Financial Accounting

Summary

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 Financial Accounting – Summary Notes
Financial Accounting – Summary Notes____________________________________________________1
Financial Statement Basics_____________________________________________________________3
Understanding of the 3 financial statements – (balance sheet, income statement and statement of cash
flows). What does each financial statement represent?______________________________________3
What is the structure of each statement?__________________________________________________3
What is the link between the three statements?_____________________________________________4
Understanding of the basic mechanics of financial accounting – (debits, credits, transaction journal
entries, adjusting entries, closing entries, t-accounts, trial balances and financial statements)________4
Balance sheet________________________________________________________________________6
How are assets and liabilities valued on the balance sheet?___________________________________6
What are the components of stockholders’ equity section?____________________________________6
How is US GAAP different from other countries?__________________________________________6
Income Statement____________________________________________________________________8
What is the difference between cash and accrual accounting?_________________________________8
When do I record revenues under accrual accounting?_______________________________________8
When I record revenue should I record other things as well?__________________________________8
When do I record expenses under accrual accounting?_______________________________________8
When do I record asset impairment charges under accrual accounting?__________________________9
When do I record restructuring charges under accrual accounting?____________________________10
Statement of cash flows_______________________________________________________________12
What is the purpose of this statement?__________________________________________________12
What is the format of the statement?____________________________________________________12
What sections does it contain? Where do certain items go on the statement?____________________12
Structure of cash flow statement_______________________________________________________12
How does US GAAP differ from other GAAP?___________________________________________13
How do I reconcile net income to operating cash flows? What is the intuition behind each adjustment?
_________________________________________________________________________________13
Analyze companies based on their statement of cash flows__________________________________14
Ambiguities in Classifying Cash Flows_________________________________________________16
Revenue Recognition_________________________________________________________________18
Revenue & Expenses vs. Gains & Losses________________________________________________18
Earned / Realized or Realizable?_______________________________________________________18
Revenue recognition at time of sale____________________________________________________18
Income recognition at times different from sale___________________________________________19
If I record the revenues, should I record other items as well?_________________________________19
“Profits you can trust”, chapter 3 – Revenue recognition____________________________________19
Inventory Accounting________________________________________________________________21
What is inventory? And basic definitions.________________________________________________21
What are the various methods of inventory accounting?____________________________________21
What is the difference between periodic and perpetual inventory systems?______________________21
Be able to explain LIFO and FIFO?____________________________________________________21
What is the LIFO conformity rule and how does this differ from depreciation methods?___________22
What is the LIFO reserve?____________________________________________________________23
What does it mean to liquidate LIFO layers? What will be the impact on the financial statements?
Why? Explain, “holding gains”._______________________________________________________23
How do we adjust financials of two companies that might be on different methods?______________23
What is the impact of LIFO versus FIFO on cash? Revenues? COGS?________________________24
What happens if prices are decreasing?__________________________________________________24
Depreciation Accounting______________________________________________________________25

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 What are the different methods of accounting?____________________________________________25
Why do companies pick one over the other? What is the relationship of depreciation methods to
taxes?____________________________________________________________________________25
How is depreciation calculated?_______________________________________________________25
What is straight line?________________________________________________________________25
What is an accelerated method? What are some examples?_________________________________25
What is the units of production method?_________________________________________________26
How does the company decide on useful life? Is it the same as physical life? Could it be?_________26
What is residual value? What is salvage value? Could the salvage value be negative? Explain.____26
What happens when a company changes its depreciation estimates?___________________________26
What happened when a company changes its depreciation methods?__________________________27
Contingent Liabilities________________________________________________________________28
What are liabilities?_________________________________________________________________28
What are contingent liabilities?________________________________________________________28
When do you record a contingent liability on the balance sheet?______________________________28
When do you record a contingent liability in the financial footnotes?__________________________28
What are the most common examples of contingent liabilities?_______________________________29
Other liabilities on the company’s books________________________________________________29
Capital leases versus operating leases___________________________________________________30
What is a capital lease?______________________________________________________________30
What is an operating lease?___________________________________________________________30
When do we record one versus the other?________________________________________________30
What is the impact on the company’s financials of recording a lease? Balance sheet? Income
Statement? Cash Flow Statement?_____________________________________________________31
How can we compare companies that have a lot of operating leases to those that have a lot of capital
leases?___________________________________________________________________________31
Why does a company lease instead of buy?______________________________________________32
Rule based versus principles based accounting treatments?__________________________________32
Stockholders’ Equity_________________________________________________________________33
What is c/s and APIC? What is par value?_______________________________________________33
What is Retained Earnings? What is Accumulated Deficit?_________________________________33
What is Treasury Stock? How does the purchase and resale of treasury stock get recorded? On the
B/S? On the Income Statement? On the Statement of Cash flows?___________________________33
Why do companies repurchase their shares?______________________________________________34
What is “Other Comprehensive Income”?_______________________________________________34
What is preferred stock?_____________________________________________________________35
How does dividend get recorded?______________________________________________________35
What is a cumulative preferred stock? What is a convertible preferred stock?___________________35
What is a convertible debt security? How does it get recorded on the financials?________________35
Acquiring marketable securities and companies (M&A accounting)__________________________37
What are the cost method, equity method, and consolidation?________________________________37
How do you treat dividends received in the equity method?_________________________________40
What is minority interest? Where does it show up on the company’s financials?_________________40
What is the treatment for M&A transactions?_____________________________________________41
What is goodwill? How is it treated in the US and outside of the US?_________________________41
Effect of accounting transactions on the statement of cash flows_____________________________42
Ratio Analysis_______________________________________________________________________45
What are ratios? What should you understand about ratios?_________________________________45
What are the major ratios?____________________________________________________________45
What is the DuPont equation? What information does it provide?____________________________45
What are common size income statements and common size balance sheets?____________________45
How do you identify industries based on the ratios?________________________________________45

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Page 4 of 48
Financial Statement Basics
Understanding of the 3 financial statements – (balance sheet, income
statement and statement of cash flows). What does each financial
statement represent?
The Balance Sheet (BS) presents a firm’s investments and financing at a moment in time. 
What is the financial position, or financial health, of a firm?
The Income Statement indicates the net income for a period of time (profit margin = net income /
revenues).  How profitable is the firm?
The Statement of Cash Flow reports the net cash flows derived from operating, investing and
financing activities for a time period  Is the firm generating sufficient cash flows from its
customers to finance operations and to acquire buildings and equipment or must it seek
new funds from lenders or owners?

What is the structure of each statement?

Balance Sheet
Investing Financing
Assets = Liabilities + Shareholders’ Equity

Assets are economic resources with the ability or potential to provide future benefits to a firm.
Current assets (e.g. cash, short term securities, accounts receivable, inventories) are consumed
or turned into cash within one year of the date of the balance sheet.
Liabilities are creditors’ claims on the assets of a firm and show the sources of the funds used to
acquire the assets. Current liabilities require payment within one year, long-term debt within more
than one year. Firms typically finance current assets with current liabilities and vice versa.
Shareholders’ equity shows the amounts of funds owners have provided and their claims on the
assets. Shareholders’ equity comprises contributed capital (e.g. common stock, additional paid in
capital) and retained earnings.

Income Statement
Revenue – Expenses = Net Income

Cash Flow Statement

3 sections:
Operating
Investing
Financing

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What is the link between the three statements?

Relation of Income Statement to Balance Sheet

Income Statement links the balance sheet at the beginning of the period with the balance sheet
at the end of the period. Balance sheet amount for retained earnings represents the sum of
prior earnings of a firm in excess of dividends. The amount of net income helps explain the
change in retained earnings for the period.
Retained Earnings (Start of Period) + Net Income for Period – Dividends Declared and Paid =
Retained Earnings (End of Period)

Relation of Cash flow Statement to Income Statement and Balance Sheet

CFS explains the change in cash between the beginning and the end of the period. The
statement of cash flows also sets forth the major investing and financing activities for the
period. Thus the statement of cash flows also helps explain changes in various items on the
comparative balance sheet.
The statement of cash flows parallels the income statement by showing the relationship
between net income and cash flow from operations. Income can be rising but cash flow can
still decline if the business does not collect cash from its customers.

Summary
Financial Position – Balance Sheet
Profitability – Income Statement
Cash generating ability – Statement of Cash Flows

Understanding of the basic mechanics of financial accounting – (debits,

credits, transaction journal entries, adjusting entries, closing entries,
t-accounts, trial balances and financial statements)

Accounting Process
 Journalizing in General Journal
 Periodic Posting to Appropriate Accounts
 Preparation of unadjusted trial balance
 Correction and adjustment of trial balance
 Preparation of financial statements
Typical Journal Entry
Date
Account Debited $Debit
Account Credited $Credit
Explanation of transaction or event being journalized

e.g
Date
Cash $Debit

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 Equipment $Credit
Purchase equipment costing $X in cash.

Posting happens periodically (e.g. weekly or monthly). Amounts from General Journal are
posted to the General Ledger. T-Accounts are used.
Trial Balance Preparation: Lists accounts in general ledger with a trial balance as of a particular
date. Equality between sums of debit account balances and credit account balances helps check
the accuracy of arithmetic.
Trial Balance After Adjustment and Correction: Errors and omissions. Unrecorded events.
E.g pre-paid items such as insurance, the costs of which are accrued over the life of the policy.
Normally done by preparing a journal entry.
Financial Statement Preparation: Can be done after corrections and adjustment.

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Balance sheet
How are assets and liabilities valued on the balance sheet?

Asset valuation
Methods:
Acquisition (historical) cost; current replacement cost, current net realizable value, present value.
Monetary assets generally appear on the balance sheet at their net present value, their current
cash or cash equiavalent value. E.g. cash, marketable securities, accounts receivable.
Noncurrent monetary assets are therefore discounted.
Nonmonetary assets (e.g. merchandise inventory, PPE) generally appear at acquisition cost, in
some cases adjusted downward to reflect that the firm has consumed some of the assets‘
services and, in others, to recognize some declines in market value. Note impairments,
depreciation or holdings losses or mark-to-market.

Liability valuation
Most liabilities are monetary. Those due within one year or less appear at the amount of cash the
firm expects to pay to discharge the obligation. If long term (due in more than one year), e.g long
term bonds appears at the present value of the future cash outflows.
Nonmonetary liabilities: a liability that involves delivering goods or services other than cash. E.g.
a warranty, cash advance. Such a liability appears on the balance sheet at the estimated cost, a
cash advance appears at the amount of cash received.

What are the components of stockholders’ equity section?

Common Stock: amounts received equal to the par or stated share value
Preferred Stock: amounts received for stock that has some preferences
Additional Paid-in Capital: received amounts in excess of par or stated value
Retained Earnings: increase in net assets due to generated earnings.
Treasury Shares: the cost of shares reacquired by the firm itself.

How is US GAAP different from other countries?

Structure of the balance sheet

US GAAP
Current assets
Noncurrent assets
Current liabilities
Long-term debt / liab.
Shareholders equity
Other countries
Noncurrent assets
Current assets
Shareholders equity
Long-term debt / liab.
Current liabilities

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Terms used for accounts
US
- Property, Plant Equipment
- Investment in securities
- Accounts receivable
- Cash
- Common Stock
- Additional paid-in capital
- Retained earnings
- Bonds payable
- Notes payable to Banks
- Accounts payable
Other countries
- Tangible Fixed Assets
- Financial Assets
- Trade receivables
- Liquid funds
- Subscribed capital
- Capital reserve
- Profit reserves, Net income available for
distribution
- Bonds
- Due to Banks
- Trade payables

Mark to Market versus Historical Cost

Some countries allow firms to mark fixed assets (PPE) to market whilst in the US this is only
allowed for Marketable Securities (Trading Securities and Available for Sale).

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Income Statement
What is the difference between cash and accrual accounting?
Cash accounting: measures the performance of a business from the selling and provision of
goods and services based on the cash received from customers.
Problems with cash accounting:
 Inadequately matches inflows and with the outflows and efforts associated with them.
 Unnecessarily delays the recognition of revenues (revenue is recognized only when cash is
received).
 Provides opportunity to distort the measurement of operating performance (by delaying
payments to suppliers at the end of an accounting period, for example)
Hence, we use accrual accounting, which recognizes revenue when a firm sells goods or renders
services. Expenses are measured using the matching principle, whereby cost expirations are
matched to revenues (or economic benefits).

When do I record revenues under accrual accounting?

Revenues are recorded when they are earned and realizable. This is defined as follows:
Earned: A firm has performed all, or most of, the services it expects to provide.
Realizable: The firm has received cash or some other asset such as a receivable,
whose cash equivalent can be measured with reasonable precision.
The above is taken from Stickney and Weil.
Another variation of the definition is that revenues are recognized when it is ‘realized or realizable
and earned’. To achieve this standard the following criteria must be met:
 Persuasive evidence of a sales agreement exists
 Delivery has occurred or services have been rendered
 The selling price is fixed or determinable
 Collection is reasonably assured.
The above points come from SEC Staff Accounting Bulletin 101, which was issued in 1999.

When I record revenue should I record other things as well?

If a firm recognizes revenues in a period before it receives cash it should also take the following
factors into account in determining how much of the total revenue to recognized.
Uncollectible accounts; i.e. some people will not pay – estimate how many will likely not pay
based on previous experience.
Sales Discounts and Allowances – Some customers may be provided with discounts for prompt
or early payment.
Sales returns – Some customers may return the goods for refund.
Each of the above must be reliably estimated and the amount of revenue recognized is reduced
as appropriate.

When do I record expenses under accrual accounting?

As assets provide future benefits to a firm, expenses measure the assets consumed in generating
revenue. Expenses are ‘expired costs’ or gone assets.

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Criteria for expense recognition:
 Matching principle – If particular revenue causes an asset to expire, that expiration becomes
an expense in the period when the firm recognizes the revenue. This treatment – the
matching principle – matches cost expirations with revenues.
 If no particular revenue causes an asset to expire, that expense becomes an expense of the
period in which the firm consumes the benefits of that asset in its operations.
Examples…
Product costs: Cost of goods sold is recognized as an expense when a firm sells the goods. A
firm which buys raw materials and through its operations transforms them into a finished product
only recognizes the direct material cost, direct labor cost and manufacturing overhead cost as
expenses when the goods are sold, not when they are purchased and paid for. (Matching
principle.)
Marketing costs: Relate primarily to the revenues of the period and these are thus recognized
as expenses in the period that they occur. They are thus referred to as period expenses. It could
be argued that certain marketing costs (e.g. advertising) produce a future benefit and should thus
be treated as an asset (AOL famously did this in the mid 1990’s and was later sued by the SEC).
Hence most accountants have a problem to quantify the future benefit (if there is one at all),
hence in normal situations marketing costs are recognized as expenses in the period in which
they are incurred. They are normally classified under Sales and General Administrative
Expenses (SG & A) by US listed companies.
Administrative costs: E.g. presidents salary, accounting and IT system costs are recognized in
the same way as marketing, i.e. as period expenses and are also generally classified under
SG&A.

When do I record asset impairment charges under accrual accounting?

Asset impairment – GAAP require a three-step measurement process for measuring impairment
on assets other than intangibles not requiring amortization.
1. Compare undiscounted future cash flows from the assets with their book value (e.g. a
property which is rented out). The impairment loss is the amount of the book value,
which exceeds their fair value (either present value of the future cash flows or market
value).
2. Compare book value to market value. Impairment loss is the excess of book value over
market value.
3. At the time the firm judges an impairment loss has occurred, the firm writes down the
book value of the asset to fair value. Fair value being 1) market value or 2) if the firm
cannot assess market value, the net present value of the expected future cash flows.

The journalizing process is as follows:

Date
Accumulated depreciation $Total amount of Accumulated Depreciation attributed to the
asset since acquisition
Asset e.g. Building – (New Valuation) $New value of the building
Loss on impairment $Difference between book value and fair value
Asset e.g. Building – (Book Valuation) $Current book value of asset (normally acquisition cost
of asset minus any impairment losses recognized
previously)

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Effect on different statements:
Balance Sheet Decreases assets by amount of impairment loss
Decreases shareholders equity. (Retained earnings?)
Income statement Appears a loss on income statement
Cash flow statement Need to increase net income by amount of impairment loss since its not a cash
flow

When do I record restructuring charges under accrual accounting?

Restructuring charges are constructive liabilities.
A constructive liability arises not from an obligation but from management intent. For example,
intent to close a plant, layoff employees and to make severance payments in amounts not yet
determined. These are often referred to as restructuring charges and journalized as follows:
When liability is recognized:
Date
Restructuring Charges $Total amount expected to be incurred in the event
Liability for severance pay to $Total amount expected to be incurred in the event
employees

When liability is incurred (i.e. paid)

Date
Liability for severance pay to employees $Total amount consumed by the event
Cash $Total amount consumed by the event

Sometimes, a constructive liability may be overestimated. In that case, the following is done to
reverse part of the initial charge.
Date
Liability for severance pay to employees $Total amount expected to be incurred in the event
Reversal of Restructuring Charges $Total amount expected to be incurred in the event

Reversal appears in income at the end of the year and is hence open to abuse by management.
Some companies take a ‘big bath’ by overestimating restructuring charges associated with a
planned event and afterwards reverse the amount not required in the restructure to boost income
in a subsequent period. Analysts and investors hence do not like to see companies do this and
are generally pleased to see a company make accurate estimates of restructuring charges.

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Effect on different statements of constructive liabilities can be summarized as follows:
Statement At estimation of When liability is incurred At estimation of liability
liability
Balance Sheet Increase liabilities by Decreases liabilities Decreases liabilities
amount estimated
Decreases cash Decreases shareholders
Decreases equity (through retained
shareholders equity earnings)
(through retained
earnings)
Income statement Appears a loss on No effect (already accounted Increases net income
income statement for as an expense when
estimated)
Cash flow statement Need to increase net Need to decrease net Need to increase decrease
income by amount of income by actual amounts of net income by amount of
estimated. cash paid. reversal.

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Statement of cash flows
What is the purpose of this statement?
Net income for a particular period does not equal cash flow from operations (due to accrual based
accounting; recognition of revenue on sale (not receipt of cash). The use of accrual accounting
therefore creates a need for a separate statement that reports the impact of operations on cash
flows.
Firms experience cash inflows and outflows from investing that do not appear directly on the
income statement. E.g. capital expenditure,
The statement of cash flows, hence explains how firms obtain and use their cash.

What is the format of the statement?

Direct format:
 Always start with ‘Cash received from customers’

 Looks more like a summary of from operating cash B/S account

 Few companies use this method, since they are required to also present a statement
describing reconciliation to indirect format

Indirect format:
 Always starts with ‘Net Income’

 Needs to be adjusted to account for non-cash revenues and expenses (see below for
details)

What sections does it contain? Where do certain items go on the

statement?
The statement explains the reasons for the change in cash between balance sheet dates.
Includes cash and cash equivalents. Cash equivalents are short-term highly liquid investments;
such as stocks and shares of publicly traded companies.
The reasons for changes in cash are classified as operating, investing or financing activity.
Cash Flows from Operations: Cash flow from operations (selling goods and providing services).
Excess cash from operations can be used to acquire long-term assets, retire long-term debt and
conduct other investing and financing activities.
Cash flows from Investing: Acquisition of non-current assets, especially PPE (CAPEX). Buying
and selling of securities and notes receivable. Growing firms will often need to borrow funds to
finance acquisitions of non-current assets.
Cash flows from Financing: Cash from short and long-term borrowing and from issues of
common or preferred stock. Payment of dividends. Interest payments on debt. Re-acquisition of
shares of common or preferred stock (treasury shares).

Structure of cash flow statement

Company X Year Ended 31 January

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Comparative Statement of Cash Flows 1998 1999

Operations
Net Income
Depreciation
(Increase) in accounts receivable
(Increase) in Inventories
(Increase) in prepayments
Increase in Accounts Payable
Increase in other current liabilities
Cash flow from operations
Investing
Acquisition of property plant and equipment
Acquisition of property plant and equipment
Realized Gains (Losses) on Investments
Cash flow from Investing
Financing
Increase (decrease) in short-term borrowing
Increase (decrease) in long-term borrowing
Increase in common stock
Acquisition of common stock
Dividends
Cash flow from financing
Change in cash
Cash, Beginning of year
Cash, End of year

How does US GAAP differ from other GAAP?

IAS specifies using same 3 classifications of usage of cash.
In US GAAP interest payments are included in Operating section. In US interests on large
construction projects are capitalized, therefore appear in investment section (they are considered
as costs to get the asset ready). As a consequence: i) those interests appear on investing
sections and ii) some of those interests can be moved to Income Statement through depreciation
of the capitalized costs.

How do I reconcile net income to operating cash flows? What is the

intuition behind each adjustment?
Net income is adjusted by the amount of non-cash transactions that either reduce or increase net
income to the net amount of cash generated from operations in a given period.
Cash Change Equation:

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Cash = Liabilities + Shareholders Equity – Non-cash Assets

Indirect method
CFS starts with ‘Net Income’.
We must adjust for all non-cash revenues and expenses included in I/S, i.e.:

 Add back depreciation => non-cash item

 Add provisions/reserves => no cash out

 Subtract increase in Working Capital Requirement (WCR=AR+Invent+Op. cash+prepaid

exp-AP-deferred exp/payables) => these revenues and expenses were recorded in the
I/S (revenues when earned and realized / expenses to match those revenues) but:
o Some revenues in Net Income included sales not yet paid for: ∆AR  no cash in

o Some expenses (COGS) included stuff bought on credit: ∆(Inv-AP)  no cash

out

 Add all other ∆accrued expense => no cash out

 Subtract all other ∆accrued revenue => no cash in

Direct Method:
Obtain Balance Sheets for the start and end of the period covered by the statement of cash flows
Prepare a T-Account Work Sheet
Explain the change in the master cash account between the beginning and end of the period by
accounting for the change in each non-cash account in the period.
Use T-Accounts to prepare formal statement of cash flows.

Analyze companies based on their statement of cash flows

SCF helps to illustrate:
1) Impact of Operations on Liquidity
2) Relations among cash flows from Operations, Investing and Financing section
Explanations of each follow:
1) Growing firms often have a lag between cash outflows and cash inflows (and hence a lag
between earnings and cash flows). Successful growing businesses hence need constant
financing from debt or equity to cover perpetual short-term needs. The more successful
the firm becomes the more sources of long term funds it will need.
Sometimes a firm which is reducing the scope of its activities can experience an increase
in cash flows due to collection of accounts receivable from prior periods without the need
to replace inventory, thus saving cash.
2) Relationships on each of the 3 business activities differ depending on the nature of its
business and maturity of its industry.
a. Rapidly growing firm:
i. Negative cash flow from operations due to build up of inventory and
accounts receivable.
ii. Heavy investments in PPE to sustain growth, hence negative cash flow
from investing.

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 iii. Sources of cash from external financing (debt and equity)
b. Steadily growing firm
i. Profitable as growth has begun to slow, hence positibe cash flow from
operations
ii. But cash flow from operations falls short of the amount required to
finance investments in PPE.
iii. The firm hence requires sources of external financing.
c. Mature Stable Firm
i. Healthy cash flow from operations
ii. Cash flow from operations sufficient to cover expenditures on PPE
(investing).
iii. Excess cash used to repay financing from earlier period and perhaps to
pay dividends
d. Firm in early stages of decline
i. Cash flow from operations has begun to decrease but remains positive
due to decreases in accounts receivable and inventory. (In the latter
stages of decline cash flow may turn negative due to falling sales.)
ii. It cuts back significantly on capital expenditure.
iii. Extra cash used to repay financing and the remainder is available for
investment in new products or industries.

Relationship of cash flow statement to phase of growth cycle

Introduction phase
 Negative cash flow from operations
 Negative cash flow from investing (building capacity)
 Reliance on external finance (likely more equity than debt)
Growth phase
 Net income turns positive, but due to increased working capital requirements, cash flow
from operations is still negative.
 Investing continues
 Reliance on financing from equity and long-term debt.
Mature phase
 Net income peaks and working capital stops growing, hence positive cash flows from
operations.
 Investments in PPE are financed from cash flow from operations.
 Excess cash used to repay borrowing and dividends to shareholders.
Weakening profitability/decline
 Cash flow from operations can still be positive as accounts receivable and inventories
decrease
 Cash flow from investing turns positive as assets are liquidated
 Excess cash used to repay borrowing or for diversification into other areas of business.

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Other information on cash flow statement analysis

Operating Section
o Operating activity is the engine of the company. Therefore we expect it to be
positive. In healthy, growing company, we expect ∆WCR to be positive to cover
growth in sales even if there can be short-term variations.
o Operating CF can be negative in startups (engine not up to speed) or in ‘down’
year of cyclical business

 Firstly, look at sign of CF (positive, null or negative) and trend (increasing, flat,
decreasing)

 Secondly, check if operating cash covers needs for investments –capex- and interest
payments (tempered by understanding of company and situation, eg startup).

Investing section
o Healthy companies are expected to continually invest in PP&E, land and other
FAs to expand and grow. Even if they often sell assets, we expect Investing
section CF to be negative.
o Temporary exceptions can occur when firms divest businesses or subsidiaries.

 Firstly, consider amount of cash invested. In healthy, mature business, firms invest
enough to keep company “whole” (ie to replace assets that are used up). Very rough
surrogate for FA replacement needs is amount of yearly depreciation. However since
prices are rising, we would expect investing activities to exceed depreciation.

 Secondly, look at other major cash needs or discretionary items. Do they fit with
availability of cash? Is the company likely to be able to continue funding? Could it hurt the
company?

Financing section:
o Financing CF can be either positive or negative and is expected to go back and
forth, depending on need for companies to get raise founds through debt or
equity issuance to finance operating activities.

 Firstly, look how financing CF fits with the rest of activities: How does the company
finance its cash needs? How does it invest excess cash?

 Secondly, analyze how cash shortfalls could be better funded (stock issuance, borrowing,
sell of assets…)? Consider sustainability of this solution (ability to continue raising debt,
impact on ratios…)

Overall remarks:
Use all evidence to build big picture. Not all news will be positive or negative. Assess importance
of each piece of evidence relative to big picture.

Ambiguities in Classifying Cash Flows

Cash received from interest and dividends might be classified as an operating activity. This is
because these items appear as revenue in the income statement. But cash from interest and

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dividends might also be in the investing section. Logic: cash flows from investments should be
classified as investing activities.
FASB Statement of Accounting Standards 95 requires that firms classify the receipt of cash from
interest and dividend revenues as an operating activity but the cash related to the purchase and
sale of investments in securities as an investing activity.
Similarly, interest expense is treated as an operating activity but the issue and redemption of debt
as a financing activity. Dividends that a firm pays are classified as financing activity. Rationale:
accountants treat interest as an expense when computing net income whereas dividends
represent a distribution of assets generated by net income, not an expense reducing net income.

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Revenue Recognition
Operating Process for a Manufacturing Firm

Acquire raw Acquire labor and other Sell product Collect cash Returns and
materials, plant manufacturing services warranty periods
and equipment and convert raw expire
materials into products Period of holding receivable
Period of production Periods of returns and warranty services

Revenue & Expenses vs. Gains & Losses

Recurring (Creation and sale of firm’s Revenue /
regular products) Expenses
Primary operating
activity Nonrecurring (Income from sales of
product or lines of business that the
firm intends to discontinue)
Recurring (e.g. periodic sales of Gains /
Peripheral to equipment previously used in Losses
primary operating manufacturing)
activity Nonrecurring (e.g. losses from
earthquakes or hurricanes)

Earned / Realized or Realizable?

Revenues get recorded when:
EARNED: Performed or substantially performed responsibility. In the case of goods, legal title has
been, or is on the verge of being, transferred to a willing buyer; in the case of service, the service
in question has been rendered.
Payments REALIZED or REALIZABLE: Collection of money reasonably assured.

Revenue recognition at time of sale

Accounting for uncollectible accounts as expenses:
 The amount of uncollectible accounts is estimated by the percentage-of-sales procedure or
the aging-of-accounts-receivable procedure (SW p. 327...)
 Direct Write-Off Method recognizes losses from uncollectible accounts in the period when a
firm decides that a specific customers‘ are uncollectible.
 Allowance Method involves estimating the amount of uncollectible accounts; the firm
recognizes this amount as an expense in the period of the sale, thereby matching expenses
with associated revenues.
The amount of sales discounts the seller expects the customers to take appears as an
adjustment in measuring net sales revenue.
In case of sales returns GAAP do not allow a firm to recognize revenue from sales when the
customers have the right to return goods unless the firm can reasonably estimate the amount of
returns and uses an allowance method to do so.

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When delivered goods are unsatisfactory or damaged the price charged to the customer might be
reduced by sales allowances; the resulting revenue reductions are recorded as an adjustment in
a separate sales revenue contra account, Sales Allowances.

Income recognition at times different from sale

Percentage-of-completion method bases the amount of revenue, expenses, and income on the
proportion of total work performed during the accounting period; the actual schedule of cash
collections does not affect the revenue recognition process. When the construction period does
not span several accounting periods firms use the completed contract method. Because of the
more timely reporting of operating performance in the percentage-of-completion method, GAAP
require the use of this method whenever firms can make reasonable estimates of revenues and
expenses; on the other hand most analysts view earnings reported under the completed contract
method as more accurate.
Most insurance companies recognize revenues and expenses during each period of insurance
coverage. The receipt of cash from policyholders and from investments creates a relatively high
degree of certainty regarding the amount of revenue. Insurance companies must, however, match
against this revenue each period a portion of the ultimate cash outflow to satisfy claims.
If the seller cannot reasonably estimate the amount of cash it will receive it may use one of the
following two reporting methods. Installment method recognizes revenue as the seller collects
parts of the selling price in cash; in parallel, this method recognizes as expenses each period the
same portion of COGS as the portion of total revenue recognized. The cost-recovery-first method
allows income to appear in the income statement only if accumulative cash receipts exceed total
costs.

If I record the revenues, should I record other items as well?

When revenues include future commitments, e.g. warranty, they can only be recorded in whole
when the estimated amount of outstanding provisions is booked at the same time. This account
includes the accrued expenses for e.g. sales discounts, returns or allowances that will appear in
future periods.

“Profits you can trust”, chapter 3 – Revenue recognition

Companies tend to report unrealistic high revenues in order to demonstrate a big volume of
business and to appear attractive for investors; bonus for sales men often depend on their
amount of revenues. The following describes ways taken from real examples how companies
have handled revenues:
 Manufacturers record revenues for a completed product and expenses for the inventory. But
Goods shipped on consignment cannot be booked as revenue!
 Channel stuffing: Retailer used as a warehouse, shipped goods recorded as sold.
 Grossing up: If an agent records as revenues the gross booking and not only his earned fees;
this happened a lot during the New Economy boom phase when the „critical mass“ – a large
customer bass corresponding to high revenues – was more important than profit.
 According to SEC revenue should be matched against costs associated with it; if a product is
sold including a long-term service contract revenue for the service should not be booked
before the service is rendered.

Page 21 of 48
 The expansive effect of low interest rates on present value; lower interest rates result in
higher present values of lease contracts and the related revenues.
 Unused capacities can be sold to related companies and bought again, recording the sale as
revenue and capitalizing the purchase, this happened e.g. in the telecom sector with fiber-
optic overcapacities.
 The Percentage of completion method was misused by construction companies when
increased fees encountering unexpected costs where reported without the clients approval.
 Booking of revenue from software upgrades that have not even been produced yet.
 Concurrent transaction, i.e. when two companies would trade banner spots on each other‘s
Web site, recording the deal as both revenue and expense but blowing up the company’s
outlook.
 Revenue resulting from advertising fees paid by own divisions e.g. happened at AOL.
 Classifying one-time gains – gains from selling real estate or other corporate assets – as
operating income and operating cash flow (not investing cash flows).

Page 22 of 48
Inventory Accounting
What is inventory? And basic definitions.
Inventory is stock of goods of another item that a firm holds for sale or for further processing as
part of its operations.

Examples:
 Tools are part of inventory for a HW store but not for a carpenter.
 Marketable securities are inventory for a securities dealer but not a manufacturing firm.

Definitions:
Merchandise Inventory – goods held for sale by a retail/wholesale business
Finished goods inventory – goods held for sale by a manufacturing firm
Manufacturing firms will also hold:
Raw materials inventory – materials being stored that will become part of a good to be produced
Work-in-progress inventory – partially completed products in the factory

Inventory Equation
Beginning Inventory  Purchases  Ending Inventory  Cost of Goods Sold

What are the various methods of inventory accounting?

1. First-in, First-out (FIFO) or (Last in Still Here = LISH)
2. Last-in, First-out (LIFO) or (First in Still Here = FISH)
3. Weighted Average

What is the difference between periodic and perpetual inventory systems?

When the firm computes the cost of goods sold each time it sells an inventory item, it uses a
perpetual inventory system. When the firm computes the cost of goods sold at the end of each
period by taking a physical inventory and presuming that any items not in ending inventory were
sold, it uses a periodic inventory system.

Be able to explain LIFO and FIFO?

FIFO (LISH)
FIFO assigns the costs of the earliest units acquired to the withdrawals and assigns the costs of
the most recent acquisitions to the ending inventory. The assumption is that the firm uses the
oldest materials and goods first. (Like a conveyor belt).
 FIFO results in balance sheet figures that are closest to cost because the latest purchases
dominate the ending inventory figures.
 But COGS expense out of date because FIFO assumes that the earlier purchases of
beginning inventory become expenses.
 If purchase prices are rising, FIFO will report higher net income.

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LIFO (FISH)
LIFO assigns the costs of the latest units acquitted to the withdrawals and assigns the cost of the
oldest units to the ending inventory. Assumes that the units acquired most recently are used first.
(Like a pile of coal). Some theorist argue that LIFO matches current costs to current revenues
and therefore that LIFO better measures income.
 LIFO ending inventory can include items acquired many years ago.
 If purchases prices are rising, LIFO computes balance sheet figures for inventory well below
current costs.
 But LIFO’s cost of goods sold figures more closely approximates current costs.
 LIFO hence results in smaller net income if purchases are rising (highest COGS) and lowest
net income if prices falling (lowest COGS).
 LIFO results in least fluctuation in gross margins of businesses where selling prices change
as current inventory prices change.

Summary
Cost Flow Income Statement Tax payments Balance Sheet Inventory on hand
Assumption assumption
FIFO COGS reflects old Higher (if Current purchase LISH
purchase prices purchase prices
prices
Net income higher
increasing)
(if purchase
prices increasing)
LIFO COGS reflects Lower (if Old purchase FISH
new purchase purchase prices
prices prices
increasing)
Net income lower
(if purchase
prices increasing)

What is the LIFO conformity rule and how does this differ from depreciation
methods?
Since it reduces tax payments, if a company uses LIFO in its income tax return, it must use LIFO
in financial statements.
This differs from depreciation rules since a company can use different depreciation methods in
financial statements and in tax reports. For example, a company can use straight-line
depreciation in financial statement while using accelerated depreciation in tax reports.

Page 24 of 48
What is the LIFO reserve?
The current cost over LIFO costs of inventories is LIFO reserve. If I was on FIFO, my balance
sheet will look different by this much.
LIFO layers: In a year, when purchases exceed sales, the amount added to inventory that year is
the LIFO layer.

What does it mean to liquidate LIFO layers? What will be the impact on the
financial statements? Why? Explain, “holding gains”.
Liquidate LIFO layers means to sell more inventory than purchases in a given year. The amount
of inventory is hence decreased. It must hence reduce inventory by liquidating LIFO layers: LIFO
layers hence leave the balance sheet and become expenses. COGS hence reflect current
purchase prices, PLUS a portion of the older (and likely lower) costs recorded in inventory.
COGS is thus lower (assuming rising prices) and tax payments will be higher.
LIFO affords management with an opportunity to manage their earnings. To boost net income, a
company can reduce inventory, liquidate LIFO layers, which reduces COGS. This hence
increases net income.
If the price of inventory is increasing, liquidating LIFO layers will decrease the cost of good sold
and increase net income. Because the book value of deep LIFO layers is less then current value
of inventory. If the price of inventory is increased, use LIFO will increase the COGS and decrease
the net income.
Realized holding gain is the difference between the current replacement cost of an item at time of
sale and its acquisition cost. It reflects the change in cost during the time that an item was held.
Unrealized holding gain is the difference between the replacement cost of current inventory and
its acquisition cost.

How do we adjust financials of two companies that might be on different

methods?
Most international companies are not allowed to use LIFO but its widely used in the US (two
thirds of companies in the US use LIFO).
Analysts comparing a firm might want to compute COGS and inventories on FIFO basis in order
to make an apples-to-apples (more valid) comparison between the firms.
SEC requires firms to disclose in notes to the financial statements the amounts by which
inventories based on a FIFO or current cost basis exceed the amounts reported on a LIFO basis.
E.g. “If FIFO inventory accounting had been used to value all inventories, they would have been
$XXX higher at the start of the year and $xxx higher at the end of the year”
To convert need to calculate the difference in COGS based on the changes in starting inventories
under the FIFO method.
We use the inventory equation: COGS = Begin Inventory + Purchases – Ending Inventory
Beginning Inventory (FIFO) = Beginning Inventory (LIFO) + Reported difference
Ending Inventory (FIFO) = Ending Inventory (LIFO) + Reported difference
Purchases (FIFO) = Purchases (FIFO)

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As Purchases and Sales/Revenues are the same in both methods, we calculate the COGS as if
we had used FIFO.
COGS (FIFO) = Begin Inventory (FIFO) + Purchases – Ending Inventory (FIFO)
Gross margin on sales (FIFO) = Sales – COGS (FIFO)
(Note: Cost of Goods Available for Sale = Purchases + Beginning Inventories)

What is the impact of LIFO versus FIFO on cash? Revenues? COGS?

The LIFO and FIFO will not affect cash directly. However, it will affect the income taxes and affect
cash by income taxes. LIFO and FIFO only affect COGS and will not affect Revenues. If the price
increases, the COGS in LIFO will larger than COGS in FIFO and hence gross margin will be
higher.

What happens if prices are decreasing?

If prices are decreasing, the COGS in LIFO will be smaller than COGS in FIFO. And net income is
LIFO will larger the in FIFO. The increments of LIFO reserve is negative, The LIFO reserve will
decrease.

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Depreciation Accounting
What are the different methods of accounting?
1. Straight-line (time) method. (95% of companies use this method in financial books)
2. Production or use (straight-line use) method
3. Accelerated depreciation (Nearly everybody uses this method in the tax books)
a. Declining-balance method
b. Sum-of-the-years’ digits method
c. Modified Accelerated Cost Recovery System for income tax reporting

Why do companies pick one over the other? What is the relationship of
depreciation methods to taxes?
The acquisition cost of a long-lived asset is the cost of a series of future services. As the firm
uses the asset in each accounting period, it treats a portion of the cost of the asset as the cost of
the service received. Therefore, the companies should choose method of depreciation based on
how the asset generated revenue in different periods. For example, if the earning power of the
asset is constant in different periods the company should use straight-line method. Because a
company can use different depreciation method to taxes and financial reports, there is no direct
relationship to the depreciation method to taxes. 90% of companies use straight-line method.

How is depreciation calculated?

1. Measure the depreciable or amortizable basis of the asset (acquisition cost – salvage value)
2. Estimate its service life
3. Choose the method of deprecation
4. Calculate Salvage Value.
5. Calculate Depreciation
Acquisition cost includes all costs associated with acquiring the asset. E.g. invoiced purchase
price (less discounts), transportation costs, installation charges, and any other costs incurred
before the asset is ready for use.

What is straight line?

The straight-line method divides the acquisition cost of the assets, less an estimated salvage
value, by the number of years of its expected service life, to calculate the annual depreciation or
amortization.
Estimated life does not equal total life of the asset, just the number of years, for which the firm
expects to use the asset.

Page 27 of 48
What is an accelerated method? What are some examples?
In some cases, the earning power of some depreciable assets declines, as they grow older.
These cases justify accelerated depreciation methods, which recognize larger depreciation
charges in early years and smaller depreciation charges in later years.
Some examples: Declining-Balance Methods, Sum-of-the-Years’-Digits Method, Modified
Accelerated Cost Recovery System for Income Tax Reporting (MACRS).

What is the units of production method?

Firm do not use all assets uniformly over time, they should use the units of production method.
Depreciation Cost per Unit = ‘Cost Less Estimated Salvage Value’ over ‘Estimated Number of
Units’

How does the company decide on useful life? Is it the same as physical
life? Could it be?
In making the estimate of useful life, the accountant must consider both physical and functional
factors that limit the life of the assets. The most important factor is obsolescence. The useful life
is not the same as physical life, For example, although a plane can use for 30 years, but
Singapore Airline decides to sell the plane after 10 years, the useful life is only 10 years. It can
however be the same if the firm decides to use the asset for its full physical life.

What is residual value? What is salvage value? Could the salvage value
be negative? Explain.
The residual value is the estimated proceeds on the disposition of an asset. The salvage value
and net residual value is proceeds on the disposition of an asset less all removal and selling
costs. The salvage value could be negative when the all removal and selling cost is larger than
the proceeds on the disposition. For example, the salvage value of a nuclear plant is possibly
negative.

Sample Journal Entry

Date
Depreciation Expense $Amount of period depreciation
Accumulated Depreciation $Amount of periodic depreciation
To record periodic depreciation expense for asset X.

Accumulated depreciation is a contra-assets account. Depreciation expense flows through to the

income statement and serves to reduce net income and retained earnings.

What happens when a company changes its depreciation estimates?

Examples:
 Changes in expected service lives or salvage values
 Additional expenses to maintain or improve the asset
 Changes in market value of the asset

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Changes in service life or salvage value
Generally only affect future depreciation. Depreciation to date is not changed.
The general accepted procedure makes no adjustment for the past misestimate but spreads the
remaining book value less the new estimate of salvage value over the new estimate of the
remaining service life of the asset. The change will be mentioned in the footnotes.

Additional expenses to maintain or improve the asset

Repairs do not extend the life on asset hence do not affect depreciation estimates.
Improvements however (which can also be called improvements or betterments) do either extend
the life or increase the salvage value of the asset. An example of an entry is as follows:
Date
Building $Amount spent to improve asset
Asset (name) – New Valuation $Amount spent to improve asset
To record expenditures on building

Changes in market value

If asset value increases in value, the financial statements are not changed. Under US GAPP,
assets are valued at the lower of book or market value. (Conservatism.)
If asset is tested for impairment however and is found to have a reduced value, this is reflected in
the financial statements. The entries would be as follows:
Date
Accumulated Depreciation $Total amount of acc dep to date (for the impaired asset)
Asset (name) – New Valuation $New value
Loss of impairment $(Book value – Accumulated depreciation) – New Value
Asset (name) – New Valuation $Acquisition Cost
Revalue of asset following impairment.

Effect on different statements:

Balance Sheet Decreases assets by amount of impairment loss
Decreases shareholders equity. (Retained earnings?)
Income statement Appears a loss on income statement
Cash flow statement Need to increase net income by amount of impairment loss since its not a cash
flow

What happened when a company changes its depreciation methods?

No restatements, but the overcharged
(undercharged) depreciation Gain on too much
accumulated in previous periods has to depreciation
be booked as Gain (Loss) from too

new

old
Page 29 of 48
TCHANGE T
much depreciation and goes into the
Income statement.
NEED TO GATHER MORE INFO AND
EXPAND THIS!

Page 30 of 48
Contingent Liabilities
What are liabilities?
Liabilities are generally classified as follows:
a) The obligation involves a probable future sacrifice of resources at a specified or
attainable date. The firm can measure, with reasonable precision, the cash equivalent
value of the resources needed to satisfy the obligation.
b) The firm has little or no discretion to avoid the transfer.
c) The transaction or event-giving rise to the liability has already occurred. (i.e. something
other than an executory contract).
Two types of liabilities:

 Current liabilities are due during the current operating cycle, usually one year.

 Non-current or future liabilities are due after one year

What are contingent liabilities?

Contingent liabilities are potential obligations, i.e. liabilities that arise from the past but we are not
yet sure they will be happening.
Contingent liabilities are recognized only when they are probable and estimable, as defined
below:
a) Information available before the issuance of financial statements indicates that it is
probable that an event has impaired an asset or caused the firm to incur a liability and
b) The firm can reasonable estimate the amount of the loss.
If there’s a range of values, which may represent the loss, the firm should select the value at the
lowest end of the range.

When do you record a contingent liability on the balance sheet?

Contingent liabilities are recorded on B/S when:
 Probable (certainty of payment is high)
 Estimable
Note that contingent liabilities are booked at FV (no discount), until settlement has been done
and they become ‘normal’ liabilities.

When do you record a contingent liability in the financial footnotes?

There are 3 levels of probability:
1. Probable,
2. Reasonably possible and
3. Remotely possible.
Contingent liabilities are recorded on footnotes when:
 Probable and not estimable
 Reasonably possible, even if estimable
Note that remotely possible contingent liabilities are not recorded at all.

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What are the most common examples of contingent liabilities?
Future obligations relating to:
 Law suits or other legal actions
 Future products recalls

Other liabilities on the company’s books

 Current liabilities (recorded at FV):

o Accounts payable

o Short-term notes payable

o Payroll accrual

o Taxes payable

o Current portion of long-term debt

 Non-current or long-term liabilities (recorded at PV);

o Mortgage

o Notes

o Bonds

o Leases

Details on many of these follow:

 Accounts payable: Amount not paid to creditors/suppliers when buying goods or services
(i.e. bought on credit).

 Accrued expenses: Expenses that have been recorded in I/S but not yet paid (ie
electricity bill)

 Interest payable: Remaining interests due on borrowings. Adjusting entries are made
when payments of interest are done (debit Interest Expense / credit Interest payable).

 Dividends payable: Account used to record amount that will be paid as dividends (once
paid, cash is credited and Dividends payable is debited).

 Tax payable: Amount due to tax collector

 Deferred tax asset or liability: Account that records the temporary difference between
actual tax due to tax collector vs. taxes calculated by firm. Difference can be explained by
difference of depreciation methods for instance.

 Lease obligation: Non-cancelable lease (contract bonding lessee and leasor for the use
of an asset) are usually recorded as liabilities. Due amount is recorded under lease
obligation.

Page 32 of 48
Capital leases versus operating leases
What is a capital lease?
In a capital lease, the lessee (the user) enjoys the rewards and bears most of the risk of
ownership, e.g. if the periodic rental payments vary with changes in interest rates. The signing of
the lease is treated as a simultaneous acquisition of a long-term asset and a incurring of a long-
term liability for the lease payments at present value. (p. 540)
Example journal entries at signing of lease
Date
Leased Asset – Computer $PV of future lease payment
Lease liability $PV of future lease payment
To recognize acquisition of asset and related liability.

At the end of the period, the asset is depreciated:

Date
Depreciation expense – on computer $Amount of depreciation
Accumulated depreciation - Computer $Amount of depreciation
To record periodic depreciation on computer.

AND the debt service payment is recorded which pays off interest and also reduces the
amount of the liability.
Date
Interest expense $Amount of interest paid
Lease liability $Amount of liability paid off
Cash $Total of the above/Total payment
To record periodic payments on lease of computer.

What is an operating lease?

In an operating lease, the lessor (the owner) enjoys the rewards and bears most of the risks of
ownership, because the amount of each payment is fixed and cannot be adapted to changes of
interest rates. The lessor therefore has to record an asset in his books. (p. 539). Recording the
lease is straightforward:
Date
Rent expense – Computer $Amount of periodic payment
Cash $Amount of periodic payment
To recognize periodic expense of leasing computer.

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When do we record one versus the other?
There is a test of 4 bright line rules to determine if a lease is a capital lease:
1. The Lessee becomes the owner of the asset at the end of the lease
2. The Lessee can buy the asset at a very low price compared to the fair market value
at the end of the lease
3. The Lease life is at least 75% of the total physical (equivalent to useful in this case)
life of the asset
4. If the Net Present Value of the lease is at least 90% of the fair market value of the
asset
If the lease fulfills any one of the above requirements the lessee must treat it as capital lease.

What is the impact on the company’s financials of recording a lease?

Balance sheet? Income Statement? Cash Flow Statement?
Lease Balance Sheet Income Statement Statement of Cash Flows
Operating Lease Not on balance Fixed expense (thus No impact. Net income
sheet reduces Net Income by includes only the cash flows for
a fixed amount) the expenses.
throughout term of
lease
Capital Lease On balance sheet. Bigger expense in In operating, add back the
early years. Lower depreciation. In Financing,
expense in later years. subtract the decrease in the
Reduces net income lease liability. Q: Why wouldn’t
more in early years the lease liability affect the
and less in later years. operating section?

How can we compare companies that have a lot of operating leases to

those that have a lot of capital leases?
We have to make the Assets and the operating cash flow look alike (see table below).
In capital leases, Assets are higher (hence a lower ROA) and the operating cash flow is higher
(captures only interest payment. The lease liability reimbursement goes into financing) than in
operating.
In operating lease we have a constant expense during the life of the lease.
In capital lease the expense is decreasing: it is equal to the depreciation (constant) + the interest
(constantly decreasing = lease liability of n-1 * Interest rate).
Event Statement Capital Lease Operating Lease
Signing a Balance Asset = + NPV of lease Nothing
lease Sheet Liabilities = + NPV of lease
Income Nothing Nothing
Statement
Cash Flow Nothing Nothing

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Making a Balance Asset = - (NPV of lease / number of years of Nothing (the expense
yearly Sheet lease) is taken into account
payment Expenses: in the Retained
Depreciation = see assets Earnings)
Interest expense = I % * Lease liability of n-
1
Cash = amount paid according to contract
Lease liability decrease = (Cash – interest
paid)
Income Interest expense = I% * lease liability of n-1 Lease Rent =
Statement Depreciation = NPV of lease / number of Expense
years of lease
Cash Flow In operating, add back the depreciation Nothing (Captured in
Statement In Financing, subtract the decrease in the the Net Income)
lease liability

Why does a company lease instead of buy?

Better ratios, no need to take on extra debt if it cannot auto-finance the acquisition, more flexible
(potentially), etc.
Might not have available cash (or be able to raise the cash required) to purchase the item
outright. Do not want to take the risk of ownership. I.e. if products become out of date.
Income tax considerations: some users of depreciable assets such as computers and airplanes
do not have sufficient taxable income to take advantage of accelerated depreciation deductions.
Many lessors have sufficient income to take advantage of income tax reductions and hence these
companies have become lessor for that purpose (e.g. GE Capital). Leases are often structured
as operating leases for income tax purposes, so that the lessor claims depreciation deductions
and saves taxes.

Rule based versus principles based accounting treatments?

Rule based principles (as in US GAAP) check only if the rule is applied. Hence if the rule says
75% of useful life and the lease duration is 74,95% the rule does not apply.
In principles based accounting (IAS), we check for principles… Are they enjoying full usage of the
asset? Is the lease in fact an acquisition with financing or a rent?
READ FINAL CHAPTER OF PROFITS YOU CAN TRUST.

Page 35 of 48
Stockholders’ Equity
What is c/s and APIC? What is par value?
 Common stock – shares in the company that have been authorized to be sold to investors. In
the event of bankruptcy, common stockholders have a claim on the assets of the company
after creditors and preferred stock holders have received amounts due to them.
 Additional Paid in Capital – The excess of the price received for a share from an investor over
the Par Value of the share.
 Par Value – The par value represents the amount of the shareholders claim on the assets of
the company (after creditors and preferred stockholders have been paid). The par value of a
share (for common stock) is generally lower than the issue price of the share.

What is Retained Earnings? What is Accumulated Deficit?

Retained Earnings – The cumulative net income generated by the firm minus any dividends that
have been declared (and one can assume have been paid out). This is cumulative and hence
would be expected to grow over time (assuming that the firm does not pay 100% of its net income
as a dividend to share holders). The addition to retained earnings for any period will be the net
income for that period minus any dividend declared during that period.
Not: Sure 100% of this. Have found the following definitions:
Accumulated deficit – Can be viewed as the opposite of retained earnings. This account captures
the accumulative loss for the company. If in any given period, the net income of the company is
negative, this account is credited by the amount of the loss. Retained earnings is thus not
increased or decreased if net income is negative.
Accumulated deficit (surplus) at year-end The difference between the net expenditures of any
year and the amounts received to finance these expenditures is carried forward to the following
year to either increase or reduce the net revenue requirement.

What is Treasury Stock? How does the purchase and resale of treasury
stock get recorded? On the B/S? On the Income Statement? On the
Statement of Cash flows?
Treasury Stock – shares of the firm bought back from the market.
Journalizing and recording process:
Upon purchase of treasury stock
Date
Treasury Shares - Common $Total amount paid for shares
Cash $Total amount paid for shares
To record $X paid to acquire x common shares at $X per share. Treasury shares - Common is a contra
account to shareholders equity.

Treasury shares are thus a subtraction from shareholders equity on the balance sheet.
Effect on different statements:
Balance Sheet Decreases assets (cash).
Decreases shareholders equity (treasury shares – common / preferred which is
contra account to SHE).

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Income statement No effect.
Cash flow statement Need to reduce net income by the cash paid for treasury shares in the financing
section.

If treasury shares are sold at a later date the journalizing process is as follows:
Date
Cash $Total Amount received for selling shares
Treasury Shares – Common $Total (Market) Value of shares when they were bought
(not current market value or amount received)
Additional Paid in Capital $ Plug Difference in Amounts debited to cash
To reissue x shares of treasury stock for $x per share.

If shares are sold for a loss, Additional Paid in Capital is debited.

Effect on different statements (assume sold for a gain)
Balance Sheet Increases assets (cash)
Increases shareholders equity (by reducing treasury shares – common /
preferred which is contra account to SHE)
Income statement No effect.
Cash flow statement Need to increase net income by the cash received for treasury shares in the
financing section.

Why do companies repurchase their shares?

Firms might purchase their stock for the following reasons:
 Use if share option agreements with key staff and management
 Serve as a worthwhile investment of cash (i.e. management considers shares undervalued)
 Defend against an unfriendly take-over bid (the less shares available on the market the
harder it is for a would-be acquirer to amass a majority stake AND the less cash on the
balance sheet, the less attractive the firm becomes as an acquisition target.
 Distribute cash to shareholders in a tax-advantaged manner (since dividends are taxed,
 Increase the value of the firm by creating a tax shield (issue debt to buy back own shares)

What is “Other Comprehensive Income”?

Other comprehensive income – A section of the Shareholders Equity section on the balance
sheet used to disclose all unrealized gains and losses that historically have bypassed the income
statement. Unrealized gains and losses can arise from marking assets and liabilities to market.
E.g. unrealized gains on stocks held available for sale (i.e. not trading securities held by a bank
which because a bank’s main business is trading, would appear in net income).
Other comprehensive income may thus be a loss and is generally referred to as ‘other
comprehensive income (loss).

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What is preferred stock?
Preferred stock – Stock that providers its owners with a senior claim on the assets of the
company in the event of bankruptcy. Additionally, preferred stock holders might receive a
guaranteed amount as a periodic dividend and cumulative dividend rights that guarantee any
postponed dividends are paid to preferred stock holders before any new dividends are made to
common stock holders. Preferred stock is thus considered less risky than common stock; hence
the expected return is lower on preferred stock than common stock.

How does dividend get recorded?

2 step process. Dividend is (1) declared and (2) paid.
Step (1) Declaration of dividend:
Date
Retained Earnings $Total Amount of dividend declared
Dividends Payable $Total Amount of dividend declared

Step (2) Payment of dividend

Date
Dividends Payable $Total Amount of dividend paid
Retained Earnings $Total Amount of dividend paid

Note: In all but only the most exceptional circumstances, will the amount of dividend declared not
equal the amount paid. It’s nearly always the same.

What is a cumulative preferred stock? What is a convertible preferred

stock?
Cumulative Preferred Stock - stock having the provision that if one or more dividend is omitted,
(arrearage) the omitted dividends must be paid to the preferred stockholders before any
dividends can be paid to the common stockholders.
Convertible preferred stock - preferred stock, which can be converted into a predefined number
of shares of common stock.
Bonds and debentures may also be recorded as ‘convertibles’.
Source: http://www.speculativebubble.com/terms/cumulativeps.shtml

What is a convertible debt security? How does it get recorded on the

financials?
Convertible debt security – debt that can be converted in common stock. Convertible bonds (for
example) are a type of bond that can be exchanged, possibly after some specific time has
elapsed, for a specific number of shares of common stock, or perhaps, preferred stock of the
lender.
Recorded as follows (I think! – Roland, please check and verify!)

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Upon issuance of debt (e.g. a Bond)
Date
Cash $Total Amount received for sale of debt
Bonds payable $Present value of debt

At the time of issuance, the value of the debt necessarily equals the amount received.
Upon periodic payment of interest and debt. 2 steps:
1) To recognize the interest due
2) To record the payment of interest and reduction of debt
1) To recognize interest due in the current period.
Date
Interest Expense $Amount of interest to be paid
Interest payable $Amount of interest to be paid

2) To record the payment of interest and reduction of debt

Date
Interest Payable $Amount of interest paid
Bonds Payable $Amount paid to reduce debt
Cash $Total amount paid to reduce debt and cover interest

Upon conversion of debt into equity (stock);

Date
Bonds Payable $Value of debt
Common Stock $Value of stock at par value
Additional Paid in Capital $Plug: Excess of value of debt over par value of common
stock

Other info on convertible bonds

Interesting article: http://riskcalc.moodysrms.com/us/research/defrate/66988.asp
During the end of the Internet age (1999/2000), several companies offered convertible bonds
which permitted conversion of the debt into a certain value of stock (not number of shares).
These were also called floorless convertibles.
See http://www.economist.com/displaystory.cfm?story_id=2044555

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Acquiring marketable securities and companies (M&A accounting)
What are the cost method, equity method, and consolidation?
The accounting for investment in securities depends on 2 aspects:
1. Expected holding period

 To be sold within one year from the date of the balance sheet would qualify as
Current Asset (Marketable securities)

 To be held more than one year would from the date of the balance sheet would
qualify as Non Current Assets (Investment in Securities)
If the investment is “consolidated” –see below- it will not appear as such in the balance sheet.
2. Purpose of the investment

 Minority, passive investment (less than 20% of voting rights), depending on the
holding period, either current or non current asset – see above

 Minority, active investment (rule is between 20% and 50% unless evidence indicates
that significant influence cannot be exercised): appear on the balance sheet as
Investment

 Majority, active investment (more than 50%): Is consolidated in the balance sheet

The Cost Method (for minority passive investments)

Acquisition:
The cost method is the one suited for the Minority passive investment. The acquisition of
securities is recorded at acquisition costs (price plus commissions, taxes and other costs
incurred).
The dividends and interests earned from these investments are recorded as revenues when
declared (dividend) and earned (interest).
Valuation post acquisition:
There are three categories:
Debt securities held to maturity: If there is a difference between the acquisition cost and the
maturity value (face value) of the debt, the firm must amortize the difference as an adjustment of
the interest revenue.
Trading securities: This means active and frequent buying and selling (some would say
speculation). These assets are adjusted to their market value. The difference is reported in the
income statement as Unrealized Holding Loss (or Gain) on Valuation of Trading Securities.
Securities available for sale: The rest of the securities. If the securities are due to be sold in the
next year then they are classified under current assets (Marketable Securities), if not, under
Investment. These assets are adjusted to their market value. The difference is not reported in the
income statement. Instead, it increases or decreases the shareholders’ equity as Other
Comprehensive Income a separate Shareholders’ equity account.
Any reclassification is recorded at market value  marked to market (MTM) but only for trading
securities and securities available for sale.
Examples of how transactions involving these items are journalized below:

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Acquisition of security
Date
Marketable securities $Acquisition cost
Cash $Acquisition cost

Revaluation to market at end of each accounting period

Gain:
Date
Marketable securities $Increase in market value above book value
Unrealized gain on marketable $Increase in market value above book value
securities
Loss:
Date
Unrealized loss on marketable securities $Decrease in market value below book value
Marketable securities $Decrease in market value below book value

Unrealized gain/loss are shareholders equity accounts (not income statement accounts).
Sale of marketable securities
2 steps. Step 1 records proceeds from sale
Date
Cash $Proceeds of the sale
Marketable securities $Acquisition cost
Realized gain on marketable securities $Plug

Realized gain appears on the income statement.

AND step 2, reverses unrealized gains….
Date
Unrealized gain on holding securities $Excess of book value over cost
Marketable securities $Excess of book value over cost

The same 2 steps are repeated as follows if it’s a loss.

Date
Cash $Proceeds of the sale
Realized loss on marketable securities $Plug
Marketable securities $Acquisition cost

Realized loss appears on the income statement before closing retained earnings.
Date
Marketable securities $Excess of acquisition cost over book value
Unrealized loss on holding securities $Excess of acquisition cost over book value

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The Equity Method (For minority active investments)
Acquisition:
The Equity method is similar to the cost method for the acquisition cost. The acquisition of
securities is recorded at acquisition costs (price plus commissions, taxes and other costs
incurred). Normally done for 20% + ownership but can also be done if ownership is less than
20% and the company can exert significant influence (e.g. seat on the board).
Journalizing process:
Upon acquisition of stock in Company S
Date
Investment in stock of Company S $Amount paid
Cash $Amount paid

Upon reporting of income from company S

Date
Investment in stock of Company S $Earnings x % ownership
Equity in earnings of affiliate (IncSt) $Earnings x % ownership

The account equity in earnings of affiliate is a revenue account.

Upon receipt of payment of dividend
Date
Cash $Dividends received (remember share of ownership)
Investment in stock of Company S $ Dividends received (remember share of ownership)

If earnings are reported and dividends declared at the same time, the above transactions are
done at the same time.
Upon sale of stock in Company S
Date
Cash $Amount received
Investment in stock of Company S $ Book value of shares sold
Gain on sale of investments in $Plug
Company S (IncSt)

The consolidation Method (for majority active investments)

In the consolidation method, the buying firm combines its financial statement with those of all its
subsidiaries (investment > 50%).
The consolidated statements are adjusted by eliminating all inter-company transactions (see
page 615 in the book): Double counting in Payables, Investment, Inter-company sales, double
counting of income, affiliate retained earnings, etc…

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How do you treat dividends received in the equity method?
The investor recognizes as revenues (expenses) his share of each period’s net income (loss) of
the other firm. The dividends are not recognized as income but as return of investment.
There is no valuation post acquisition. Instead, the accounting for net income and dividend is the
following: Year 1 (Operation 1 to 3) acquisition of the stocks, Incorporation of net income and
dividend. Year 2, incorporation of net income, dividend and sale of 25% of investment for 165,000
US$.

Investment in Stock of S (30%) 600,000

Cash 600,000
Equity in Earnings of Affiliate (30% of net income of affiliate) 24,000
Investment in Stock of S 24,000
Cash (30% of dividend distributed) 9,000
Investment in Stock of S 9,000

Equity in Earning of Affiliate 30,000

Investment in Stock of S 30,000
Cash 12,000
Investment in Stock of S 12,000
Cash (30% of dividend distributed) 165,000
Investment in Stock of S = 25% (600,000+24,000-9000+30,000- 158,250
12,000)
Gain on Sale of Investment in Stock of S 6,750

What is minority interest? Where does it show up on the company’s

financials?
Often the parent does not own 100% of the voting stock of a consolidated subsidiary. The parent
refers to the owners of the remaining shares of the company as minority interest. These
shareholders have provided a portion of the subsidiary’s financing and have a claim to a portion
of its assets.
Assume the parent owns less than 100% of the company. GAAP allows firms to show 100% of
the assets and liabilities on its balance sheet. The consolidated balance sheet will hence
disclose the interest of the minority shareholders in the consolidated but less than wholly owned
subsidiary.
The amount of minority interest appearing in the balance sheet generally results from multiplying
the % of equity held by minority shareholders by the amount of common shareholders equity.
Minority interest generally appears among the equities on the consolidated balance sheet;
between the liabilities and shareholders equity.
The parent company subtracts the minority shareholders share of net income in calculating
consolidated income.

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What is the treatment for M&A transactions?
Prior to the Statement 141 in 2001, there were 2 methods to account for corporate acquisitions:
The purchase method and the pooling of interests method. This latter is now prohibited.
The purchase method is similar to the acquisition of a single security. If the price is higher than
the book value of the net asset acquired, the excess is allocated to identifiable assets and
liabilities to revalue them to market values. Any remaining excess should be allocated to goodwill.
The Pooling of interest method does not entail any excess purchase price and the retained
earnings of the acquired company carry over. However, the Pooling of Interests Method is no
longer allowed under US GAAP. Since this, the amortization of Goodwill (from Purchase Method)
is treated somewhat differently than before (see below)

What is goodwill? How is it treated in the US and outside of the US?

Goodwill is the excess of the purchase price over the market value of all identifiable assets minus
liabilities.
The goodwill is any remaining excess price paid compared to net value (adjusted to market value)
of the acquired company. The goodwill is no longer amortized under US GAAP. Rather, an
impairment test is done at the end of each period and the book value of the goodwill is written
down whenever its market value declines below its book value.
Goodwill is no longer amortized but instead it’s tested for impairment and can be written off as
judged so by management. This modification was made to accommodate needs of firms such as
Cisco that make many acquisitions involving large amounts of goodwill.
Outside US, Goodwill can be amortized although this is under review.

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Effect of accounting transactions on the statement of cash flows
The notes below pertain to the indirect method of creating the cash flow statement.

Line 1: Net Income.

Provisionally assume that cash has increased by net income.

Line 2: Depreciation of buildings and equipment

Depreciation is included in COGS and hence net income. Depreciation is thus viewed as product
cost, not a period expense. It must be hence added back.

Line 3: Amortizing a Patent

Conceptually same process as for depreciation.

Line 4: Loss on sale of marketable securities

All proceeds from sale are classified as an investing activity. But the accountant has also
included a realized loss in net income. Thus when preparing the statement of cash flows, the net
income must be adjusted to reflect that all cash received from the sale of the securities is
included in the investing section.

Line 5: Deferred Income Taxes

Deferred income taxes are included in net income but were not paid, thus no cash changed
hands. The amount of deferred income must thus be added back to the operating section of the
SCF.
Line 6: Excess of Coupon Payments over Interest Expense

Line 7: Gain on sale of equipment

All cash from sale is included in the investing section. However, a part of this cash will have been
included in net income as a gain on sale. The gain on sale that was included in the Net Income
must therefore be reduced out of the operating section. If it were sold as a loss then the loss
would be added back in to the operating section.

Line 8: Equity in undistributed earnings of affiliate

Net income includes the equity in earnings of affiliate resulting from the affiliate reporting earnings
for the period. However, this amount did not result in any cash being received. It did however
receive a dividend, which is also included in net income. Thus one must subtract the difference
between the dividend received and earnings in equity of affiliate reported from the operating
section of the SCF.

Line 9: Decrease in pre-payments

If prepayments have decreased it means that the cash expended less cash for new prepayments
in the current period than it did in previous periods. Thus the difference in prepayments must be
added to the operating section of the statement of cash flows. Had prepayments increased, an
amount would be deducted.

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Line 10: Increase in account payable
New purchases on account exceeded those for the previous period. This provides the firm with
more cash. This added back in the operating section.

Line 11: Increase in advances from customers

More cash received, hence it is added to the operating section.

Line 12: Increase in accounts receivable

Less cash received. Hence deducted from operating section. This entry automatically
incorporates any changes in allowances for uncollectable accounts.

Line 13: Increase in Inventories

If inventory has increased, the firm has purchased more inventory than it sold. Thus cash will be
reduced by the amount of the change in inventories.
Line 14: Decrease in Warranties Payable
Moving into the investing section…

Line 15: Sale of Marketable Securities

All cash flows received are classified as an investing activity. See treatment of line 4, where
realized loss/gain is backed out of net income.

Line 16: Sale of equipment

As above, the proceeds received are recorded here. Any gains/losses recorded in net income
are reversed in the operating section of the SCF.

Line 17: Acquisition of equipment

All cash paid for equipment acquired in the period is recorded in the investing section.
Moving into the financing section…

Line 18: Short term bank borrowing

Cash received from loan or bank note. Even though loan is short term, it is still classified as a
financing not operating activity.
Line 19: Long-term bonds issued
All cash received from bonds issued is recorded in the financing section.

Line 20: Preferred stock issued

As above.

Line 21: Retirement of long-term debt at maturity

The income statement shows no gain or loss on the retirement of long term debt if the debt was
retired at book value. Hence, there are no adjustments to be main in the operating section unless
a loss/gain was recorded and included in net income.

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If debt had been retired prior to maturity a loss/gain would be recorded. Net income would be
adjusted in the operating section such that all cash received would be shown in the financing
section.

Line 22: Acquisition of common stock

Purchases of treasury stock are not recorded in net income hence all cash paid is recorded in
financing section of SCF. No changes required to Net Income.

Line 23: Dividends

All cash paid to shareholders in the form of dividends is recorded here. No adjustment to net
income required.

Relationship of Net Income and Cash Flows from Operations

Net income differs from operating cash flows for 2 reasons:
1. Changes in non-current assets and non-current liabilities
2. Changes in operating working capital accounts
Changes in non-current assets and non-current liabilities
Examples follow:
 Capital intensive firms will show a substantial add back for depreciation, whereas service
firms show a smaller amount.
 Rapidly growing firms will likely show an add back for deferred tax expense, whereas firms in
decline will show a subtraction.
 Firms that grow through acquisition will show a subtraction from net income for equity in
undistributed earnings of affiliates.
 Firms that increase or decrease in size will show additions or subtractions in the investing
section to reflect acquisition or disposal of assets.
Changes in operating working capital accounts
 This relate mainly to rate of growth. Examples follow:
 Rapidly growing firms usually experience substantial increases in accounts receivable and
inventories.
 Some firms use their suppliers (accounts payable) to finance these needs but others use
short of long-term borrowing or equity financing.

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Ratio Analysis
What are ratios? What should you understand about ratios?
Ratios express the relationship between items in the financial statements. Ratios aid financial
statement analysis because they conveniently summarize data in a form easy to understand,
interpret, and compare.

What are the major ratios?

Profitability:
Rate of Return on Assets
Rate of Return on Common Shareholders’ Equity
Earning per Share of Common Stock

Short-term Liquidity Risk:

Current Ratio
Quick Ratio
Cash Flow from Operations to Current Liabilities Ratio
Working Capital Turnover Ratio

Long-team Liquidity Risk:

Debt Ratios
Cash Flow from Operations to Total Liabilities Ratio
Interest Coverage Ratio

What is the DuPont equation? What information does it provide?

ROE = Profit Margin Ratio fro ROCE * Total Asset Turnover Ratio * Leverage Ratio
= ((Net Income – Dividends on Preferred Stock) / Revenue) * (Sales / Average Total Assets ) *
(Average Total Assets / Average Common Shareholders’ Equity)

What are common size income statements and common size balance
sheets?
Common size balance sheets: A percentage statement based on total assets
Common size income statements: A percentage statement based on Sales

How do you identify industries based on the ratios?

Different industries will have different kind of ratios. For example, a Pharmaceutical Company
such as Eli Lilly, a Retail Company such as Walmart and a Utility Company will have same ROE
but different other ratios. A pharmaceutical have a high profit margin but a low leverage ratio. A
retail company has a small profit margin but a high total asset turnover ratio. A utility company
have small profit margin and low total asset turnover ratio but a high leverage ratio. Although they
have same ROE, we can identify industries by analyzing their ratios.

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