Introduction
15.501/516 Accounting
Spring 2004
Professor Sugata Roychowdhury
Sloan School of Management
Massachusetts Institute of Technology
Feb 4, 2004
1
Session 1:
Agenda
Administrative matters
Discussion of Accounting
Why is accounting interesting?
Why do we need accounting?
Course objective
Sophisticated financial statement
user
An overview of information in
financial statements
2
The required materials are:
5th Edition of Jamie Pratt
Financial Accounting In An Economic Context
Case Packet
Sloan Space
Syllabus
Schedule
Homework assignments
Textbook problem solutions
Sample exams
3
Few quick issues
Access to MITServer
MIT students
Non-MIT students
First point of contact: TAs
Best way to contact me: email
Syllabus:
Schedule conflict
April 26 material
4
Course Grading
Written Problem Sets 10%
Class participation 10
Midterm 1 20
Midterm 2 20
Final 40
5
Accounting Introduction
Discussion of Accounting
Why is accounting interesting?
Why do we need accounting?
Course objective
Sophisticated financial statement
user
An overview of financial
information
6
What is Accounting trying to do?
Demand for Information
Financial Accounting
provides information primarily to people outside the company
provides information that would be helpful in attracting capital
Equity and debt (useful in debt contracts)
Credit from suppliers
Customers
Employees
Managerial Accounting
provides information to people inside the company
Internal investment decisions
Performance evaluation
Tax Accounting
provides information to the tax authorities
7
Why do We Need Financial Accounting?
Resources
Today
Outsiders
- investors
Company
- employees
- suppliers
Resources
Tomorrow 8
Why do We Need Financial Accounting?
Financial
Financialaccounting
accountingpromotes
promotesthe
theexchange
exchangeof
ofresources
resources
Resources
Today
Outsiders
- Investors
Company
Information - Suppliers
(e.g., financial - Creditors
statements)
Resources
Tomorrow 9
Nature of Financial Accounting
Information
Useful to those making investment and credit decisions,
who have a reasonable understanding of business and
economic activities.
Helpful to
present and potential investors
creditors
other users
in assessing the amount, timing, and uncertainty of future cash
flows.
Provides information about economic resources, the
claims to those resources, and the changes in them.
10
How important is this information?
The Reaction of Walmart Stock to Announcement of 3rd Quarter Earnings
59.5
59
58.5
58
57.5
ST O C K PR IC E
57
56.5
56
55.5
55
54.5
54 11
1-Nov-03 3-Nov-03 5-Nov-03 7-Nov-03 9-Nov-03 11-Nov-03 13-Nov-03 15-Nov-03 17-Nov-03 19-Nov-03 21-Nov-03 23-Nov-03
DATE
Financial Accounting
Introduction
Discussion of Accounting
Why is accounting interesting?
Why do we need accounting?
Course objective
Sophisticated financial
statement user
An overview of financial
information 12
WHAT IS OUR COURSE
OBJECTIVE?
To become intelligent users of accounting
information
Be comfortable looking through an annual report
Learn the language and techniques
Begin to develop the ability to use financial
statements to assess a companys performance
Have a sense of the limitations of financial
statement data
What are not our objectives
to train you to be an accountant or bookkeeper
Financial Statement Analysis - take 15.535
13
World of a Sophisticated
Financial Statement User
Events are occurrences that affect the firm.
Examples include:
1) Microsoft sued by the Justice Department
2) McDonald's sells hamburgers
3) United Airlines workers go on strike
4) The GAP announces a new marketing strategy for
its Old Navy Clothing stores
14
World of a Sophisticated Financial
Statement User
Events / Actions
Rules
&
Management
choices
Financial Statements
15
World of a Sophisticated Financial
Statement User
Financial Accounting = translates events
into financial statements
Events
Generally
Accepted
Accounting
Rules
& Principals (GAAP)
Management
choice Management selects
from alternative rules
and from allowable
Financial Statements estimates under GAAP
16
Three keys to becoming a sophisticated
financial statement user
Understand the rules and managements
discretion
Understand what explains the rules and
the type of management discretion
Incentives
Understand how events affect firm value
17
Financial Accounting
Introduction
Discussion of Accounting
Why is accounting interesting?
Why do we need accounting?
Course objective
Sophisticated financial statement user
An overview of financial information
18
Accounting is complex and
interesting because
Diversity of businesses and events
Many different players
Diverse incentives
Economic
Other
Uncertainty
Many regulations
19
Financial Accounting
Introduction
Discussion of Accounting
Why is accounting interesting
Why do we need accounting?
Course objective
Sophisticated financial statement
user
An overview of financial
information
20
Financial Reporting
Requirements
Audited Annual Report (10-K)
Unaudited Quarterly Reports (10-Q)
Current Reports (8-K)
within 10 days of the end of a month
containing a significant event (e.g.,
major asset sales, changes in
ownership, bankruptcy, changing the
auditor)
Foreign Companies (20-F)
21
Focus: The Annual Report
The Management Letter
Management discussion on developments during the
year and current state of the company
The Financial Statements
The Auditors Report
22
Financial Reports:
The Auditor's Report
GAAS (Generally Accepted Auditing Standards)
Reasonable assurance that financial statements are free of
material misstatement
Assess the accounting principles used and significant
estimates made by management
Actual opinion
financial statements present fairly, in all material respects, the
financial position, the results of operations, etc.
are in conformity with GAAP (Generally Accepted Accounting
Principles).
23
Financial Reports:
The Auditors Report
Management responsible for
the preparation and integrity of the financial statements, etc.
Statements prepared in accordance with GAAP.
Estimated amounts based on management's best estimates
and judgments.
Maintenance of an internal control system to ensure that
assets are safeguarded and transactions are properly
authorized, recorded and reported.
The Board has an Audit Committee composed
entirely of outside directors
This committee appoints the auditor who has direct access
to the Audit Committee.
24
Financial Statements
Contain primarily historical Information
Balance Sheet
Assets, liabilities & owners equity
Income Statement
Revenue (-) Expenses = Net Income
Statement of retained earnings
Cumulative sum of undistributed profits
Statement of cash flows
Operating, Investing and Financing activities
Footnotes
Significant accounting policies, estimates, etc.
25
Financial Statements: Balance Sheet
Balance sheet is a statement of the
financial position of a business as of a
certain date.
Assets, e.g., cash, accounts receivable,
equipment, land
Liabilities -- amounts/services owed by the
company, e.g., loans payable, accounts
payable, customer advances, etc.
Stockholders equity -- initial investment by
the owners (capital stock -- common and
preferred stocks) plus the sum of
undistributed profits (retained earnings)
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Financial Statements: Income Statement
Income statement measures the performance of a
company over a period of time
Revenues -- a measure of economic benefits generated by
the sale of products or providing of services over a period
of time
Expenses -- a measure of economic sacrifices incurred to
earn the revenues of a given period
Examples of expenses -- cost of inventory sold, salaries to
employees, rent and lighting,, advertising, .......
Net income = revenues (-) expenses
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Dividends
Are dividends paid to owners considered an
expense?
Owners are residual claimants
Dividends are distributions to the owners out of the
profits earned by the business
In determining accounting profits to the residual
owners, we only subtract the costs of all factors of
production, e.g., physical capital (depreciation),
human capital (salaries), debt capital (interest
cost), etc.
Dividends are not a factor of production
28
Financial Statements: Retained
Earnings & Shareholders Equity
Retained earnings
A measure of undistributed profits of a business
Do not include capital contributed by owners
Retained earnings = Cumulative sum of profits
earned from the inception of business (-)
Cumulative sum of all dividends distributed to
the owners from the inception of business
Statement of shareholders equity describes the
change in retained earnings over a period of time
(e.g., a year)
Beginning balance in retained earnings
Add Net income earned during the period
Subtract Dividends distributed during the period
Ending balance in retained earnings 29
Summary
Accounting is a complex field contrary to
common perceptions.
Financial accounting information facilitates the
exchange of resources.
To become a sophisticated financial statement
user, you need to understand how the
information in financial statements is recorded.
30
Cost Allocation II
Death Spirals
15.501/516 Accounting
Spring 2004
Professor S. Roychowdhury
Sloan School of Management
Massachusetts Institute of
Technology 10
11
Allocation of Indirect Costs of a Cost Center
to Departments
Assume the following:
IT Department costs $100,000/month
5 Departments have equal access to IT services
Current allocation is $20,000/month to each
12
1
Allocation of Indirect Costs of a Cost Center
to Departments
Outside
Dept. Cost Charge Result
A $ 18,000 $ 20,000 Unhappy, wants out
B $ 22,000 $ 20,000 Happy
C $ 30,000 $ 20,000 Happy
D $ 30,000 $ 20,000 Happy
E $ 30,000 $ 20,000 Happy
Total $130,000 $100,000
13
Allocation of Indirect Costs of a Cost Center
to Departments
Outside Charge Charge Charge Charge
Dept. Cost 1st Iteration 2nd Iteration 3rd Iteration 4th Iteration
A $ 18,000 $ 20,000 exits
B 22,000 20,000 25,000 exits
C 30,000 20,000 25,000 33,333 exits
D 30,000 20,000 25,000 33,333 exits
E 30,000 20,000 25,000 33,333 exits
Total $130,000 $100,000 $100,000 $100,000 ???
This is a death spiral -- a positive feedback loop.
14
Allocation of Indirect Costs of a Cost Center
to Departments
Outside
Dept. Cost Charge
A $ 18,000 $ 20,000
B $ 22,000 $ 20,000
C $ 30,000 $ 20,000
D $ 30,000 $ 20,000
E $ 30,000 $ 20,000
Total $130,000 $100,000
Why might departments C, D, and E have a higher outside
cost than department A? Should they pay more for IT
services than A?
15
2
Allocating Costs to Departments
- General Points -
Charge cost center costs to departments based on % of cost
center products they use, so that these departments properly
incorporate cost center costs in their decisions.
Under-charging some departments for cost center use implies
that these under-charged departments are be subsidized by
other departments using the cost center
When a cost center is not operating at capacity, allocation of
the cost centers overhead costs may result in allocated costs
exceeding the cost of outside alternatives. Thus departments
purchase products from external parties.
Result in the firm overpaying for products.
16
The Issue of Joint Costs
A joint cost is incurred to produce two or
more outputs from the same input.
Consider a firm that produces fillets,
drumsticks and wings from chickens.
The chicken and the initial processing of
separating it into various parts costs $2.00
17
Joint costs - Split-Off Point
Split off point: the point beyond which further processing
has to take place for fillets, drumsticks and wings before they
can be sold.
Assume following data
Price Further Processing Cost NRV*
Fillets 2.40 (0.80) 1.60
Drumsticks 0.80 (0.04) 0.76
Wings 0.30 (0.16) 0.14
*Net Realizable Value
18
3
Joints Costs How To Allocate?
By weight seems appropriate
Weight in oz
Total Fillets Drumsticks Wings
Weight 32 16 12 4
%age weight 100% 50% 37.5% 12.5%
Allocated
Cost 2.00 1.00 0.75 0.25
19
Net Profits With Joint Cost Allocation
With weight-based allocation,
NRV Joint costs allocated Net Profit
Fillets 1.60 (1.00) 0.60
Drumsticks 0.76 (0.75) 0.01
Wings 0.14 (0.25) (0.11)
2.50 (2.00)
If input/output prices and yields are fixed, then it appears
optimal to drop wings
20
Joints Costs How To Allocate II?
Drop wings
Redistribute joint costs by weight across
fillets and drumsticks
Weight in oz
Total Fillets Drumsticks
Weight 28 16 12
%age weight 100% 57% 43%
Allocated
Cost 2.00 1.14 0.86
21
4
Joint Cost Allocation Death Spiral?
With weight-based allocation,
NRV Joint costs allocated Net Profit
Fillets 1.60 (1.14) 0.46
Drumsticks 0.76 (0.86) (0.10)
If input/output prices and yields are fixed, then it appears optimal to drop
drumsticks
With only fillets, joint cost allocation is easy!
NRV Joint costs allocated Net Profit
Fillets 1.60 (2.00) (0.40)
If input/output prices and yields are fixed, then it now appears optimal to
drop fillets!
22
Joints Costs & NRV
Allocate by proportion of NRV
Total Fillets Drumsticks Wings
NRV 2.50 1.60 0.76 0.14
%age NRV 100% 64% 30.4% 5.6%
Allocated
Cost 2.00 1.28 0.61 0.11
With above allocation,
NRV Joint costs allocated Net Profit
Fillets 1.60 (1.28) 0.32
Drumsticks 0.76 (0.61) 0.15
Wings 0.14 (0.11) 0.03
23
Joint Costs & NRV
Proportion of NRV (Net Realizable Value) is the
only correct way to allocate joint costs
Why?
Once the joints costs are incurred, the company is going
to have fillets, drumsticks and wings anyway.
As long as the profit margins on each of those products
are positive, the joint costs are essentially irrelevant in
deciding the relative profitability of product lines.
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5
Summary
Death Spirals result not just from overhead
allocations, but from cost-of-raw-material
allocations as well
In most or at least many cases, there are credible
alternate allocation methods to avoid death spirals.
Eg, joint costs should be allocated using NRVs
But one has to be careful!
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