15.515 | Fall 2003 | Graduate

Financial Accounting

Lecture Notes


This section of the session road map below specifies the learning objectives you should achieve through (a) the assigned readings and homework, (b) the class discussion or lecture, or (c) the weekly T.A. session (if needed). Periodically, it also summarizes key concepts. You and your group can gauge your progress by assessing the extent to which you have met these objectives and understand the concepts.<

Class Preparation Questions

As these problems are related to the class discussion and often will be used as the basis of class discussion, they should receive your utmost attention. You may find it valuable to discuss these with your group members before class. Some questions refer to the Intel 2002 Annual Report, which is available for download from the Intel Web site. (PDF)


Overview and Introduction - Setting the Stage and the Course Framework (PDF)

Acknowledgement is hereby given to Professor G. Peter Wilson for his authorship of the following works incorporated into this slideshow:

  • The Five Challenges (slides 4-5)
  • “What Do Intel and Accountants Have in Common?” (slides 9-16)
  • A Conceptual Framework for Financial Accounting (slide 17)


1. Build a working relationship: What are our responsibilities?

2. Answer the following: What do accountants do and why is it important?

3. Understand the course objective and challenges, and our strategy to meet them.

4. Begin to gain an understanding of the course framework.

5. Understand how individual events affect financial statements.


Principles of Accrual Accounting (PDF)


1. Understand how accrual accounting differs from a cash basis.

2. Develop a mental model for classifying types of accounting accruals.

3. Understand how accruals affect the financial statement.

4. Become familiar with the basic bookkeeping model that illustrates how record keeping impacts the financials.

5. Understand the accounting cycle: 
a. recording events during the accounting period, 
b. end-of-period adjustments, 
c. closing entries, 
d. financial statement preparation.

Class Preparation Questions:

1. How do the Income Statement and the Balance Sheet relate to one another?

2. What does a firm’s ending balance of Retained Earnings represent? In Figure 4-11 on p. 167 of Pratt, Why does Net Income appear on both the Income Statement AND the Statement of Retained Earnings? Why does Ending Retained Earnings Balance not equal Ending Cash Balance on the Balance Sheet?

3. How do you determine what fiscal period a firm is using? Why would companies use something other than calendar year as a fiscal period?

4. From a financial reporting perspective, what’s the difference between consistency and uniformity? Why do U.S. accounting principles require the former but not the latter?

5. What is the difference between capitalizing and expensing a cost?

6. How is recognizing depreciation for PP&E an example of the Matching Principle?

7. Pratt E4-19 (we will do this in class).


Elements of an Annual Report and Financial Ratios (PDF)


1. Become familiar with the main parts of an annual report: 
a. CEO’s letter, 
b. description of business activity, 
c. management discussion and analysis, 
d. audit report, 
e. financial statements, 
f. description of accounting procedures, 
g. footnotes.

2. Understand the purposes of the four financial statements: 
a. balance sheet, 
b. income statement, 
c. statement of cash flows, and 
d. statement of owners’ equity.

3. Become familiar with the types of economic activity that are associated with common financial-statement line items, and thus the reasons why users of financial reports might find these items useful.

4. Understand the distinction between recognition and disclosure of information.

5. Begin to understand commonly-used financial ratios.

Class Preparation Questions:

Questions about the Intel 2002 Annual Report (PDF)


Revenue Recognition and Accounts Receivable (PDF)


1. Discuss the criteria for revenue recognition under accrual accounting: a firm recognizes revenue when it is deemed to be 
a. earned and 
b. collectible.

2. Introduce the different types of contra-asset accounts related to Accounts Receivable: Allowance for Doubtful Accounts (“ADA”), Allowance for Returns, and Deferred Income Liability.

3. Understand the three alternative methods used to calculate the Allowance for Doubtful Accounts: direct method, percentage of sales, and aging.

4. Work on a detailed example: reverse engineering Intel’s cash collections in 2001.

Class Preparation Questions:

1. What are the criteria necessary to recognize revenue?

2. Under what circumstances would managers have the incentive to manipulate the timing of revenue recognition? How would they do it? What risks are involved?

3. Instead of using an ADA (Allowance for Doubtful Accounts) account, why can’t we just subtract estimated future write-offs from the Accounts Receivable?

4. Problem E6-7 from the course textbook: J. Pratt. Financial Accounting in an Economic Context. 5th ed. John Wiley & Sons, Inc.

5. What is Intel’s revenue recognition policy?

6. How would you go about calculating Intel’s cash collections in 2002? (Hint: preview the class lecture notes).


Revenue Recognition


1. Reinforce and extend your understanding of revenue recognition.

2. Illustrate how accounting numbers can influence the operating decisions they reflect.

Class Preparation Questions:

In addition to the two questions at the back of Circuit City (CC), answer the following:

1. Show the BSE (Balance Sheet Equation) effects of the following events under the 3 accounting alternatives described on pp. 2 and 3.

a. On 1/1/90, CC sells a stereo for $1,000 cash. Cost of inventory is $900. Customer also pays $100 cash for 2-year warranty coverage, which CC expects to require $20 in parts and labor over that period (through 12/31/91).

b. 12/90, the customer brings the stereo in for inspection. Actual cost to CC is $8.

c. 12/91, the customer brings the stereo in again; actual cost to CC is $15.

2. Compare yearly and total Net Income (i.e., for 1990 + 1991) of the scenario posed above under the three accounting treatments.

3. How will Circuit City’s financial statements be affected if the FASB requires them to change the accounting treatment for extended warranty and product maintenance contracts? What additional information or assumptions would you need to estimate the dollar impact of this change?

4. As a user (lender, investor) of CC’s financial statements, how would you prefer they account for extended warranty contracts? Why?


Accounting for Inventory and COGS (PDF)


1. Understand three decisions related to accounting for inventory: 
a. Product Costing (managerial accounting). 
b. Cost-flows from inventory to Cost of Goods Sold. 
c. Valuation adjustments (after midterms).

2. Begin to understand these related issues: 
a. Alternative accounting rules (focus on LIFO and FIFO). 
b. Reporting consequences. 
c. Terms and concepts. 
d. Computations. 
e. Tax effects.

Class Preparation Questions:

1. What are the four major alternatives for calculating cost-flow (flow of value from inventory to COGS)? How do these relate (if at all) to the physical flow of products sold?

2. When costs are increasing over time, which assumption (LIFO or FIFO) results in higher reported Net Income? In a higher reported value for Inventory on the Balance Sheet?

3. What does “LIFO Reserve” represent? What causes it to increase or decrease?

4. Does Intel use LIFO or FIFO? Where would you find this information?

5. Calculate Intel’s 2002 Inventory Turnover ratio.


The Matching Principle and Long-lived Assets (PDF)

Concepts and Objectives:

1. Understand more applications of the matching principle: 
a. Allocating historical costs to future revenues. 
b. Accruing expenses related to outstanding obligations.

2. Understand the concept of “Depreciation” and the assumptions used to calculate depreciation.

3. Continue to learn how to reverse engineer related accounting entries from financial statement information.

4. Begin to understand and appreciate the Statement of Cash Flows.

Class Preparation Questions:

1. Explain how depreciating PP&E is an example of the matching principle.

2. When a long-lived asset is sold, how is the gain or loss (if any) determined? Why would a gain or loss arise? How would it affect the Income Statement and Statement of Cash Flows?

3. How is the Accumulated Depreciation account similar to other asset accounts you have seen in the past?

4. What was the value of Intel’s gross PP&E and accumulated depreciation at the end of 2002? What is Intel’s depreciation expense for 2002? How much PP&E did Intel purchase in 2002?

5. Pratt: E9-10 (straight-line only), E9-15 (parts a. and c. only, use the BSE instead of journal entries).


Matching Principle: Property, Plant, and Equipment


1. Reinforce and extend your understanding of accounting for property, plant, and equipment.

2. Better appreciate how the usage and judgment challenges are contextual, depending especially on the business, the individuals making decisions, and the regulatory environment.

Game Plan and Class Pedagogy:

Case discussion.

Class Preparation Questions:

Case preparation questions for Delta and Pan Am (PDF)


The Statement of Cash Flow (PDF)


1. Understand the purpose of the SCF.

2. Distinguish between the three sections of the SCF.

3. Understand the differences between the direct and the indirect SCF.

4. Understand how to derive the indirect SCF from the Income Statement and the Balance Sheet.

Note on Cash Flow Statements (PDF), with examples

XYZ Company (PDF): An Exercise for Preparing the Statement of Cash Flows using the Direct and Indirect Methods.

Class Preparation Questions:

1. Explain the differences between the direct and the indirect SCF.

2. Why is a company’s Net Income different from its net cash increase for the year?

3. In the Operating Activities section of the indirect SCF, why is depreciation expense added back into the cash flow?

4. In the Operating Activities section of the indirect SCF, why do you subtract an increase in an asset account such as Accounts Receivable?

5. Looking at Intel’s SCF, did Inventories increase or decrease in 2001? By how much? What about Intel’s Accounts Payable?

  Midterm Exam  

Class Preparation Questions:

1. Distinguish between the objectives of financial reporting and the reporting according to the Internal Revenue Code.

2. What is a temporary tax difference? What are some examples? What is a permanent tax difference? What are some examples?

3. What is the effective tax rate? Why might it be different from the statutory tax rate?

4. Why does the accelerated method of depreciation for tax purposes lead to a liability?

5. What was Intel’s provision for taxes in 2002? How much of it was current and how much was deferred?

6. Does Intel have net deferred tax assets or liabilities? What were Intel’s largest sources of deferred tax assets and liabilities? How much cash was paid during 2002 for income taxes?


Marketable Securities and Valuation Adjustments (PDF)


1. Understand when accounting departs from the “transactions-based” model and towards market-driven valuations.

2. Illustrate the role of judgment in applying the LCM rule for inventory.

3. Understand how marketable securities are valued on companies’ Balance Sheets.

4. Understand the Income Statement effects of valuation adjustments.

Class Preparation Questions:

1. When should market values be used in the valuation of assets and liabilities in the Balance Sheet?

2. Are there cash flow effects of the “mark-to-market” rule?

3. The former GAAP requires lower-of-cost-or-market in the accounting for marketable securities, applied on a portfolio basis. If managers have the incentive to increase earnings, what behavior is induced by this rule? How does “mark-to-market” mitigate this behavior?

4. The new GAAP gives discretion to managers on how marketable securities are classified, based on managers’ intent. Although most securities are marked-to-market, this new GAAP still allows securities (in particular, debt securities) to be carried at historical cost. Given this discretion in classification, does the new rule improve the ability of accounting to measure firm performance?

5. What was the market value of the Available for Sale securities held by Intel at the end of 2002? What was the original cost to Intel? What was the tax effect of the appreciation/depreciation?


Current Liabilities and Contingencies and an Introduction to Long-Term Debt (PDF)


1. Understand the nature and reporting requirement of short-term liabilities.

2. Illustrate the trade-off between reliability and relevance of accounting numbers in the accounting for contingencies.

3. Understand the time value of money and the mechanics of present value calculations.

Class Preparation Questions:

Accounting for Frequent Fliers Questions (PDF)

For current liabilities: What kind of current liabilities does Intel have? What types of contingencies does it disclose? How much did Intel accrue to cover contingencies?


Long-Term Debt (PDF)


1. Understand the terminology of long-term debt including par value, stated versus effective interest rate, discounts, premiums, and mortgages.

2. Understand how long-term debt affects the financial statements over time.


Debt and Valuation


1. Understand the role of judgment in determining valuation allowances.

2. Understand important factors that can influence this judgment.

3. Understand how various parties influence the reported numbers – the pressure they put on the reported numbers.

4. Reinforce your understanding of record keeping and reporting and search issues related to valuation allowances.

5. Introduce banking terms and concepts.

Class Preparation Questions:

First National Bank Corporation Class Preparation and Homework Questions (PDF)

Special Note: First National Bank builds on the previous three sessions and you should review the terms and concepts from those sessions. The class preparation questions will guide the case discussion. The economic activity for this session centers on credit analyses related to loans. The accounting decision is determining the allowance for bad debts, a decision that requires considerable judgment. The case refers to numerous users’ decisions that are affected by this accounting decision.


Leases (PDF)


1. Understand the rationale for leasing, and the distinction between operating and capital leases.

2. Understand the Income Statement and Balance Sheet differences between operating and capital leases. (Note: we will focus on accounting from the lessee’s perspective, not the lessor.)

Game Plan and Class Pedagogy:

Lecture and directed discussion.

Class Preparation Questions:

1. What are the operational and the financial advantages to a company to lease as oppose to purchase PP&E? What are some disadvantages?

2. What are the advantages and disadvantages of accounting for a lease as an operating lease versus a capital lease?

3. What are the accounting criteria for a capital lease?

4. Does Intel lease its PP&E under capital leases or operating leases? What was Intel’s lease expense in 2002? What is Intel’s minimum commitment under all its non-cancelable leases in 2003?

Class Preparation Problem:

1.  Leases: Capital vs. Operating (PDF)
2. Leases Blank Spreadsheet (XLS)


Stockholders’ Equity (PDF)


1. Understand the components of stockholders’ equity.

2. Understand the effects various transactions have on stockholders’ equity.

3. Better understand ratios based on stockholders’ equity.

4. Begin to understand the accounting for stock options.

Class Preparation Questions:

1. What are the components of Stockholders’ (Owners’) Equity?

2. What is EPS? How does diluted EPS differ from EPS?

3. What is Treasury Stock?

4. What are stock options? How do they affect stockholders’ equity?


Acquisitions (PDF)


1. Understand that the accounting method used for acquisitions depends on the extent to which the investor exerts influence over the investee.

2. Understand the effects of dividends received and investee income on the financial statements of the investor under the equity method.

3. Understand the effects of consolidated accounting on the balance sheet and income statement of the investor: 
a. Does an acquisition effect shareholders’ equity? 
b. What do minority interests on the income statement and balance sheet represent? 
c. How is goodwill computed?

Class Preparation Questions:

1. What are the differences between the equity method and the consolidation method?

2. What are the differences between the purchase and the pooling methods of consolidation?

3. How are minority interests treated under the consolidation method?

4. What happens if the fair market value of the assets of an acquired company is less than the purchase price of the company? How is this excess amount recorded on the Balance Sheet of the parent company?

5. How much did Intel pay for these acquisitions? What was the total market value of the assets acquired? What was the total amount of goodwill associated with theses acquisitions that Intel recognized in 2002?


Current Issues in Financial Reporting


1. Better understand issues associated with consolidated financial reporting.

2. Address recent accounting issues raised in the popular and financial press.

3. Give you time to learn deferred taxes, marketable security accounting, leases, etc.


Introduction to FSA


1. Synthesize your knowledge of financial reporting through a comprehensive case analysis.


Course Review and Wrap-up


1. To review the course framework and course material and preview related courses.

Class Preparation Questions:

Up to you and as needed to feel comfortable with your mastery of the course material.

  Final Exam  

Course Info

As Taught In
Fall 2003
Learning Resource Types
Lecture Notes
Problem Sets