuation)c) Financial planning..

Money-related Professions (narrowly)

Accounting: a) Control (bookeeping & internal controls);b) Financial reporting;c) Auditing;d) Tax-planning. Risk-management:a) Consulting; practices & procedures,

systems design, policy implementation; b) Insurance; underwriting.

Where? Economics: 1. The Federal Reserve Banks.2. DOC, DOL, DOT, all Legislatures.3. Big manufacturing firms.4. ? Banking: 1. Commercial banks: Citi, BofA, Wells Fargo.2. Investment banks: Goldman, Lehman, Bears?3. Credit Unions: NFCU, America First, SD

County.

Where?

Accounting: 1. Ernst & Young.2. Deloitte & Touche.3. KPMG.4. Price-Coopers (PWC).5. Arthur Anderson R.I.P.And the Regionals1. Moss Adams.2. McGladry Pullen

Where?

Insurance:1. Marsh & McLennan2. A.I.G.3. GEICO, All State, Farmer’s, Traveler’s.4. ? Risk-management: 1. Kroll, Inc.2. ?

Who?

Economics:1. M.A.’s2. Ph.D.’s Finance: 1. CFA’s2. CFP’s3. CIRA’s4. RIA’s5. CFO – job title allows you to join the

FEA

Who?

Accounting:1. CPA’s2. EA’s3. CMA’s

Insurance: 1. CLU’s2. ?3. AA’s

Why accounting?

It’s a formal way of keeping track of cash, claims to cash, obligations, & stuff:

1. Transactions & inventory.

2. Promises & contracts.

3. Money – my investment in your efforts.

Financial Reporting

A report card on a Company’s:1. Performance – profits – via the Income

Statement2. Position – assets & liabilities – via the

Balance Sheet3. Liquidity – the sources & uses of ca$h –

via the SCF

Financial Reporting

To interested parties:Outsiders:

a) Investors – owners; Purchase company stock.b) Creditors – lenders; Purchase company bonds.c) Regulatorsd) Vendors – suppliers & employees.

Insiders:a) Managers

Functions

#1Collection1. The transactions of AN ENTITY2. w/other Entities (persons and/or

organizations)3. Over a PERIOD of time – the Fiscal Year “FY”

and its 4 Quarters.

#2Measurement1. In a monetary unit “$” 2. Using some rules, guidelines, & judgment

Functions

# 3 Classification: every transaction creates a number that will be “labelled”:

1. Asset 2. Liability 3. Equity 4. Revenue 5. Expense

And also1. Gain2. Loss

Functions

#4Presentation – the reporting part

1. Income Statement – performance OVER the Period – lists Revenues and Expenses, sometimes Gains & Losses.

2. Balance Sheet – position AT A POINT, the end of the Period – lists all Assets, Liabilities, and Equity.

3. Statement of Cash Flows – translates the reported performance on the I/S and changes in the B/S into the most objective, most fungible, resource - CA$H.

Starbuck’s “SBUX” Stock

Financial Statements

Income Statement

Top-down presentation Sales or Revenue = inflows from Primary

Activities Less Expenses = outflows from Primary

Activities There are three categories of expenses and

many types, of Expenses ! = Earnings – a measure of profit There are several levels of profit ending (at the

bottom line) with Net Income.

Sales = $7,998,265,000 1

1 Company-owned stores. The Company’s total sales (ttm) was $10,097,790,000.

Financial Statements

Balance Sheet One of civilizations greatest achievements. Keeps the accounting system in order. Assets = Liabilities + Equity What we OWN = What we OWE

Everything must have = a Source Assets = Capital Assets = Trade Credit + IBD + PinK + Retained

Earnings

Financial Statements

Balance Sheet

Yours’ Your Parents’ Your Employer’s Your Nation’s A Global Balance Sheet? – if Al Gore says

so.

Financial Statements

Statement of Cash Flows

Only Cash is Cash ! A required Financial Statement since 1987 w/ SFAS

95. Three Sources and Uses of Cash:1. Operating2. Investing3. Financing Required because of the Accrual nature of accounting.

Objectives of Financial Accounting

Useful to the providers of money capital:

1. Relevant2. Reliable: consistent & comparable3. Timely

Capital Providers

Investors – provide equity capital

1. As initial Paid-in-Capital “PinK”2. As retained earnings from profitable

activities. Creditors – provide debt capital

1. Trade credit2. Interest-bearing Debt

Capital Providers con’t

The source of money capital for companies

Investors & Creditors literally “Sell Cash” to Company’s in exchange for:

Financial claims:

1. Bonds – debt2. Stocks - equity

Need Useful Information

Capital Providers want information: For Decision-making About starting, staying-the-course, ending A financial relationship … With what Companies? Comparability is the corner stone of GAAP

Accounting Assumptions

One entity. Record-keeping for “a Period” of

time. On-going concern Conducting transactions that can be

measured in Dollar$

Accounting’s Principles

Cost – historical Objectivity – b/w independent parties Realization – of Revenue ≡ Sales Matching – Expenses w/ Sales Materiality – don’t show the small

stuff

Employees & Stores

172,000 employees worldwide; 144,000 U.S.A.

163,000 employees in Stores; 9,000 in Admin. 8,505 Company-owned Stores; 6,506

licensed.

Sales per store-employee in Company-owned stores?

$ 49,065

and $ 46,501 per total employees

Profits

• Net Income = $ 672,640,000

• Per employee = $ 3,800

• Profit Margin = 7.15 %

Two Methods of Accounting

Cash-basis Only collect &

report “cash” transactions only.

Accrual Collect &

measure & report all transactions.

Cash-basis Accounting

We measure activity when “cash” is received and when it is disbursed.

The difference is cash-basis profit.

This is the basis for taxation of small businesses.

Cash-basis accounting is a rules-based measurement system.

Accrual

What matters is completed

activities – selling goods/services

regardless of whether cash is

collected at the time or sale,

before, or after.

Accrual

Is about measuring success in dollar units as they are associated with activities including claims and obligations created while selling.

Is a principles-based measurement system, using the realization & matching principles to recognize Revenue and Expenses.

Once Upon a Time there was a little ranch in Wyoming

With gentle tenant farmers

My parents

Starting with $ 6,000 in cash from prior earnings (Retained)

Balance Sheet at 12/31/07.

Cash = $ 6,000

AR = $ 0

INV = $ 0

PrePd $ 0

LLA $ 0

(Accum DA)

UnER = $0

Pay = $0

AcEx = $0

IBD = $0

P-in-K = $0

RE = $ 6,000

2008 Activities

Purchase ten 400# hefers and steers in

March.

Grass feed them for about 10 months.

Start selling them in when they each

weigh 1000# in about November.

Next Stop: Ruth Chris’

All Transactions: March-December

1. Purchase 10 animals @ $400 each = $4,000 cash.

2. Purchase salt & minerals: $ 400 cash.3. Agree to pay my father: $100/mo. x 10 = $1,000

but we forget to pay him for December.4. Sell 8 animals @ $1,000 each by the end of

December, but two customers don’t pay until January 2009.

5. What will my 2008 Financials look like?

It depends

Do we measure success on a:

Cash-basis?Or by the

Accrual method?

Cash-basis Income Statement for 2008

Revenue

(COGS)

GP

(G&A)

Profit

6,000 of cash sales = 6 x $1,000 cash received.

( 4,000) direct expenses – 10 x $400 cash paid.

2,000

( 1,300) $400 cash for supplies & $900 cash for labor,

700

Note: We have two $1,000 IOU’s plus a $100 labor obligation and two animals still in the barn.

Accrual Income Statement for 2008

Revenue

(COGS)

GP

(G&A)

Profit

8,000 Revenue as $6,000 cash + $2,000 in IOU’s

( 3,200) match the 8 sole x $ 400 as Direct Expense

4,800

( 1,400) match $400 supplies cost + $1,000 labor cost

3,400

Close the Balance Sheet at 12/31/08for the Accrual method: Fill-in these

numbers

Cash = $ ????

AR = $ ????

INV = $ ????

PrePd $ 0

LLA $ 0

(Accum DA)

UnER = $0

Pay = $0

AcEx = $0

IBD = $0

P-in-K = $ 0

RE = $ ????

Make a Cash Journal

Beginning cash $ 6,000 12/31/2007Purchase animals ($ 4,000)Purchase supplies ($ 400)Pay for Labor ($ 900)Cash for Sales $ 6,000 Ending cash $ 6,700 11 Ending cash will be recorede on the 12/31/2008 Balance Sheet.

Also note that Ending Cash – Beginning Cash = Cash flow = $700

Adjusting the Balance Sheet Accounts

Basic internal control formula.a) What you start withb) plus what you receive,c) less what you useequalsd) what you end with.

Articulate Retained Earnings

The internal control formula.a) start with $ 6,000b) plus 2008 Profit of $ 3,400c) less nothingequalsd) ending Retained Earnings of $ 9,400.

The Balance Sheet at 12/31/08for the Accrual method

Cash = $ 6,700

AR = $ 2,000

INV = $ 800

PrePd $ 0

LLA $ 0

(Accum DA)

UnER = $ 0

Pay = $ 0

AcEx = $ 100

IBD = $ 0

P-in-K = $ 0

RE = $ 9,400