introduction to finance 1

8/9/2019 introduction to finance 1

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Characteristics of Equity FinancingInvestors contribute resources/capital in exchange forownership interests in a business. In a corporation thisownership is evidenced by shares of stock. Ownershiptypically grants the following rights:

Investor contributions of resources are not subject torepayment at a future date and there are no interest charges.Equity financing is permanent financing.

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A. A right to vote or have a say in the affairs of the business.

B. A right to share in any profits of the business. This cost of capital could be very expensive.C. A right to share in any remaining resources in the event of business termination.

The Key Advantage of Debt Financing:- No sacr ifice of ownership rights (voting, profit sharing)

The Key Advantage of Equity Financing:- No requirement to repay the capital contributed.

How does an owner/investor get their investment back if thebusiness has no obligation to rep ay th e contributed capital?

1. Distributio ns upon discontinuance of the business - If a businessterminates, any excess resources of the business after the payment of alldebts are distributed to owners. There is no assurance this distributionwill be the same as the amount invested. If it results in a higher orlower amount, the investor realizes a gain or loss on investment,respective ly.

Subsequent sale of ownership interests to other investors - Originalinvestors of capital in corporations receive shares of stock as evidence oftheir ownership interests and rights. This stock can be subsequently sold toother investors, usually through a stock exchange (ie. NYSE, NASDAQ,etc.). The amount received upon sale may be more or less than the amo untoriginally inv ested resulting in capital gains or losses for the investor.

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Sharing in the business operating profits.Distributions of resources created through profitableoperations to owners is referred to as a dividend .

Capital gains or losses on the sale of stock ordistributions upon the termination of the business.

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The Two Ways Owner/Investors Makea Profit/Loss on Investment

Most Investors and Creditors RequireInformation for Their Investment Decisions

Creditors want to evaluate a company's credit worthiness.

"Will the business be able to repay the debt plus interest ona timely basis?"

Investors want to evaluate the profit potential of aninvestment in a company's stock. "What are the

possibilities that stock will increase in value or that therewill be substantial dividends in the future?"

The primary purpose of financial accounting is to provideinformation that assists investors and creditors in suchevaluations.

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Financial Accounting seeks to provide information to current or future providers of capital (investors or creditors) and other interested partiesoutside of management (ie. government regulatory bodies). This isaccomplished through periodic general purpose financial statementswhich provide summarized historical information on the company'sfinancial position and results of operations.

Managerial Accounting seeks to provide information to assistmanagers in the effective operation of a business. This is accomplishedthrough customized management reports that tend to be more detailed innature and may include future budgets and forecasts as well as historicaldata. These reports are not generally available to the public and seekonly to improve management's future performance.

Financial vs. Managerial Accounting


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1. Balance Sheet or Statement of Financial Position

2. Income Statement or Statement of Operations

3. Statement of Cash Flows

These financial statements can be found in a company's annualreport which is readily available to the public. To prove this,you are to complete the Financial Statement ReviewAssignment as noted in the syllabus.

Financial Accounting's Focus is the GeneralPurpose Financial Statements

Two critical conditions must exist for financialstatements to be truly useful.

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Comparability

Credibility

-Generally accepted accounting principles (GAAP) are the rules and standardsof accounting used to create comparable of information.

-This need for GAAP became obvious with the stock market crash of 1929.There were no generally accepted accounting principles or standardizedinformation requirements before the crash.

-In 1973, a new private organization, the Financial Accounting Standards Boardwas formed to assume the responsibility for establishing GAAP.

-The SEC has the legal authority to determine GAAP for publicly-heldcompanies, but originally delegated that responsibility to the American Instituteof Certified Public Accountants (AICPA).

-In response, Congress created the Securities and Exchange Commission (SEC)to regulate the capital transactions of publicly-held companies.

-The FASB is subject to some political pressure given the authority of the SEC.

Two critical conditions must exist for financialstatements to be truly useful.

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2.

Comparability

Credibility

Credibility refers to the need for the financialstatements to provide information that is materiallyaccurate and reliable.

-A company's management is responsible for its accounting system and thepreparation of its financial statements.

-Management may have conflicts of interest in the accurate preparation of the

statements.

-Materially innacurate financial statements are at best worthless and at worst,may actually deceive and severely damage the user of financial statements.

-As a result, the SEC requires that all financial statements of publicly-heldcompanies be subject to outside independant audit for accuracy by anindependent certified public accounting firm (CPA).

-The CPA must issue an auditor's report which must accompany a company'sfinancial statements and clearly state the material reliability of the informationand its compliance with GAAP.

UPDATE

At the time this lesson was originally produced there was relativelylittle going on in the area of international accounting standards.However, today over 100 countries accept and use standards

established by the International Accounting Standards Board (“IASB”)operating out of London, England. These standards are referred to asInternational Financial Reporting Standards or “IFRS” and in somecases they are very different from US GAAP.

Recently, the FASB and IASB joined together recognizing the growingneed for common world-wide standards and agreed to participate in a

joint effort to reconcile the differences between US GAAP and IFRS.This process, known as convergence, is progressing today on an activebasis.


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Federal Agencies

Commission)

SEC(Securities &

Exchange

Investors&

Creditors

Annual Report(and other

information)

Publicly-Held Companies

Service)

IRS(Interal

Revenue

Collect IncomeTaxes

Private Organizations

Investors&

Creditors


information)


Accountants)

AICPA

(American Instituteof Certified Public

CPA's

License and Certify

Audit


Investors&

Creditors


information)


Accountants)

AICPA

(American Instituteof Certified Public

CPA's

Establish Rules ofHow to Conduct an Audit

RegulateStock & BondTransactions

Federal Agencies

Commission)

SEC(Securities &

Exchange

Investors

&Creditors


information)


UPDATE

(Continued)

It is now clear that the world is pushing towards a single set ofconverged standards that will ultimately be used by all countriesincluding the U.S. In fact, in 2008 the SEC began allowing foreigncompanies to trade their stocks and bonds on U.S. exchanges usingIFRS. In addition, the SEC is considering some future deadline inwhich all companies will be required to use converged interna-tional standards in their financial reporting.

Fortunately, for this “Introduction to Accounting; The Language ofBusiness” most of the material included in the lessons is the sameunder both U.S. GAAP and IFRS. When current differences existthey will be noted along the way.

UPDATE

(Continued)

It is now clear that the world is pushing towards a single set ofconverged standards that will ultimately be used by all countriesincluding the U.S. In fact, in 2008 the SEC began allowingforeign companies to trade their stocks and bonds on U.S.exchanges using IFRS. In addition, the SEC is considering somefuture deadline in which all companies will be required to useconverged international standards in their financial reporting.

Fortunately, for this “Introduction to Accounting; The Languageof Business” most of the material included in the lessons is thesame under both U.S. GAAP and IFRS. When current differencesexist they will be noted along the way.


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Studying and understanding the language of business and

understanding the kinds of information available to decisionmakers (investors, creditors and management) is greatpreparation to become a business decision maker.

Career opportunities in CPA firms.- Partner/Ownership in large international firms or small local firms- Stepping stone to other opportunities:

CFO, CEO and other management positionsEntrepreneurship

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The Value of an Accounting Education

Create GAAP

(Standards of Accounting)


Investors&

Creditors


information)


Accountants)

AICPA(American Instituteof Certified Public

Standards Board)

FASB(Financial

Accounting

Lesson SummaryWhat is a business? (Manufacturing, Merchandising, Service businesses)Successful businesses need:

-Good Idea-Capital-Management Skill

Two ways businesses access capital:1. Borrow it.2. Investment from owners/investors.

Investors and creditors need infromation in making their capitalinvestment decisions.

Financial accounting seeks to provide financial statements for investor and creditor use in those decisions.Useful financial statements must be comparable and credible.GAAP, established by the FASB, provides the key to comparable financial statements among differing companies.CPA audits required by the SEC for publicly-held companies seek to insure financial statement credibilty.

1. Exclusive right to perform audits of financial statements.

2. Tax advice and preparation of various kinds of tax returns.

3. Business consulting and advice:1. Information systems design and implementation.2. Performance or operational audit.3. Business valuations.4. Mergers and business acquisitions.5. Fraud auditing and internal control reviews.6. Personal financial planning and investment advice.

What Do CPAs Do?

FYI

In 2002, following a number of highly publicized financial statementfrauds, Congress passed the Sarbanes-Oxley Act, known as “Sarbox.”This legislation created a higher level of federal regulation over CPAsand the audits they perform on publicly held companies. That’s donethrough an organization called the Public Company AccountingOversight Board or “PCAOB,” which is overseen by the SEC.

This board has a broad mandate to promote audit quality and protectthe public interest through its authority to set audit standards, conductinspections of CPA firms performing audits of publicly held compa-nies, initiate enforcement actions, and impose penalties on those firmsnot meetings certain standards. In short, Sarbanes-Oxley reduced the

role of the AICPA in regulating their member CPAs performing auditsof publicly held companies and increased the role of the federalgovernment through the SEC and the PCAOB.

By the way, CPAs are also sometimes called upon to perform auditsof privately-held or non-public companies. These companiessometimes require an audit if they have plans to go public in thefuture or need current financing. Companies planning to go publicmay need as many as three years of audited financial statementsbefore receiving SEC permission to “go public,” although the SECdoes provide certain exceptions for smaller businesses. As far asother financing is concerned some private investors, banks or otherlenders may require audited financial statements before making theirinvestment or lending decisions.

For audits of private companies with no immediate plans to gopublic the federal government has no regulatory authority. Therefore,the AICPA continues to provide standards and oversight of CPAsperforming such audits.


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Some students enter directly into business, usually in acompany's accounting, finance, internal audit and informationsystems department. With time and promotions, managementopportunities arise along with opportunities to move within abusiness to other disciplines.

An accounting education provides a great base for:A career in finance, investment banking, stock brokerage

and personal financial planning.Continuing education (Law School, MBA, MPA)A career in teachingGovernment service: FBI, IRS, GAO, other state and

local.

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"Overall, an accounting educationprovides a better foundation forrunning a business than that of anyother profession."

Robert R. WoodsonPresident of

John H. Harland Co.

Business Ownership:Three Basic Legal Forms

1. Proprietorship:- One owner.- No legal red tape except if employees hired.- No seperation of business and personal legal liability. (This

can be addressed through insurance.)- No separate income taxation.

2. Partnership: Same as proprietorship except there is more thanone owner.

- No legal red tape except if employees hired.- A formal partnership agreement is recommended but not required.- No separation of business and personal liability.- No separate income taxation.

3. Corporation: A separate legal entity apart from its owners- Legal red tape in formation and operation imposed by the state.- One or more owners. A corporate form of business greatly

facilitates many owners and the transfer of ownership interests.- Separation of business and personal liability of owners.- Seperation of business and personal taxation (double taxation)

Effects of Separate Corporate Taxation$10 millionx 36%$6.4 million

x 40%$3.8 million

ProfitCorporate federal income taxAfter tax corporate profit paid as adividend to ownersPersonal federal income taxOwners' after tax return on investment

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Example of Double Taxation

Assume that after years of effort a business begins to operate successfully andgenerates a $1,000,000 profit in the current year. If that business operates as aproprietorship, the $1,000,000 of profit is then included in the owner’s personal incometax return and taxed at his or her personal rate. If we assume a federal income tax rateof 28% and a state rate of 7% then the 35% combined rate would result in a $350,000

tax payable which leaves $650,000 as the net after-tax profit to the owner. By the way,as mentioned previously, partnerships are taxed similar to proprietorships in that theirprofits are allocated to the partners and then included in their personal income taxreturns. There is no separate or additional tax charged to the partnership.

On the other hand, if this business operates as a corporation then its profits are taxedfirst at a corporate rate before an additional tax is charged to the owners on anydistribution of the remaining profits. For example, using the maximum federalcorporate income tax rate of 35% and an assumed 7% state income tax rate thecombined 42% would result in a $420,000 corporate income tax payable on the$1,000,000 of profit. That leaves $580,000 for the owners which is then taxed again ifit’s distributed as a dividend. Dividend income is currently taxed at a 15% federal ratewhich means an additional $87,000 tax payable by the owners.

Example of Double Taxation (continued)

This is the “double taxation” that comes with operating a business in the form of acorporation. In this example the end result is that only $493,000 is left to the ownersafter the payment of all taxes.

This raises the following question…. Is there any way to legally avoid some of thesetaxes --- at least the effect of double taxation associated with corporations? Theanswer is yes.

One approach is through the use of salaries and bonuses as a way of distributingprofits to owners rather than dividends. In other words, if you simply took the$1,000,000 of total profit and paid it all out to the owners as a salaries and bonusesthen the business would have zero net income given that such salaries and bonuses aredeductible expenses of the business. The $1,000,000 of profit less $1,000,000 ofsalaries and bonuses to the owners leaves zero net income and zero corporate incometax payable. In that case the only income taxes payable would be the amount due onowners based on salaries and bonuses received.


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Unfortunately, the IRS knows that corporations can do this to avoid the effect ofdouble taxation. As a result, any amount paid to owners for salaries and bonusesmust be reasonable relative to the amount of services they provide. In otherwords, if an owner provides no work or other services to the business then nosalary or bonus is allowed. However, these determinations can be subjective andin many cases the final amount allowed is based on a negotiated agreement withthe IRS.

Another approach that is commonly used to eliminate the effect of double taxationis referred to as the “Subchapter S Election” under the Internal Revenue Code.This election was originally designed for smaller growing companies andprovides for corporations with relatively few shareholders to be taxed as if it werea partnership. In other words you may still operate as a corporation with separatelegal liability between the business and the owners but the income of the businessis taxed directly to the owners without the imposition of a separate corporate tax.But, again, this Subchapter S Election is limited to only certain companies havingrelatively few shareholders.


Another possibility is the relatively new and popular form of ownership referred toas Limited Liability Corporations or LLCs. This form of ownership providesseparate legal liability for owners but is otherwise treated like a partnership for taxand other purposes. This allows for the avoidance of double taxation but cancreate some other issues worth considering. For example, the transfer ofownership interests in LLCs are much more problematic than in regularcorporations. For example, if a particular owner in an LLC wishes to sell an

interest, the transfer of that interest must receive the full approval of all of theother owners. That is not the case in a regular corporation. In addition, if anowner dies the business must then be dissolved and reformatted before it cancontinue. In short, there are some problems associated with LLCs; however, it isa popular and fast growing form of business ownership in that it creates separatelegal liability for owners and avoids the problem of double taxation.

Clearly from this discussion, the choice of a legal form of business can besomewhat complicated. In most cases, additional study and some legal counselmay be necessary before making this decision.

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The Board of Directors acts on behalf of the company in the hiring of seniormanagement personnel and makes other strategic decisions for the business.

Senior Management is accountable to the Board, and therefore the owners, andis responsible for the business operations in an effort to maximize profits for thebenefit of the owners. Management may or may not own shares themselves.

Board of Directors (Advise for a fee)

Top Management Personnel (Manage for a salary)

Other Employees (Work for a salary/wage)

Produce Profits for Owners

Elect

Hires

Hires

Shareholders (Invest Capital)

Corporate Ownership, Governanceand ManagementStates authorize the formation of separate corporate entities.

Articles of Incorporation and By Laws created by the founder(s) andfiled with the state determine how the corporation will be governed.

Corporate ownership is evidenced by stock certificates (shares of stock).

Shareholders/Owners have the right subject to the by-laws to vote oncorporate matters (one vote per share) and the right to share in dividendson an equal per share basis. (A shareholder's influence and percentageparticipation in profits depends on how many shares are owned and howmany shares are outstanding.)

Corporations are governed on a representative basis through a Board of

Directors elected by shareholders. Directors need not be shareholdersand are often compensated for their work.

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Respond briefly to the following questions:

A. Why is accounting sometimes referred to as the "languageof business"?

B. What is financial accounting as opposed to managerialaccounting?

C. Why would an investor considering an investment in thestock market find financial accounting information of value?

D. What is GAAP? Does it apply to managerial or financialaccounting or both? Why is GAAP so important?

Problem #1

Respond briefly to the following questions:

A.

B.

C.

D.

What are the SEC, FASB, AICPA and IRS? Describe thegeneral purpose of each.

What kinds of businesses must have external audits performedon their financial statements and why?

Who has exclusive authority to perform external audits?

What advantages would be had for global business if there wereinternational standards for GAAP?

Problem #2

SEC (Securities and Exchange Commission) - Federal agency charged with theresponsibility of r egulating the capital markets (debt and equity investments) forpublicly held businesses.

FASB (Financial Accounting Standard Board) - Private institution whichcurrently determines GAAP.

AICPA (American Institute of Certified Public Accountants) - Private nationalorganization of CPA's. The AICPA assists states in the CPA certification processby administering a national examination, establishes standards of auditing andprofessional conduct for CPA's and encourages compliance with those standards.

IRS (Internal Revenue Service) - Federal agency charged with the responsibilityof federal tax collection.

A. What are the SEC, FASB, AICPA, and IRS? Describe the general purposeof each.

Problem #2The answer

C. Who has exclusive authority to perform external audits?

Certified Public Accounting firms

D. What advantages woud be had for global business if there were international standards for GAAP?

If all countries required the same, high-quality standards of accounting, thenfinancial information for businesses worldwide would be comparable andglobal capital markets would be improved. Investments of capital worldwidewould have lower risk and the cost of capital would be reduced. High qualityinternational GAAP would ultimately improve the worldwide economy.

B. What kinds of businesses must have external audits performed on their financial statements and why?

Businesses which seek to acquire capital from the public must provide audited

financial statements. The SEC requires such companies to provide financialstatements prepared in accordance with GAAP and subjected to independentaudit by a Certified Public Accountant.

Problem #2The answer

Lesson 1 problems/answers

C. Why would an investor considering an investment in the stockmarket find financial accounting information of value?

In order to make intelligent and informed investment decisions,investors need current information on a company’s financial positionand results of operations as a basis for projecting its future investment

potential.

D. What is GAAP? Does it apply to managerial or financialaccounting or both? Why is GAAP so important?

GAAP stands for "Generally Accepted Accounting Principles,"which are the standards by which accounting information is preparedand presented to external users. GAAP applies only to financialaccounting information. GAAP is important because it helps createcomparable information among companies seeking capital and

allows investors and creditors to make more informed investmentdecisions.

A. Why is accounting sometimes referred to as the "language of business?"

B. What is financial accounting as opposed to managerial accounting?

Financial accounting seeks to provide information to those who are

external to the day to day operations of the business. External usersinclude investors and creditors, government regulatory bodies, laborunions, the media and other users external to the management of thebusiness.

Managerial accounting is the providing of information to management,those who are internal to the business.

Accounting is the language of business because it seeks to communi-cate information to those who are interested in a business.


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Problem#3

Read the following and respond to the questions provided:

“Fraud Victims”MiniScribe, a computer disk-drive manufacturer was in a mighty big hurry. After sevenconsecutive quarters of record-breaking profits, and the quintupling of its stock valueover the last 18 months, this was a company on a roll. In fact, the company wasdesperate for more cash in its rush to grow and was expediting efforts to raise $100million through the issuance of bonds.

After a somewhat frantic effort, the required financial statements and forms werecompleted and filed with regulators along with a clean audit report. The bonds wereissued and the future seemed assured. Life was sweet for management and investors

alike.

Unfortunately, MiniScribe's superlative record was actually more fantasy than fact.Within four years of the bond sale the company was forced to file bankruptcy andliquidate assets ultimately repaying bondholders less than $.50 on each original $1.00invested. Subsequent investigations revealed that the financial statements previouslycertified as accurate by the prestigious accounting firm of Coopers & Lybrand had beengrossly overstated. Fake sales and phony shipments to phantom customers and otherschemes had gone undetected as management perpetrated a massive fraud on its investorsand creditors. Lawsuits filed on behalf of bond and stockholders brought claims totalinghundreds of millions of dollars against MiniScribe's former chairman, Q.T. Wiles; the

company's investment bank, Hambrecht & Quist; and Coopers & Lybrand.

Malpractice suits against accounting firms are a common event in today’s business world.As more companies fail and stock values plummet investors are looking for someone to

blame and cover their financial losses. In recent years, virtually all of the largeinternational CPA firms have paid out millions to settle investor claims that they weremore interested in the companies that paid their audit fees than the investors who reliedon their work. Recent settlements over accounting malpractice "call into question theentire audit process," says John Shank, an accounting professor at the Amos Tuck schoolof business at Dartmouth College. At issue is the ability of auditors to serve the publicinterest given their inherent conflict of interests.

Court documents indicate that the partners at Coopers’ Denver office responsible for theMiniscribe audit were feeling significant economic pressure themselves. With a generaleconomic downturn and settlements on other audits gone wrong, the firm was sensitive tocustomer satisfaction. MiniScribe was an important office client. As a result, awillingness to “go along” with management or overlook certain accounting irregularitiesmay have prevailed.


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Problem #3 Answer

A. Who sued whom and why?

This article refers to lawsuits filed by bond and stockholders of MiniScribe against thecompany's management, investment banking company and the CPA firm that audited thefinancial statements. Bondholders, relying upon the information provided in the financialstatements, loaned approximately $100 million to MiniScribe. The financial statements

proved to be materially misstated and the bondholders and stockholders ultimately lost alarge part of their investment when the company subsequently failed.

B. What is an auditor's report and why is it important?

The auditor’s report is an independent verification as to the material accuracy of thefinancial statements. This report is critical because without it the financial statementshave no credibility - no one can rely on them.

C. Why should auditors be independent?

Auditors need to be independent because investors and creditors are going to rely on theauditor’s opinion relative to the accuracy of the financial statements.

D. Can auditors be truly independent and why?

Because companies pay their auditors there is always a conflict of interest. Auditors may be tempted to ignore management misstatement of the financial statements to maintainrelations with management and secure future audit fees. However, as the MiniScribearticle describes, such auditors face the risk of investor lawsuits and sanction or loss oflicense by the SEC and AICPA.

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