Week 1: Foundations of Finance and Accounting

Week 1: Introduction

“Introduction… The Building Blocks… Overview of the Finance Principles… The Four Financial Statements… The Practice of Accounting…”
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Summaries

  • Introduction
  • 1.1 The Building Blocks of Accounting
  • 1.2 Overview of the Finance Principles
  • 1.3: The Four Financial Statementsl
  • 1.4 The Practice of Accounting

Introduction

  • People in the business world whose jobs entail something other than finance and accounting.
  • Probably aren’t familiar with process of accounting and the way that business finances run today.
  • We’re then going to move on and look at the four financial statements.
  • So what are they? How are they put together? What do they tell us? And how do we use them? From the financial statements, we’re then going to look into costing, how we determine the costs of things.
  • What something costs many times determines whether a business is feasible.
  • From there, we’re going to go on to financial ratios.
  • How liquid is the business? How able are they to pay off their, their upcoming debts? What’s this business what’s this business’ strengths? What are the business’ weaknesses? Many of these ratios are going to, work together to kind of give us a bigger overall picture of how a business is doing, and more importantly, to be able to evaluate, and compare similar businesses, or businesses in the sector.
  • We’re going to take those ratios into the next session, section, and we’re going to look at the valuation of a business, a business opportunity, or an investment.
  • What is a business worth? What is an investment worth? What’s a business opportunity worth? And this kind of is the, the pinnacle of finance where we start to, to value things and say this is what it’s going to be worth.
  • So that’s the general road map we’re going to follow on this course.
  • We are going to talk a bit about accounting and finance.

1.1 The Building Blocks of Accounting

  • So now we’re gonna talk about accounting and finance.
  • He went over to the board and he drew one dollar on the board, and he said in accounting this is one dollar.
  • Accounting, as we are about to see from the accounting equation, accounting deals with.
  • If you write that you’ve got $5 in accounting, you’ve got $5. Finance is really in the actual usage of money that you have.
  • You see in accounting, you can have negative a million dollars.
  • In accounting you just minus one million and there you go, negative a million dollars.
  • You see, I can’t as a person, actually have negative money in my pocket.
  • If I had negative a dollar in my pocket and I put a dollar in my pocket, by definition that dollar would just disappear.
  • I can actually owe $1,000,000, and yet still be walking around with $100 in my pocket.
  • What am I worth? I’m worth negative a million dollars, minus the $100 I’ve got in my pocket, right? In terms of finance, I’ve got $100. Right? This is the basic difference.
  • We’re going to go to what we call the accounting equation.
  • The accounting equation is the basic equation that defines all of accounting, and this accounting is assets equal liabilities plus equity.
  • Because this is the, the manifestation of the accounting equation.
  • Traditionally, the balance sheet was done with two sides, right? You had the left hand side, assets, and on the right hand side you’d have liabilities and equity.
  • This was left and right, and when you’re an accounting student, you actually start that way, because it’s important for us to see that left and right, because that left and right, it, it has other imp, implications for us.
  • You go out to the parking lot out here, you’ll see my car parked in the parking lot.
  • Right? But I haven’t paid the full $50,000 on that car, yet.
  • I’ve paid some of that car I’ve paid $30,000 of that car.
  • Now, I don’t just drive around the $30,000 part, I have the whole car.

1.2: Overview of the Finance Principles

  • The financial equation is, it’s really, it’s one equation but we are going to break it down into three because the, the one equation has some components to it that, that we want to be very familiar with.
  • Now the accounting, I’m sorry, the finance equation, basically, the bottom line of the finance equation is income equals revenue minus cost.
  • So what I make, my income, is my revenue, everything that comes in, minus what I had to pay, the costs incurred in getting that revenue.
  • Now because of that, we’ve actually got a couple of other equations, right? Because what is what is my revenue? Well, we got that equation.
  • Then we have to calculate costs and that’s actually, we’re going to be looking at that in detail in the next section.
  • Cost is fixed plus variable, two kinds of costs.
  • Now, we can now calculate our revenue, we can now calculate our costs, which means all we have to do is subtract our costs from our revenue, get our income, and this is the financial equation.
  • The accounting equation, assets equal liability plus equity.
  • The finance, the financial equation, income equals revenue minus cost.
  • Finance is, is using what we’re tracking to determine how we can get those costs reduced, how we can get that revenue increased, and how we can increase that bottom line of income, which equals revenue minus cost.
  • In the next section we’re going to look at costing, costing methodologies, how we do this.

1.3: The Four Financial Statements

  • So this brings us to the 4 Financial Statements.
  • Okay? The 4 Financial Statements that we use in accounting, and of course we also use in finance.
  • Now, what’s often considered the first of these statements, although they really aren’t in any particular order, is the balance sheet.
  • Of course, quarterly statements that are published, it’s at the end of every quarter we’re going to see the balance sheet of that business.
  • Okay? Well if the balance sheets shows us the accounting equation, then no sheet out there better shows us the financial equation than the Income Statement.
  • The Income Statement is different than the balance sheet in a couple of ways, well, in every way really.
  • Primarily the balance sheet, remember it’s a snapshot? The Income Statement takes place over a period of time.
  • What do you want? You can run an Income Statement from the very first transaction that was ever conducted in the business.
  • More often what we do is, we do Income Statements for quarters and Income Statements for a year.
  • So for the year ending, so what was the income generated by that business that year.
  • What were all the revenues minus all the expenses generating the income?
  • What’s the income for the quarter? What’s the income for the year? We specify the duration, the time frame that we’re going to look at.
  • Then during that time frame, the Income Statement, it lists all of the different sources of revenues, all of the different sources of costs and subtracts the costs from the revenues, arrives at the income.
  • How much money did we make? Now these are really the two principal financial statements.
  • The actual, as it says, the Cash Flow Statement, the flows of cash.
  • You see, because as we’re going to learn a little bit later, the reporting of income.
  • Okay when income is generated, when costs are occurred.
  • Every three months, I have to send a decent size check over to the state of California and send them all of the income, I’m sorry, all of the sales tax that I have collected during that period.
  • The, the sales tax that I collect is not income.
  • On my cash flow statement, we are going to see this.
  • We’re not going to see that in the income statement.
  • The tax that I pay is a cost on my income statement.
  • You’ll never see on my income statement, the inflow of cash of, of, of tax into my business.
  • On my income statement, I’m equally going to divide the cost of that truck over five years.
  • You’re not going to see that on the income statement.
  • You are going to see it in the statement of cash flows.
  • So although income is a driver of cash the income statement and the cash flow statement can differ and sometimes significantly.
  • One is to show us the income our business is doing, that’s the income statement.
  • The income that we’re getting, or the loss that we’re getting.
  • The final financial statement actually goes by many different names.
  • It can be called the statement of retained earnings.
  • This is the statement that shows us the nature of the equity that we have in the company.
  • So the statement of retained earnings or the statement of shareholder’s equity basically shows us the nature, that the amount and the nature of the equity.
  • The Balance Sheet, the Income Statement, the Cash Flow Statement and the Statement of Shareholder’s Equity or the statement of returned, retained earnings.
  • These are the statements that we use in analyzing, evaluating companies and doing our, our accounting.
  • Accounting is the department that puts those statements together.
  • Then finance often uses those statements to evaluate the business to see how the business is doing, to run the different ratios.
  • And investors use those statements to make their investment decisions. So I think there’s a lot to be learned about consumers in different parts of the world and how they interface with the tourism product.

1.4: The Practice of Accounting

  • We’re going to talk now about the way that accounting is practiced.
  • One of the very famous ones is U.S. GAAP, G, A, A,P, Generally accepted accounting principles.
  • These people, these organizations put out guidelines and enforce the rule, or help enforce the rules of accounting and make sure that accountants are accounting the way they should be.
  • So there’s these principles of what we do when we’re accounting for something.
  • Now the Historical cost Principle says that we record the value of an item at the price for which we acquired it.
  • If I go and buy a brand new car for $50,000, the moment I drive that car off the car lot, it’s not a brand new car anymore it’s a used car and now it’s just lost at least 10% of its value, it’s not worth more than 45,000 now.
  • So I buy a car and I put that on the books at $50,000.
  • Well, how about a year later? What’s it worth a year later? What’s it worth two years later? What’s it worth three years later? Well historical costs tells us it doesn’t matter.
  • As long as it’s on the books, the car is going to be worth $50,000.
  • One of these is well, the car is one of the items that we’re going to depreciate.
  • So we’re going to depreciate the car over time.
  • Therefore we’re going to have historical costs.
  • Then we’re going to have the cost net of depreciation.
  • So in the case of the car we actually are going to show the, the value of that car net of depreciation.
  • So every time that market value changes we can update the, the value of that on our books.
  • Well what’s the difference? How come I can do that with a stock or a marketable security, and I can’t do it with my car or with my building? To un, unlike my car, my building is probably worth more over time.
  • Well, the reason for this is, is because marketable securities, the value of them, is actually set by the market, and we can see that value in real time easily and instantly, right.
  • It costs me a lot to do it’s time consuming and therefore, I record my building at historical cost.
  • If I do that, then I can actually update my book value and I can record the actual the new value of my building as opposed to the past value.
  • You’ve got this this principle of historical cost.
  • We record things at the cost of which they were purchased.
  • So in accrual accounting, we don’t necessarily, we don’t account for things as they happen, which is called cash accounting, which is pretty much statement of, of cash flows, we don’t record them as they happen but as they accrue to the business.
  • I also accrue costs as they are incurred, so a cost that maybe I pay in 60 or 90 days, I accrue that cost on my books as it is incurred, okay.
  • That way we’re able to match the revenue and the costs, therefore the income of a business to the actual period in which it generated.
  • Depreciation, as I mentioned before, when I buy a car and I depreciate that over time.
  • I buy a car and that car is going to be used for my business and I have, I figure that the usable life of that car is five years.
  • I simply depreciate that car, I allocate the same amount of, of expenditure for that car to every month of my business for five years.
  • I’m matching the expense of that car to the use of that car.
  • The moment they purchase the item, my cost of goods sold is accounted for, right.
  • It matches the cost with the actual transaction and of course with the time.
  • My costs of goods sold will be very high this month.
  • So if we weren’t matching cost of goods sold to sales, I would show huge expenses in September and huge incomes and profits in December.
  • The Consistency principle says whatever kind of accounting you want to use.
  • There’s different ways to account for things, as we’ll see. When you cost, have a cost of goods sold, well I’ve got an item in my shop right now that comes from two different purchases, and because the size of those purchases varied, one of that item is at one price, and one of that item is another.
  • So if you walked into my shop today, and you bought one of those items, well, which cost of goods sold do I associate.
  • Do I associate the oldest one on the shelf, or the newest one on the shelf, or do I do something called average cost, the average cost of my shift, on my shelf.
  • Finally we have what’s called the cons, conservatism principal, saying that accounts, the financial statements, should be as conservative as possible, to not give an overly rosy view or an overly optimistic view of a business.
  • So in the next module we’re going to look at costing methods.
  • We’re going to look at how we cost our product, our service, and how that fits in to finance in general, and becomes part of our financial equation.

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