EDSPIRA’S GUIDE TO

Financial Statements
By Michael McLaughlin

TABLE OF CONTENTS
Part 1 ................................................................................................................................... 2

Chapter 1: Overview ........................................................................................................... 2

Chapter 2: The Income Statement................................................................................... 3

Chapter 3: The Balance Sheet.......................................................................................... 12

Chapter 4: The Statement of Cash Flows ...................................................................... 19

Chapter 5: The Statement of Stockholders’ Equity ..................................................... 24

Part 2 ................................................................................................................................ 27

Chapter 6: How the Financial Statements are Related .............................................. 27

Chapter 7: Financial Statement Analysis ...................................................................... 32

Appendix: Debits and Credits ......................................................................................... 38

Frequently Asked Questions ........................................................................................... 42

CHAPTER 2 EDSPIRA 2

Part 1

Chapter 1: Overview
The 4 main financial statements are:

The Income Statement

The Balance Sheet

The Statement of Cash Flows

The Statement of Stockholders’ Equity

The Income Statement1 shows you whether the firm made a profit or loss for a given period.
The Balance Sheet2 shows you what the firm owns and owes as of a specific date.
The Statement of Cash Flows tells you why the firm’s cash balance increased or decreased.
The Statement of Stockholders’ Equity tells you why the Stockholders’ Equity accounts
increased or decreased.

Publicly-traded3 companies in the United States must publicly disclose these financial
statements every quarter (in a “10-Q” filing) and every year (in a “10-K” filing).

EXAMPLE

Click here to access Apple’s 2018 10-K filing.

Apple’s financial statements appear on pages 38 through 42.
Apple’s notes appear on pages 43 through 64.

• The financial statements are accompanied by “notes” that provide additional detail
• Apple’s Note 10, for example, breaks down Apple’s performance by geographic region.
Apple’s Income Statement, in contrast, shows the performance of the entire firm

1
Also known as the Profit and Loss (P&L) Statement or the Statement of Operations.
2
The Balance Sheet is known as the Statement of Financial Position per International Financial Reporting
Standards (IFRS).
3
If a company is “publicly-traded” this means anyone can purchase the company’s stock.
CHAPTER 2 EDSPIRA 3

Chapter 2: The Income Statement

The Income Statement lists a company’s revenues and expenses for a particular period of time.
Here is Apple’s Income Statement for the year ended September 29, 2018:

The amounts listed above are in millions, so Apple generated over $265 billion in Net Sales for
the fiscal year ended on September 29, 2018. 4 Net Sales is a type of revenue that Apple
generates by (a) selling products and (b) providing services.

4
The Income Statement does NOT show all the revenues that Apple has ever earned; it only shows the
revenues earned for that fiscal period (similarly, it only shows the expenses incurred during that period).
CHAPTER 2 EDSPIRA 4

Revenues are inflows or other enhancements of assets of an entity OR settlements of

its liabilities during a period from delivering or producing goods, rendering services,
or other activities that constitute the entity’s ongoing major or central operations.

Expenses are outflows or other using-up of assets OR incurrences of liabilities during

a period from delivering or producing goods, rendering services, or other activities
that constitute the entity’s ongoing major or central operations.

The difference between revenues and expenses is the company’s PROFIT or LOSS.

Profit (Loss) = Revenues – Expenses

On the previous page, Apple’s Income Statement notes that Apple had a profit of
$59.531 billion for the fiscal year ended on September 29, 2018.5

The firm posts a PROFIT,

Total Revenues > Total Expenses
which is called a “Net Income”

The firm posts a LOSS,

Total Expenses > Total Revenues
which is called a “Net Loss”

Sometimes you will see the words “gain” or “loss” on an Income Statement.
Gains and losses are similar to revenues and expenses, so don’t let this confuse you.

• Gains have the same effect on the Income Statement as revenues

• Losses have the same effect on the Income Statement as expenses

So what’s the difference between revenues/expenses and gains/losses?

Revenues and expenses pertain to the company’s main operations; gains and losses pertain to
peripheral activities. When Apple sells an iPhone, Apple records sales revenue. But if Apple sells
stock it owns in another company, this is not part of Apple’s main business and would lead to a
gain or loss (not sales revenue) so investors aren’t confused about the source of Apple’s income.

Not every Income Statement looks the same. Here’s a sample Income Statement:

5
The bottom-line profit is called Net Income (or Net Loss if it’s negative).
CHAPTER 2 EDSPIRA 5

Revenues can come from selling products, providing services, generating rental income,
earning interest, and other activities. A movie theater, for example, generates revenue primarily
from ticket sales and concessions, but may also generate rent revenue from allowing people to
rent the theater for special events. Revenues are how the company makes money.

The company’s main revenue source (e.g., sales) is listed at the top of the Income Statement.
Because sales revenue is the primary source of revenue for most companies, investors
commonly refer to sales growth as “top-line growth.” A bank, however, would list interest
revenue (not sales) at the top of its Income Statement.
CHAPTER 2 EDSPIRA 6

Here are the most common categories of expenses:

For a retailer, this is what the company paid to its suppliers to

Cost of Goods Sold acquire inventory. For a manufacturer, this is what it cost the
company to manufacture its inventory. If the company does not sell
(aka Cost of Sales)
inventory (i.e., the company is a service provider), the company
would not have Cost of Goods Sold.

SG&A stands for “selling, general, and administrative.” Selling costs

include any selling expenses; the salary of a sales manager, rent for a
sales office, sales commissions paid to the sales force, and the cost
SG&A Expense of shipping goods to customers (“freight out”) are all selling costs.
General and administrative costs, on the other hand, include salaries
(the accounting staff, legal team, company executives, etc.) plus rent
and other costs related to the corporate headquarters or other
administrative facilities.

R&D stands for “research and development.” Money spent by a

R&D Expense pharmaceutical company to identify a new drug and get it through
the various phases of testing would be considered an R&D expense.

Wear and tear on the company’s fixed assets (property, plant, and
equipment). Note that (a) depreciation is non-cash expense and (b)
Depreciation Expense
not all assets are depreciated. Land, for example, is not depreciated
because land does not wear out or become used up over time.

Interest incurred on the company’s debt. Some companies combine

Interest Expense Interest Revenue and Interest Expense into a single line item called
“Interest Income.”

Taxes on federal, state, and foreign income. Tax accounting and

Financial Accounting have different rules, so Income Tax Expense is
Income Tax Expense not the actual income tax paid to the government. On job interviews
you should assume Income Tax Expense is equal to pretax income
multiplied by the company’s average statutory income tax rate.

You might also see on the Income Statement:

• A gain or loss from the disposal of equipment or the sale of an investment
• Earnings from Affiliates, which is the company’s share of an investee’s profits

Also: when a company sells one of its divisions, the profit or loss from that division (plus any
gain or loss recognized on the sale of that division) is presented as a separate line item called
Discontinued Operations. This is presented separately (net of tax) to show investors that this
income (or loss) will no longer be part of the company going forward.

Let’s return to Apple’s Income Statement and go through it line-by-line.

CHAPTER 2 EDSPIRA 7

• Net Sales is the revenue Apple received from selling goods and services, minus any sales
returns, sales discounts, or sales allowances

Net Sales = Sales – Sales Returns – Sales Discounts6 – Sales Allowances7

• Cost of Sales is what Apple paid to buy or build its inventory. If Apple bought a charging
cord from a supplier for $7, Apple recognizes $7 for Cost of Sales when it sells the cord
• Gross Margin is a subtotal, not an account. It is sometimes called Gross Profit

Gross Margin = Sales - Cost of Sales

6
Some companies offer a discount when customers that bought inventory on credit pay their bill early.
7
Sales Allowances are discounts given to a customer when the goods arrived damaged or defective.
CHAPTER 2 EDSPIRA 8

• Below Gross Margin are Apple’s Operating Expenses. Apple has two operating expenses:
R&D and SG&A. The Operating Expenses are subtracted from the Gross Margin to obtain
Operating Income (aka Operating Profit). Operating Income is thus a subtotal

Operating Income = Gross Margin – Operating Expenses

• Below Operating Income you have Nonoperating Items, which includes Nonoperating
Revenues and Nonoperating Expenses. Apple nets these together as “Other Income”
o An Operating Expense pertains to the firm’s core operations (e.g., SG&A Expense)
whereas a Nonoperating Expense (e.g., Interest Expense) is outside the core operations
• After “Other Income” Apple lists Income before Provision for Income Taxes
o This is the same as Earnings before Taxes (EBT)
• The final expense Apple lists is Provision for Income Taxes (aka Income Tax Expense)
• Subtracting Income Tax Expense from EBT yields the bottom line: Net Income8

Note that two important metrics are missing from Apple’s Income Statement!

EBIT & EBITDA

Investors often talk about a firm’s EBIT and EBITDA.

These two measures of profitability are critical, even though you are not likely to see them in a
typical Income Statement.

EBIT stands for Earnings before Interest and Taxes. It is calculated as follows:

EBIT = Net Income + Interest Expense + Income Tax Expense

Some investors assume EBIT is the same as Operating Income. This is technically not true.
There is because some investors include certain Nonoperating Items in EBIT, while
Nonoperating Items are never included in Operating Income.9 There is no clear-cut rule on
whether Nonoperating Items such as “Other Income” should be included in EBIT (or EBITDA);
whatever your preference, be consistent.10

8
Net Income can also be expressed on a per-share basis (Earnings Per Share, or “EPS”). If you hear in the news,
“Company X reported earnings that exceeded analysts’ expectations” this is referring to EPS.
9
If Apple recognized a $16 million gain due to a foreign currency transaction, the gain would NOT be included in
Operating Income (it doesn’t pertain to Apple’s core business) but some investors would include it in EBIT.
10
See Paul Pignataro’s “Financial Modeling & Valuation” (pages 7 and 8) for a discussion of the pro’s and con’s.
CHAPTER 2 EDSPIRA 9

EBITDA stands for Earnings before Interest, Taxes, Depreciation, and Amortization.

You can calculate a company’s EBITDA by adding the total Depreciation and Amortization
Expense back to the company’s EBIT.

EBITDA = EBIT + Depreciation and Amortization Expense

If you’re wondering why someone would use EBITDA instead of EBIT, the answer is that
EBITDA more closely approximates operating cash flow. This is because EBITDA adds
back Depreciation and Amortization Expense (a significant non-cash expense).

EBITDA-based metrics and multiples are heavily used in valuation and leveraged buyouts.

Caveats:

• For purposes of calculating EBITDA, the best place to find the total Depreciation and
Amortization Expense is the operating section of the company’s Statement of Cash Flows.11
This is because (a) some companies don’t list Depreciation and Amortization Expense on
the Income Statement and (b) even if a company does list Depreciation and Amortization
Expense on the Income Statement, the company might have some depreciation included in
its Cost of Goods Sold. Thus, go to the Statement of Cash Flows to find the correct total.

• When calculating EBIT and EBITDA, some companies add back Net Interest Expense instead
of Interest Expense. Doing this removes Interest Income from EBIT and EBITDA.

• Some investment bankers use an Adjusted EBITDA where they add back non-recurring
expenses such as restructuring charges, impairments, asset write-downs, etc.

Many investors find EBIT (or EBITDA) more useful than Net Income for 3 reasons:
1. EBIT and EBITDA are not affected by Interest Expense
• People want to compare two companies’ core profitability on an apples-to-apples basis.
If Target has a lot of debt and Walmart does not, then it wouldn’t be a good idea to
compare the Net Income of each company. This is because Target’s Net Income would
be decreased by Interest Expense whereas Walmart’s Net Income would not be affected
by Interest Expense. Thus, a firm’s Net Income is affected not just by its core business

11
Target Stores reported $2.224 billion in Depreciation and Amortization Expense as a line item on its 2018 Income
Statement. Target included some Depreciation and Amortization in COGS, however, so its total Depreciation and
Amortization Expense was $2.474 billion. The $2.474 figure is found on Target’s Statement of Cash Flows.
CHAPTER 2 EDSPIRA 10

operations but by the company’s financing decisions. An investment banker wants to

compare the core profitability of the companies, irrespective of financing decisions.

2. EBIT and EBITDA are not affected by Income Tax Expense

• If you want to compare the core profitability of two companies, Income Tax Expense
should not be included. This is because Income Tax Expense is a function of the
company’s tax strategy and is not necessarily related to the firm’s core profitability

3. EBIT and EBITDA are not affected by non-core business activities

a. Some investment bankers exclude non-core business activities from EBIT and EBITDA.
Net Income, however, is affected by non-core business activities (e.g., a gain or loss on
the disposal of PP&E) as well as non-recurring one-time charges (e.g., an impairment)

EBIT and EBITDA tell you about the firm’s core profitability, without being affected
by borrowing decisions, tax strategy, non-core activities, or one-time events.

You’re going to use EBIT and EBITDA a lot, so be sure to master these concepts.

FYI, companies can still run into financial trouble even if they have a high EBITDA. For example:

• If the company has borrowed heavily, the interest payments might exceed the EBITDA

• If the company is in a capital-intensive industry, its capital expenditures (CAPEX) might

exceed the EBITDA

And if you’re wondering when you would use EBIT instead of EBITDA, note that EBIT accounts
for capital investments (because it includes depreciation and amortization) whereas EBITDA
does not. Thus, if you’re looking at a firm in a capital-intensive industry, you might prefer EBIT
to EBITDA. But both EBIT and EBITDA are frequently used, so neither is better than the other.

There are some issues with using EBITDA (and EBIT, for that matter). Those drawbacks are:

• EBITDA doesn’t account for changes in working capital

• EBITDA doesn’t account for earnings quality

• EBITDA isn’t adjusted for capital expenditures

Let’s discuss the usefulness of the Income Statement and then move on the Balance Sheet.
CHAPTER 2 EDSPIRA 11

Usefulness of the Income Statement

1. It’s frequently used by investors to evaluate the firm’s past performance

• Analysts evaluate companies based on earnings (EPS), which is derived from Net Income
• Investment bankers calculate EBIT and EBITDA using figures from the Income Statement

2. It can be used to predict a company’s future performance

• Analysts forecast future earnings by looking at historical trends of top-line revenue
growth and profit margins. These historical trends come from the Income Statement

Limitations of the Income Statement

1. It is backward-looking and doesn’t reflect the most current information

• If a small firm signs a contract today to sell billions of dollars of inventory to Walmart
over the next 10 years, the company’s stock price will probably go up. Yet, there will be
NO EFFECT on the Income Statement today12

2. It is affected by managers’ choice of accounting methods

• If Company A uses straight-line depreciation while Company B uses an accelerated
depreciation method, Company A’s profit could be higher (all else equal) because the
straight-line method results in less depreciation during the early years of an asset. This
makes it difficult to do an apples-to-apples comparison of the two firms’ profitability

3. It is affected by managers’ judgement

• If a company estimates that it will use a machine for 30 years instead of 20 years, the firm
will spread its depreciation expense over a longer time horizon. This will result in less
depreciation expense (and higher profit) in the current period. A competing firm might
depreciate the same type of asset over 14 years, which again makes it difficult to do an
apples-to-apples comparison of the two firms’ profitability

12
Companies can’t recognize revenue until they ship inventory to customers. The stock market, however,
reacts to the good news immediately because it assumes the firm will ship the inventory when the time comes.
CHAPTER 3 EDSPIRA 12

Chapter 3: The Balance Sheet

The Balance Sheet lists a company’s asset, liability, and stockholders’ equity account balances
as of a specific point in time.

Assets are probable future economic benefits obtained or controlled by a particular

entity as the result of past transactions or events.

Liabilities are probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other
entities in the future as a result of past transactions or events.

Stockholders’ Equity13 is the residual interest after subtracting liabilities from assets.

The following equation must always hold true:

Assets = Liabilities + Stockholders’ Equity

EXAMPLE

You start a corporation called Fuber on 1/1/20 by investing $10,000 cash.

• Fuber has $10,000 in assets (the cash you invested)
• Fuber has no liabilities
• Fuber’s stockholders’ equity is $10,000 [$10,000 of assets - $0 of liabilities]

If Fuber acquires land on 1/15/20 by promising to pay $80,000 at some point in the future, then
a Balance Sheet prepared as of 1/15/20 would show that:
• Fuber has $90,000 in assets (the cash you invested plus the land)
• Fuber has $80,000 in liabilities (Fuber has an obligation to transfer assets in the future)
• Fuber has $10,000 in stockholders’ equity

13
Stockholders’ Equity is also known as “Shareholders’ Equity” or “Owners’ Equity.” If you’re talking about a
person instead of a company, you would refer to it as “Net Worth.”
CHAPTER 3 EDSPIRA 13

Assets are classified as either CURRENT or NONCURRENT.

Current assets are assets that will be used up or converted to cash within one year.14

Noncurrent assets are assets that are NOT current assets.

Here are the most common types of CURRENT assets:

Type Description

Cash and Cash Equivalents Currency and demand deposits, highly liquid investments15

Short-term Investment Investments that will be sold or mature within 1 year

Accounts Receivable Amounts owed by customers

Inventory Goods the company intends to sell to customers

Prepaid Expenses Insurance premiums paid in advance, rent paid in advance, etc.

Current assets are usually listed in order of liquidity, which the most liquid assets at the top.

Here are the most common types of NONCURRENT assets:

Type Description

Property, Plant, & Equipment Buildings, vehicles, machines, equipment

Long-term Investment Investments that will not be sold or mature within 1 year

Intangibles Trademarks, copyrights, patents

Goodwill The premium paid for another company in an acquisition16

14
Technically, it is “within one year or the length of the operating cycle, whichever is longer.” The operating
cycle is the time it takes to acquire inventory, sell inventory, pay suppliers, and collect cash from customers.
15
A treasury bill that matures in less than 3 months would be considered a “cash equivalent.”
16
Goodwill is the excess of the price paid for a firm over the fair value of its net assets. Assume the fair value of
a company’s net assets (assets minus liabilities) is $2 million. If you pay $10 million to acquire that company,
you will record $8 million of goodwill.
CHAPTER 3 EDSPIRA 14

Liabilities are classified as either CURRENT or NONCURRENT.

Current liabilities are liabilities the firm expects to satisfy within one year.17

Noncurrent (aka Long-term) liabilities are liabilities that are NOT current liabilities.

Here are the most common types of CURRENT liabilities:

Type Description

Accounts Payable Amounts owed to suppliers

Salaries Payable Amounts owed to employees

Interest Payable Amounts owed for interest accrued on the company’s debt

Income Taxes Payable Amounts owed to governments for income taxes

Unearned Revenue Cash collected for products not yet delivered or services
not yet performed

Here are the most common types of NONCURRENT liabilities:

Type Description

Notes Payable Amounts owed due to a written promise to pay18

Bonds Payable Amounts owed due to a bond issuance

Long-term Debt This is a generic term that could refer to notes, bonds, etc.

Lease Liability An obligation to make rent payments for a lease

Pension Liability An obligation to pay employees after they retire

Also: you will often hear the phrase Net Working Capital when discussing the Balance Sheet:

Net Working Capital = Current Assets – Current Liabilities

17
Technically, it is “within one year or the length of the operating cycle, whichever is longer.” The operating
cycle is the time it takes to acquire inventory, sell inventory, pay suppliers, and collect cash from customers.
18
The difference between Accounts Payable and Notes Payable is that a note is a formal, written promise.
CHAPTER 3 EDSPIRA 15

Here are the most common Stockholders’ Equity accounts:

Type Description

Common Stock and Money invested in the company by common shareholders

Additional Paid-in Capital

Preferred Stock Money invested in the company by preferred shareholders

Treasury Stock Repurchases of the company’s own stock (reduces equity)

Retained Earnings Past profits of the company, minus dividends distributed

Accumulated Deficit Past losses of the company (negative Retained Earnings)

Accumulated Other Gains and losses that bypassed the Income Statement
Comprehensive Income

Represents the ownership stake of noncontrolling

Noncontrolling Interest shareholders in investments where your firm bought more
than 50%, but less than 100%, of another company
CHAPTER 3 EDSPIRA 16

Here is Apple’s Balance Sheet:

CHAPTER 3 EDSPIRA 17

Note that:
• Apple separates its assets into current and noncurrent assets
• Apple separates its liabilities into current and noncurrent liabilities
• Apple’s total assets are equal to its total liabilities plus stockholders’ equity

Usefulness of the Balance Sheet

The Balance Sheet can be used to calculate ratios that tell you about the company’s
(1) rate of return, (2) liquidity, and (3) solvency.19

1. Rate of return
• Return on Assets (ROA) / Return on Equity (ROE)
o If two companies have the exact same profit, the company that achieved the profit
using fewer assets and/or less equity generated more bang for investors’ buck

2. Liquidity
• Current Ratio / Quick Ratio / Net Working Capital
o These tell you whether the company can pay its bills in the short-term
o They also tell you whether the firm can afford to pay dividends or repurchase shares of
its stock

3. Solvency
• Debt-to-Equity Ratio / Altman Z-score
o These tell you whether the company is at risk of bankruptcy

When a firm is in financial distress, the Balance Sheet is the most important financial
statement. This is because the Balance Sheet can be used to estimate what value
might be generated if the company were to be liquidated (if the firm’s assets were
sold off and its debts were paid).

19
The calculation of these ratios is covered in more detail in chapter 9.
CHAPTER 3 EDSPIRA 18

Limitations of the Balance Sheet

• Some assets are undervalued because they appear on the Balance Sheet at historical cost
• The domain name www.Facebook.com would appear on Facebook’s Balance Sheet at the
cost to register and renew the domain name, not the domain name’s fair market value. This
is a big deal, since it costs $10 to register a domain name, and this particular domain name
is worth billions
• Note: I said “some assets are undervalued” and not “all assets are undervalued.” This is
because some assets, such as certain types of investments, are presented on the Balance
Sheet at their fair market value

KEY TAKEAWAY: The Balance Sheet does NOT show you the fair
values of all the firm’s assets and liabilities.

• Some assets are not recorded on the Balance Sheet

• The creativity of Google’s engineers is critical to its success, but this won’t appear on
Google’s Balance Sheet
• You might think of a firm’s employees as an “asset” but they do NOT constitute an asset for
purposes of accounting
• Similarly, brand value created by Google won’t appear on its Balance Sheet either

Note: when someone says that a company has a strong Balance Sheet, this typically means that:

1. The company doesn’t have a lot of debt

2. The company has plenty of cash and other assets that are easily converted to cash
(Accounts Receivable and Short-term Investments can be quickly turned into cash)
CHAPTER 4 EDSPIRA 19

Chapter 4: Statement of Cash Flows

The Statement of Cash Flows shows a company’s cash flows from operating, investing, and
financing activities over a period of time.

The purpose of the Statement of Cash Flows is not to calculate a company’s cash balance; you
can see the cash balance by looking at the Balance Sheet. The Statement of Cash Flows tells
you why the cash balance changed from one period to the next.

The Statement of Cash Flows is the most important financial statement because
cash flow is critical; a company can’t stay in business if it runs out of cash.

The Statement of Cash Flows has 3 sections:

1. Cash received (or used) in Operations

• These are cash inflows (or outflows) from the company’s core business operations

2. Cash received (or used) in Investing

• These are cash inflows (or outflows) related to fixed assets and investments

3. Cash received (or used) in Financing

• These are cash inflows (or outflows) related to transactions with creditors and investors

Let’s define these 3 types of cash flows in more detail.

Cash Flow from Operations20 is the company’s profit (or loss) computed on a cash basis.

Cash Flow from Operations is what the firm’s Net Income (or Net Loss) would have
been if the company had used cash-basis accounting instead of accrual accounting.

To calculate Cash Flow from Operations, you start with Net Income and then adjust for any non-
cash expenses (by adding these back) and/or changes to operational balance sheet items.

20
Commonly known as “Operating Cash Flow.”
CHAPTER 4 EDSPIRA 20

Cash Flow from Investing…

Includes the following cash outflows:
• Cash paid for property, plant, and equipment (aka “capital expenditures” or “CAPEX”)
• Cash paid for stock of other companies21
• Cash paid for copyrights, trademarks, or patents

Includes the following cash inflows:

• Cash proceeds from the sale of property, plant, and equipment (NOT sales of inventory)
• Cash proceeds from selling other companies’ stock (NOT issuing your own stock)

Cash Flow from Financing…

Includes the following cash outflows:
• Cash paid to repurchase the company’s own stock
• Cash paid to repay the company’s debt (but NOT cash paid for interest)
• Cash paid to the company’s investors as dividends

Includes the following cash inflows:

• Cash received from issuing stock to investors
• Cash received from borrowing money

Companies can prepare the Statement of Cash Flows using one of two methods:

1. Indirect Method

2. Direct Method

The investing and financing sections are IDENTICAL regardless of which method is used.
The only difference between the two methods is the way the OPERATING section is presented.

99% of companies use the Indirect Method, so this guide covers the Indirect Method.

INDIRECT METHOD

• The operating section starts with accrual-basis Net Income (from the Income Statement)
and makes adjustments to obtain cash-basis Net Income
• The adjustments reconcile Net Income to Cash Flow from Operating Activities

If the company classifies equity securities as “Trading Securities” then purchases/sales of those securities
21

would be accounted for in the operating section of the Statement of Cash Flows.
CHAPTER 4 EDSPIRA 21

• Adjustments include:
o Adding back non-cash expenses (depreciation, amortization, impairment charges)
o Subtracting increases in current assets (accounts receivable, inventory, etc.)
o Adding increases in current liabilities (accounts payable, unearned revenue, etc.)

EXAMPLE

Toys or Bust posted Net Income of $100,000 last year. The company incurred $20,000 of
Depreciation Expense. Accounts Receivable increased by $30,000.

Cash Flow from Operating Activities would be $90,000. ($100,000 + $20,000 - $30,000)

Net Income $100,000

Adjustments to Net Income:

Depreciation Expense $20,000

Increase in Accounts Receivable ($30,000)

Cash Flow from Operating Activities $90,000

Depreciation Expense is added back because it reduced Net Income but had no effect on cash.

Net Income is lower because of the Depreciation Expense, so we need to undo this.

The increase in Accounts Receivable is subtracted because the increase in Accounts Receivable
(which occurs when a sale is made on credit) increased Net Income but had no effect on cash.

Net Income is higher because of the increase in Accounts Receivable, so we need to undo it.

But we shouldn’t just look at Cash Flow from Operating Activities; we need to examine cash
flows from investing and financing activities as well.

EXAMPLE

Assume that during its most recent fiscal year, the company Healthy Pizza:
• Generated $20,000 cash from making and selling pizzas
• Used $140,000 cash to acquire pizza ovens and other equipment
• Borrowed $300,000 from a bank
CHAPTER 4 EDSPIRA 22

Healthy Pizza’s cash balance increased by $180,000. [$20,000 - $140,000 + $300,000]

Does this mean the company is doing great? Not necessarily.

We want to know why the cash balance increased. In this case, it increased because the firm:
1. Received $20,000 cash from its operating activities
2. Spent $140,000 cash on its investing activities
3. Received $300,000 cash from its financing activities

We can break this down as follows:

Δ Cash = Δ Cash Flow from Operations + Δ Cash Flow from Investing + Δ Cash Flow from Financing

Thus:
$180,000 = $20,000 + (-$140,000) + $300,000

The company had positive Cash Flows from Operating Activities and the cash balance went up;
however, the main reason the cash balance went up is that the company borrowed money. If
the company had not been able to borrow money, the cash balance would have decreased by
$120,000. The Cash Flow from Operating Activities wasn’t sufficient to pay for the capital
investments the company needed (the new pizza ovens and equipment).

Key takeaway: just because cash increased doesn’t mean the company is doing well.
• A company might have positive Cash Flow from Operating Activities, but not enough to
pay for capital expenditures
• A company might be losing cash on its core business operations, but generating cash
from borrowing, issuing stock, or selling fixed assets
Conversely, a decrease in the cash balance doesn’t mean the company is doing poorly.
• The company might be generating a high level of Cash Flow from Operating Activities, but
be re-investing this money in the business (capital expenditures) or using it to repay debt,
repurchase stock, or pay dividends

Thus, the fact that the cash balance went up or down does not tell you much.
You want to know why the cash balance increased or decreased, and this is what the Statement
of Cash Flows tells you.

Let’s take a look at Apple’s Statement of Cash Flows.

CHAPTER 4 EDSPIRA 23
CHAPTER 5 EDSPIRA 24

Note that:
• Apple’s Statement of Cash Flows has 3 parts: operating, investing, and financing
• Apple’s cash balance increased by $5.624 billion during the fiscal year. This is because:
o Apple generated $77.434 billion in cash from operating activities
o Apple generated $16.066 billion in cash from investing activities
o Apple used $87.876 billion on financing activities

$5.624 (increase in cash) = $77.434 (operating) + $16.066 (investing) - $87.876 (financing)

• Apple was highly successful in producing operating cash flow, and it used a lot of the
cash it generated to repurchase its own stock (you can see this in the financing section)
• Apple had positive cash flow from investments because it sold some investments and
some of its debt investments matured

You can tell a lot about a company just by looking at its Statement of Cash Flows.

Here are some cash flow patterns that generally hold true:

If the company has… The company is probably…

High, positive Cash Flow from Operating Activities A mature, successful company.

Negative Cash Flow from Operating Activities
Negative Cash Flow from Investing Activities
Positive Cash Flow from Financing Activities
Startup/early-stage company.
(it’s burning through cash with its
operations and making capital
investments, so it’s relying on
debt and/or equity to survive.)

A company in distress.
Negative Cash Flow from Operating Activities
(it’s burning through cash with its
Positive Cash Flow from Investing Activities
operations, so it’s selling fixed
assets/investments to stay afloat)
CHAPTER 5 EDSPIRA 25

Chapter 5: The Statement of

Stockholders’ Equity
The Statement of Stockholders’ Equity shows how a company’s Stockholders’ Equity accounts
changed during the period.

The Statement of Stockholders’ Equity is NOT prepared to determine the ending balance of
Stockholders’ Equity. If you wanted to know the balance of Stockholders’ Equity, you would just
look at the Balance Sheet.22

The Statement of Stockholders’ Equity shows why Stockholders’ Equity accounts

changed from one Balance Sheet date to the next.

If you wanted to know why Additional Paid-in Capital increased from $20 million to $75 million,
for example, you would look at the Statement of Stockholders’ Equity.

Investors focus most of their time on the 3 main financial statements. Thus, the Statement of
Stockholders’ Equity is not as important. However, you should be familiar with the Statement of
Stockholders’ Equity since it appears in the 10-K and 10-Q.

A typical Statement of Stockholders’ Equity lists each account at the top of a column, with the
rows beneath showing the changes that occurred in each account during the period.

Let’s look at Apple’s Statement of Stockholders’ Equity, which uses the format just described.

22
This is the same idea as the Statement of Cash Flows. The Statement of Cash Flows isn’t prepared to tell
investors the ending cash balance, as that information appears in the Balance Sheet. The Statement of Cash
Flows is prepared to show why the cash account changed from one Balance Sheet date to the next; similarly,
the Statement of Stockholders’ Equity is prepared to show why Stockholders’ Equity accounts changed from
one Balance Sheet date to the next.
CHAPTER 5 EDSPIRA 26

Apple has four Stockholders’ Equity accounts:

1. Common Stock
2. Additional Paid-in Capital
3. Retained Earnings
4. Accumulated Other Comprehensive Income

The amounts in the top row show the account balances as of 9/30/17.
The amounts in the bottom row show the account balances as of 9/29/18.
The rows in between the top row and bottom row show changes that occurred during the year.

Note that:
• Apple combines its Common Stock and Additional Paid-in Capital accounts
o This makes sense, since Common Stock and Additional Paid-in Capital are what
investors paid Apple to acquire Apple’s common shares
• Apple also shows the number of common shares (it’s common to see this)
 PART 2 EDSPIRA 27

Part 2

Chapter 6: How the Financial

Statements are Related
The 3 major financial statements are related in the following ways:

Financial Statements Relationship

Income Statement & Balance Sheet • Net Income from the Income Statement increases
Retained Earnings (and thus Stockholders’ Equity) on
the Balance Sheet

Income Statement & Statement of Cash Flows
• Net Income from the Income Statement is the first line
of the Statement of Cash Flows
• When calculating Cash Flow from Operating Activities,
non-cash expenses from the Income Statement
(depreciation, impairments) are added to Net Income

Statement of Cash Flows & Balance Sheet
• The Statement of Cash Flows tells you why the
company’s cash balance changed from one Balance
Sheet date to the next
• The ending cash balance on the Statement of Cash
Flows matches the cash balance on the Balance Sheet
• When calculating Cash Flow from Operating Activities,
increases in current assets and decreases in current
liabilities are subtracted from Net Income. Conversely,
decreases in current assets and increase in current
liabilities are added to Net Income
• Changes in noncurrent assets (PP&E) and noncurrent
liabilities (Long-term Debt) appear in the investing and
financing sections of the Statement of Cash Flows

The table above is just a summary; let’s discuss these relationships in more detail.

We’ll start with the relationship between the Income Statement and Balance Sheet.
PART 2 EDSPIRA 28

Income Statement & Balance Sheet

Net Income from the Income Statement affects Retained Earnings on the Balance Sheet.

Thus, Net Income appears in the formula for calculating Retained Earnings:

Retained Earnings, Beginning Balance

+ Net Income (or minus Net Loss) that occurred during the period
- Dividends declared during the period
= Retained Earnings, Ending Balance

Note how Net Income affects Retained Earnings in the examples below.

EXAMPLE

Uncle Tito’s Fritos began operations on January 1, 2020.

Uncle Tito’s earned Net Income of $30,000 for the year ended December 31, 2020.
Uncle Tito’s declared a dividend of $6,000 on June 30, 2020.
Uncle Tito’s ending balance of Retained Earnings is therefore $24,000.
[$0 + $30,000 - $6,000 = $24,000]

EXAMPLE

Fruitarian had an Accumulated Deficit 23 of $80,000 as of January 1, 2020.

Fruitarian earned Net Income of $200,000 for the year ended December 31, 2020.
Fruitarian declared a dividend of $6,000 on June 30, 2020.
Fruitarian’s ending balance of Retained Earnings is therefore $104,000.
[-$80,000 + $200,000 - $6,000 = $114,000]

Net Income from the Income Statement affects Retained Earnings on the Balance Sheet
because revenues and expenses (used to calculate Net Income) are temporary accounts.

This means that companies only track revenues and expenses for a single year. Revenue and
expense accounts are then zeroed out as part of the year-end closing process. The balances of
revenue and expense accounts are transferred to Retained Earnings (Stockholders’ Equity).

23
Accumulated Deficit is what we call Retained Earnings when the Retained Earnings account is negative.
CHAPTER 6 EDSPIRA 29

Thus, when you’re looking at Microsoft’s Income Statement, you’re looking at revenue for the
fiscal year; the revenue doesn’t include all the revenues that Microsoft has ever earned since the
company was founded. At the end of the year, Microsoft’s accountants will mark all the revenue
and expense accounts to zero and transfer their balances to Retained Earnings.

EXAMPLE

Natalia starts a hot dog stand on January 1, 2022.

Natalia sells $200,000 of hot dogs (revenues) and incurs $130,000 of expenses during the year.
Natalia therefore posts a Net Income of $70,000 for the year ended December 31, 2022.
Natalia then begins year 2 with zero revenue, zero expenses, and zero Net Income.
The year 1 revenues and expenses don’t disappear, but are transferred to Retained Earnings.

Thus:
• Revenues not only increase Net Income, they increase Retained Earnings
• Expenses not only decrease Net Income, they decrease Retained Earnings

Because revenues and expenses are zeroed out to Retained Earnings, they also affect
Stockholders’ Equity (because Retained Earnings is a Stockholders’ Equity account).

Here’s a summary:

Revenues INCREASE… Expenses DECREASE…

Net Income Net Income

Retained Earnings Retained Earnings

Stockholders’ Equity Stockholders’ Equity

All accounts on the Balance Sheet are permanent accounts; this means they are never zeroed out.

This doesn’t mean Balance Sheet accounts can never have a balance of zero; if a company sells
100% of its inventory, the inventory balance will be zero. But an accountant would not
deliberately mark the inventory balance to zero just because it’s the end of the year.

• All Income Statement accounts are zeroed out at the end of the year
• No Balance Sheet accounts are zeroed out at the end of the year

Thus, you now know how the Income Statement and Balance Sheet are connected.

Now let’s discuss how the Statement of Cash Flows is connected to Balance Sheet.
CHAPTER 6 EDSPIRA 30

Income Statement & Statement of Cash Flows

The Income Statement and Statement of Cash Flows are connected in 2 ways:
1. Net Income from the Income Statement is the first line on the Statement of Cash Flows
• This is because the purpose of the operating section of the Statement of Cash Flows is
to take accrual-basis Net Income (which includes accruals like credit sales) and
convert it to a cash basis (Operating Cash Flow)
2. Non-cash expenses from the Income Statement are added back to Net Income as
adjustments in the operating section of the Statement of Cash Flows
• Income Statement items such as depreciation, amortization, and impairment charges
reduce Net Income but have no effect on cash. Thus, these items need to be added
back to Net Income when converting Net Income to Operating Cash Flow
CHAPTER 6 EDSPIRA 31

Statement of Cash Flows & Balance Sheet

The Statement of Cash Flows and the Balance Sheet are connected in 4 ways:

1. The Balance Sheet tells you the company’s cash balance as of a specific point in time,
whereas the Statement of Cash Flows tells you why the cash balance changed from one
Balance Sheet date to the next
2. The ending cash balance on the Statement of Cash Flows matches the cash balance on
the Balance Sheet
3. When calculating Operating Cash Flow:
• Increases in current assets and decreases in current liabilities (from the Balance
Sheet) are subtracted when converting Net Income to Operating Cash Flow on
the Statement of Cash Flows
• Decreases in current assets and increases in current liabilities (from the Balance
Sheet) are added when converting Net Income to Operating Cash Flow on the
Statement of Cash Flows
4. Changes in noncurrent assets (PP&E) and noncurrent liabilities (Long-term Debt) appear
in the investing and financing sections of the Statement of Cash Flows

EXAMPLE

Tom’s Automotive had $20,000 cash on its Balance Sheet as of 12/31/19.

Tom’s Automotive had $30,000 cash on its Balance Sheet as of 12/31/20.
From these comparative Balance Sheets, we see that the cash balance increased by $10,000.
The Statement of Cash Flows will also show that the cash balance increased by $10,000.

Finally…

When it comes to the financial statements, remember that the Balance Sheet is a snapshot of
the company’s financials as of a specific date whereas the other financial statements show the
company’s financials over a specific period of time (one year or one quarter).
Statements prepared for a PERIOD of time Statements prepared for a POINT in time

Income Statement Balance Sheet

Statement of Cash Flows

Statement of Stockholders’ Equity

APPENDIX EDSPIRA 32

Chapter 7: Financial
Statement Analysis
Investors use companies’ financial statements to predict the timing, certainty, and amount of
cash flows. The metric investors pay the most attention to is a company’s earnings, which
stands for Earnings Per Share (EPS). For example, you might here in the news that,

“Pinterest’s stock price jumped by 18% today after Pinterest reported better earnings than
analysts had expected.”

EPS is basically the company’s Net Income divided by the number of common shares.24

Because EPS is the single most important metric, analysts spend most of their time trying to
predict what EPS will be in the future. Because EPS is calculating using Net Income, EPS is a
function of a company’s revenues and expenses. Remember that:

Revenues – Expenses = Net Income25

Companies can increase their Net Income in only 3 ways:

• Increase revenues
• Decrease expenses
• Increase revenues and decrease expenses

Thus, for a company’s earnings to grow, it must occur in one of the 3 ways listed above.

Analysts care a lot about growth, not just in revenues, but in EPS.

24
EPS = (Net Income – Dividends Paid to Preferred Shareholders) / Weighted-average common shares
outstanding
25
Technically it’s “Revenue + Gains – Expenses – Losses = Net Income” but it’s usually helpful to just think of
Net Income as the difference between revenue and expenses.
APPENDIX EDSPIRA 33

EXAMPLE

Let’s take a look at Amazon’s Income Statement (numbers are in millions):

2018 2017 2016

Revenue 232,887 177,866 135,987

Cost of Goods Sold 139,156 111,934 88,265

Gross Profit 93,731 65,932 47,722

Operating Expenses

Fulfillment 34,027 25,249 17,619

Marketing 13,814 10,069 7,233

Technology and Content 28,837 22,620 16,085

General and administrative 4,336 3,674 2,432

Other 296 214 167

Operating Profit 12,421 4,106 4,186

Interest Revenue 440 202 100

Interest Expense 1,417 848 484

Other Income (Expense) -183 346 90

Earnings before Taxes 11,261 3,806 3,892

Income Tax Expense 1,197 769 1,425

Investment Revenue, net of tax 9 -4 -96

Net Income 10,073 3,033 2,371

APPENDIX EDSPIRA 34

A good way to begin analyzing an Income Statement is to look at top-line growth.

That’s the year-over-year revenue growth, expressed as a percentage:

2018 2017 2016

Revenue 232,887 177,866 135,987

% Growth 30.93% 30.80%

Note that Amazon’s top-line revenue26 grew 30.80% from 2016 to 2017, and 30.93% from 2017 to
2018. We only have two data points here, but since they’re so close together you wouldn’t be
foolish to guess that Amazon’s top-line revenue would grow somewhere around 30 or 31% from
2018 to 2019. Anything can happen, and analysts consider much more information than this.
They’d look at a breakdown of Amazon’s top-line revenue (the amount of revenue from product
sales, Prime memberships, Amazon Web Services, etc.), macroeconomic factors (e.g., is there
expected to be a recession), industry factors (e.g., is Amazon’s industry expected to grow faster
than in the past?), and other factors.

Top-line revenue is important not just for predicting future revenue, however. Analysts also use
top-line revenue to predict future expenses. They do this by expressing each operating expense
as a percentage of sales. If selling expenses have historically been 10% of top-line sales, for
example, an analyst might forecast top-line sales and then multiply the forecasted sales by 10%
to estimate the selling expenses. This method isn’t perfect, as there’s no guarantee that an
expense will always remain the same percentage of top-line revenue. However, this is a
common method of predicting future expenses.

26
Top-line revenue includes revenue from selling products and providing services. Things like interest
revenue, however, aren’t included in Amazon’s top-line revenue because interest isn’t one of Amazon’s
primary ways of making money.
APPENDIX EDSPIRA 35

2018 2017 2016

Revenue 232,887 177,866 135,987

Cost of Goods Sold 139,156 111,934 88,265

% of Sales 59.8% 62.9% 64.9%

Gross Profit 93,731 65,932 47,722

Operating Expenses:
Fulfillment 34,027 25,249 17,619
% of Sales 14.6% 14.2% 13.0%
Marketing 13,814 10,069 7,233
% of Sales 5.9% 5.7% 5.3%
Technology and content 28,837 22,620 16,085
% of Sales 12.4% 12.7% 11.8%
General and administrative 4,336 3,674 2,432
% of Sales 1.9% 2.1% 1.8%
Other 296 214 167

% of Sales 0.1% 0.1% 0.1%

Operating Profit 12,421 4,106 4,186

Interest Revenue 440 202 100
Interest Expense 1,417 848 484
Other Income (Expense) -183 346 90

Earnings before Taxes 11,261 3,806 3,892

Income Tax Expense 1,197 769 1,425
Investment Revenue, net of tax 9 -4 -96

Net Income 10,073 3,033 2,371

When the operating expenses are expressed as a percentage of sales (as presented above), the
Income Statement is referred to as a common-size Income Statement.
APPENDIX EDSPIRA 36

Note that the nonoperating items aren’t expressed as a percentage of sales. This is because
nonoperating items, such as interest expense, would be forecasted on a case-by-case basis. For
interest expense, you would look at the company’s long-term debt (disclosed in the notes to the
financial statements) and use the interest rate for each debt issuance to predict the total
interest expense. To predict Income Tax Expense, on the other hand, you would take your
forecasted Earnings before Taxes and multiply it by the statutory tax rate.

Now you have some knowledge how to forecast revenues and expenses to predict earnings.

But analysts also compute several ratios to analyze a company’s ability to generate profits.

There are 4 main types of ratios:

1. Profitability Ratios
Operating Profit
a. Operating Margin = Sales Revenue
Net Income
b. Profit Margin = Sales Revenue
Net Income
c. Return on Assets = Average Total Assets
Net Income
d. Return on Equity =
Average Total Stockholders′ Equity

Profitability ratios such as Operating Margin and Profit Margin are used to assess how good the
company is at controlling expenses and squeezing profit out of each dollar of sales.

Profitability ratios such as Return on Assets (ROA) and Return on Equity (ROE) are used to assess
how good the company is at generating profit given the resources it has or given the equity put
up by investors. If two companies each generate $100,000 of Net Income, you’d be more
impressed if one of the companies achieved this with only $500,000 of assets whereas the other
company achieved this with $50 million of assets.

2. Liquidity Ratios
Current Assets
a. Current Ratio = Current Liabilities
Cash + Securities + Accounts Receivable
b. Quick Ratio = Current Liabilities

Liquidity ratios such as the Current Ratio and Quick Ratio are used to determine how likely it is
that the company will be able to pay its bills in the next year.
APPENDIX EDSPIRA 37

3. Long-term Solvency Ratios

Total Liabilities
a. Debt-to-Equity Ratio27 = Total Stockholders′ Equity

EBIT
b. Interest Coverage Ratio = Interest Expense

The Debt-to-Equity Ratio is used to determine how leveraged the company is. For example, a
company that owes a great deal of money to lenders will be a more significant investment risk;
if the company fails to make its interest payments, the lenders could take over the firm, with
investors receiving nothing. The Interest Coverage Ratio is the company’s profit expressed as a
multiple of its interest expense; a higher multiple means the company has plenty of profit to
service its debt.

4. Activity Ratios
Sales Revenue
a. Asset Turnover Ratio = Average Total Assets
Cost of Goods Sold
b. Inventory Turnover Ratio = Average Inventory

The Asset Turnover Ratio is used to assess how good the company is at generating top-line
revenue given the assets the company has at its disposal.

The Inventory Turnover Ratio is used to calculate how many times the company sells through
its inventory each period.

Ratios can be used in 3 ways:

1. To identify trends

• How is the firm performing over time? Is performance improving or getting worse?

2. To benchmark against competitors

• How is the firm performing relative to other firms in its industry?

3. To detect financial manipulation

• If accounts receivable turnover is continually decreasing, perhaps the company has

relaxed its credit policy, is engaging in channel stuffing, or has fictitious sales

Some analysts prefer the ratio Long-term Debt to Equity, because total liabilities includes accounts that have
27

nothing to do with the company’s leverage (e.g., unearned revenue).

APPENDIX EDSPIRA 38

Appendix: Debits and Credits

Whenever an economic event takes place, an accountant must record that event in the
company’s financial records so that it can be reflected in the company’s financial statements.

For example, let’s say that a company purchases $100 of inventory on credit from a supplier.

The company’s records need to be updated, otherwise the Balance Sheet will understate the
Inventory account by $100 and understate the Accounts Payable account by $100.

Billions of economic events might occur in a single year, so companies use a formal system for
recording financial information. This system is called double-entry accounting.

This is how the transaction in the example listed above would be recorded:

Debit Credit

Inventory $100
Accounts Payable $100

The picture you see above is called a journal entry. This particular journal entry has two entries:

• A $100 “debit” to Inventory

• A $100 “credit” to Accounts Payable

If an account is debited, this means the number is written in the LEFT column.

In the example below, Inventory is being debited.

Debit (left column) Credit (right column)

Inventory $100
Accounts Payable $100

If an account is credited, this means the number is written in the RIGHT column.

In the example below, Accounts Payable is being credited.

Debit (left column) Credit (right column)

Inventory $100
Accounts Payable $100
APPENDIX EDSPIRA 39

Assets and Expenses increase with a debit.

• This means that if an Asset (or an Expense) account is increasing, you write the amount
of the increase in the left column (the debit column)

Liabilities, Stockholders’ Equity, and Revenues increase with a credit.

• This means that if a Liability or Stockholders’ Equity (or Revenue) account is increasing,
you write the number in the right column (the credit column)

Increases with a… Decreases with a…

Asset DEBIT CREDIT

Liability CREDIT DEBIT
Stockholders’ Equity CREDIT DEBIT
Revenue CREDIT DEBIT
Expense DEBIT CREDIT

Note 1:
Some students think “debit” means “increase” and “credit” means decrease.

Other students think “credit” means “increase” and “debit” means decrease.

BOTH OF THESE ARE WRONG.

If you tell me an account was debited, I can’t know whether the account increased or
decreased. You need to tell me what type of account (asset, liability, etc.) was debited.

The same goes for credits; whether credit means “increase” or “decrease” depends
on the type of account.

Note 2:
Every journal entry includes at least two entries. This is why it’s DOUBLE-entry accounting.
For any economic transaction, there are at least two effects that need to be recorded.

Thus, every journal entry has at least one debit AND at least one credit.

And the total debits must always equal the total credits.
APPENDIX EDSPIRA 40

For example, if a firm sells inventory for $275 cash, and the firm had originally purchased the
inventory for $100, you would record the following journal entry:

Debit Credit

Inventory $275
Cost of Goods Sold $100
Sales Revenue $275
Inventory $100

The numbers in the journal entry are then posted to a T-account.

Each account (Cash, Inventory, etc.) has its own T-account which tracks the account’s balance.

• A journal entry records the effects of a single economic event

• A T-account keeps a running total of a particular account, which includes the effects of
many economic events

EXAMPLE
Frogs for Dogs has $3,000 in its cash account on January 1, 2020.
• As of January 1, 2020, the company has no inventory and owes no money
• On January 4, 2020 the company borrows $40,000 cash from a bank
• On January 15, 2020 the company pays $15,000 cash to acquire inventory

Here are the journal entries to record what happened on January 4th and January 15th:

1/4/2020 Debit Credit

Cash $40,000
Note Payable $40,000

1/15/2020 Debit Credit

Inventory $15,000
Cash $15,000
APPENDIX EDSPIRA 41

Here are the T-accounts to update the accounts affected by the journal entries:

Cash
beginning balance $3,000
$40,000
$15,000

ending balance $28,000

Note Payable
beginning balance $0
$40,000

ending balance $40,000

Inventory
beginning balance $0
$15,000

ending balance $15,000

The ending balances from the T-accounts are the numbers that would be used to make the
financial statements. In the example above, the Balance Sheet would show “Cash” of $28,000.
FREQUENTLY ASKED QUESTIONS EDSPIRA 42

Frequently Asked Questions

1. What is the most important financial statement?

The Statement of Cash Flows. This is because:

a. You can value a firm based on its expected cash flows (DCF analysis)
b. Without cash, a company will go bankrupt
c. Cash flows are more reliable than accrual-based profit (e.g., Net Income is affected by
credit sales, which might never be collected)
d. If the company uses the indirect method, then Net Income (or Net Loss) will appear at
the top of the Statement of Cash Flows. Thus, by choosing the Statement of Cash Flows,
you not only get to see cash flow information but also get to see information from one of
the other statements (the Income Statement)

2. When a company pays dividends, is this an expense?

No. Dividends are NOT an expense.

The declaration or payment of dividends has NO EFFECT on a company’s profit.

3. Can a company go bankrupt if it has positive Retained Earnings?

Yes. Retained Earnings is not the same as cash in the bank.

In its final 10-K, RadioShack reported positive Retained Earnings on its Balance
Sheet. Yet, RadioShack went bankrupt soon thereafter.

If the firm runs out of cash, it will go bankrupt – regardless of Retained Earnings.

4. What is GAAP?

GAAP stands for Generally Accepted Accounting Principles. GAAP thus refers to the set of
accounting rules a company must adhere to when preparing its financial statements.

5. What is the FASB?

The Financial Accounting Standards Board is a nonprofit agency that makes the
accounting rules for companies in the United States.

6. What is the IASB?

The International Accounting Standards Board is a nonprofit agency that creates the
International Financial Reporting Standards (IFRS). Each country can choose to
FREQUENTLY ASKED QUESTIONS EDSPIRA 43

make its own accounting rules or to adopt IFRS. More than 100 countries have
adopted IFRS. The United States is one of the countries that has NOT adopted IFRS.

7. What is Comprehensive Income?

Comprehensive Income includes Net Income PLUS adjustments for gains and losses
that bypass Net Income.

For example, unrealized gains and losses on Available-for-Sale debt securities do

NOT affect Net Income. Yet, the unrealized gains and losses do affect Stockholders’
Equity. Thus, we book unrealized gains and losses on AFS securities to an account
called Other Comprehensive Income (OCI).

Comprehensive Income = Net Income + Other Comprehensive Income

This is equivalent to:

Comprehensive Income = Net Income + Gains that bypass Net Income

– Losses that bypass Net Income

At the end of each period, OCI is closed out to the account Accumulated Other
Comprehensive Income (AOCI) on the Balance Sheet.

Companies can disclose Comprehensive Income in one of two ways:

• They can issue a Statement of Comprehensive Income

• They can disclose Comprehensive Income at the bottom of the Income Statement

8. What’s the difference between accrual accounting and cash-basis accounting?

Accrual Accounting

• Firms recognize revenues when they are earned and record expenses when they are
incurred, regardless of when cash changes hands
o Example 1: Caterpillar receives an order for an excavator. Caterpillar ships the
excavator to the customer. The customer receives the excavator and promises to pay
Caterpillar in 30 days. Caterpillar can recognize revenue now, and does NOT have to
wait until the customer pays for the excavator
o Example 2: Caterpillar receives a utility bill in the mail. Caterpillar must record Utility
Expense, even though it has not yet paid the utility bill
FREQUENTLY ASKED QUESTIONS EDSPIRA 44

Cash-basis Accounting

• Firms recognize revenues when cash is received and record expenses when cash is paid
o Example 1: Caterpillar receives an order for an excavator. Caterpillar ships the
excavator to the customer. The customer receives the excavator and promises to pay
Caterpillar in 30 days. Caterpillar would wait to recognize revenue until it receives
cash payment from the customer
o Example 2: Caterpillar receives a utility bill in the mail. Caterpillar would wait until it
pays the utility bill to record Utility Expense
• Farms and small businesses are the primary users of cash-basis accounting28
• Companies that use accrual accounting would only use cash-basis accounting when
preparing the Statement of Cash Flows
o Thus, if you’re looking at Microsoft’s Income Statement, you can be certain that it was
prepared using accrual accounting. On Microsoft’s Statement of Cash Flows, however,
the line item, “Cash flows from operating activities” would be prepared using cash-
basis accounting

9. What’s the difference between Net Income and Operating Cash Flow?

Net Income (or Net Loss) is the company’s profit (or loss) per accrual accounting.
Operating Cash Flow29 is the company’s profit (or loss) per cash-basis accounting.

10. What’s the difference between Common Stock and Additional Paid-in Capital?

Both Common Stock and Additional Paid-in Capital represent money that investors
paid to the firm in exchange for shares of the company’s common stock.

Common Stock represents the par value of stock issued by the firm.
Additional Paid-in Capital represent money the firm received above and beyond the
par value of the stock.

Here’s an example:

Facebook issues 1,000 shares of stock, with a par value of $0.50/share, to Tom.
Tom paid Facebook $203,000 for the shares. On Facebook’s Balance Sheet:

28
All large corporations use accrual accounting.
29
Operating Cash Flow is the same thing as Cash from Operating Activities.
FREQUENTLY ASKED QUESTIONS EDSPIRA 45

Cash would increase by $203,000.

Common Stock would increase by $500 [1,000 shares * $0.50/par value share].
Additional Paid-in Capital would increase by $202,500 [$203,000 - $500].

The combination of Common Stock ($500) and Additional Paid-in Capital

($202,500) is the sum total that Tom invested in Facebook.

11. Do Common Stock or Additional Paid-in Capital change when a company’s stock price
fluctuates?

No. When an investor acquires shares directly from a firm, the Common Stock (and
possibly Additional Paid-in Capital) account is adjusted. But if the investor turns
around and sells that stock to a different investor, this has no effect on the company.

12. What’s the difference between Depreciation Expense and Accumulated Depreciation?

Depreciation Expense:
• Appears on the Income Statement
• Reduces profit
• Shows the depreciation incurred by the firm during one specific period

Accumulated Depreciation:
• Appears on the Balance Sheet
• Has no effect on profit
• Shows the depreciation incurred by the firm over multiple periods

13. What is a “debt investment”?

If a company purchases a U.S. treasury bond, a corporate bond, a municipal bond, or

other debt security, this would be considered a debt investment.

14. How does a company account for a debt investment?

Companies may account for a debt investment in 3 possible ways:

Classification Used when the firm owns… Accounting treatment?

Trading The firm intends to sell the The investment appears on the
investment in the next year Balance Sheet at its fair value.
Unrealized gains or losses affect Net
Income
FREQUENTLY ASKED QUESTIONS
Held-to-Maturity The firm has the ability AND
the intention to hold the
investment until its maturity
Available-for-Sale The investment is NEITHER
Trading nor Held-to-Maturity
15. What is an “equity investment”?
If a company purchases stock in another company, this would be an equity investment.
16. How does a company account for an equity investment?
Companies may account for an equity investment in 4 possible ways:
Classification Used when the firm owns…
Fair Value Method Less than 20% of the
investee
Cost, Minus Any Less than 20% of the
investee, but the investee’s
Impairments
fair value cannot be
assessed
Equity Method 20% to 50% of the investee
EDSPIRA 46
The investment appears on the
Balance Sheet at its amortized cost.
Unrealized gains or losses do NOT
affect Net Income
The investment appears on the
Balance Sheet at its fair value.
Unrealized gains or losses do NOT
affect Net Income. However,
unrealized gains or losses do affect
Other Comprehensive Income (and
thus affect Stockholders’ Equity)
Accounting treatment?
The investment appears on the Balance
Sheet at its fair value. Unrealized gains or
losses affect the investor’s Net Income.
Dividends received by investor affect the
investor’s Net Income
The investment appears on the Balance
Sheet at its historical cost, minus any
impairments. Unrealized gains or losses
do NOT affect the investor’s Net Income;
impairments, however, reduce the
investor’s Net Income. Dividends
received by investor affect the investor’s
Net Income
The investment is initially measured at
cost, but the amount on the Balance
Sheet increases (or decreases) by the
proportionate share of the investee’s
profits (or losses). Dividends received by
the investor do NOT affect the investor’s
Net Income, but reduce the amount of
the investment on the Balance Sheet.
Unrealized gains or losses do NOT affect
the investor’s Net Income
FREQUENTLY ASKED QUESTIONS EDSPIRA 47

Consolidation Method
More than 50% of the Investor & investee are treated as a single
investee entity. Investee’s assets and liabilities
become the investor’s assets and
liabilities. If the investor owns less than
100% of the investee, the investor will
have a line item called Noncontrolling
Interest in the Stockholders’ Equity
section of its Balance Sheet

17. What’s the difference between LIFO and FIFO?

LIFO and FIFO are both inventory cost flow assumptions.

• LIFO stands for, “Last in, first out.”

• FIFO stands for, “First in, first out.”

The LIFO/FIFO difference is best illustrated with an example.

Assume that a retailer, Toys that Rust, purchases:

• one Happy Tubby toy on January 2 for $10

• one Happy Tubby toy on January 5 for $12
• one Happy Tubby toy on January 7 for $16

Then on January 10, Toys that Rust sells one of the Happy Tubby toys. Because all
the Happy Tubby toys look the same, the company’s accountant can’t know which
Happy Tubby toy was sold, and thus can’t know what to put for Cost of Goods Sold –
unless an assumption is made.

If the LIFO assumption is made, the most recent purchase (the last unit to enter the
inventory) goes to Cost of Goods Sold first (last in, first out). COGS would be $16.

If the FIFO assumption is made, the least recent purchase (the first unit to enter the
inventory) goes to Cost of Goods Sold first (first in, first out). COGS would be $10.

Note: LIFO is only permitted in the United States. It is not allowed under
International Financial Reporting Standards.

18. What is goodwill?

Goodwill is an asset that is recorded when a company acquires a target firm, and the
purchase price exceeds the fair value of the target firm’s net assets.
FREQUENTLY ASKED QUESTIONS EDSPIRA 48

Goodwill to be recorded = Purchase price – Fair value of target’s net assets30

For example, assume that Deloitte & Touche pays $200 million to acquire BotKeeper.
An appraiser determines that the fair value of BotKeeper’s assets is $45 million, and
that the fair value of its liabilities is $27 million. Deloitte & Touche would thus
recognize $182 million31 of goodwill on its Balance Sheet from this transaction.

Goodwill is technically an intangible asset, but it is usually presented as a separate

line item in the Assets section of a company’s Balance Sheet.

19. Is goodwill amortized?

No, but it may become impaired. Publicly-traded companies are required to perform
an annual test to assess whether goodwill has become impaired.

20. What’s the difference between Depreciation Expense and Amortization Expense?

They are conceptually similar; each involves the expensing of an asset over its useful life.
The only difference is that:

• Depreciation Expense pertains to Property, Plant, & Equipment

• Amortization Expense pertains to Intangible Assets

21. Are all Intangible Assets amortized?

No, just Intangible Assets with a limited life (aka definite life).
For example:
• You would amortize a copyright that expires in 70 years and can’t be renewed
• You would NOT expense a trademark that can be renewed every 10 years
o This is because the trademark could theoretically have an infinite life

22. What is Depreciation Expense, conceptually?

Let’s assume that U-Haul paid $80,000 cash to acquire a truck. Under cash-basis
accounting, you would record an $80,000 expense this period. Under accrual
accounting, however, you would record the truck as an asset (Property, Plant, &
Equipment) and then expense the truck over its estimated useful life.

30
Fair value of target’s net assets = Fair value of target’s assets – Fair value of target’s liabilities.
31
$200 million – ($45 million - $27 million) = $182 million.
FREQUENTLY ASKED QUESTIONS EDSPIRA 49

Thus, Depreciation Expense exists because of accrual accounting. Depreciation is an

example of the matching principle, which says that expenses should be matched with
the periods in which the asset is expected to generate revenue. If you plan to use the
truck for 10 years, then the expense should be spread across the 10 years. If you
instead expensed the entire $80,000 in year 1, it would look like U-Haul did poorly in
year 1 (because it had a big expense) and did great in years 2 through 10. But the
reality is that U-Haul benefitted in years 2 through 10 from the truck that was acquired
in year 1. Thus, accrual accounting suggests that the financial statements would
portray a more accurate picture of the company’s operations if it spread the cost of the
truck over the years in which the truck is used to generate revenue.

23. What is an asset retirement obligation?

An asset retirement obligation (ARO) is a long-term liability that a company recognizes when
it has an asset that must be retired (shut down, disassembled, etc.) at some point in the future.

For example, if a company operates a nuclear reactor, a drilling rig, a landfill, or a mine,
it will incur costs at some point in the future when it takes that asset out of operation.
The company must recognize a liability for those future costs today (the costs are
discounted to their present value).

Exelon, a company that operates multiple nuclear power plants, has an Asset Retirement
Obligation on its Balance Sheet to reflect costs it will incur when it decommissions the
nuclear power plants at some point in the future. This includes costs for shutting down
the plant, dismantling the nuclear reactor, and providing security for the site until it has
been fully decommissioned.

24. If a company improperly capitalized an expense, how would this affect Net Income?

Net Income would be higher in the current period, but lower in future periods.

Assume, for example, that a company capitalized $20,000 of routine maintenance

costs related to its Property, Plant, & Equipment account. Routine maintenance is
supposed to be expensed as incurred, so the company should have recognized a
$20,000 expense in the current period. However, by capitalizing the expense, the
company makes the $20,000 an asset (it increases the Property, Plant, & Equipment
account) and expenses it over the estimated useful life of the asset. Thus, the
company will still expense $20,000, but it will spread the expense over many years,
instead of booking it all this year.
FREQUENTLY ASKED QUESTIONS EDSPIRA 50

Capitalizing costs that should have been expensed is a type of fraud that was
employed by WorldCom and Waste Management.

Note that certain types of costs (e.g., the purchase of Property, Plant, & Equipment)
should be capitalized and expensed over time.

25. What does it mean to capitalize a lease?

When you agree to lease32 something for longer than one year, you must record the
leased item as an asset on your Balance Sheet (even though you don’t technically
own it). In addition, you must recognize a liability for the future lease payments.

For example, let’s assume that Lennar agreed to lease an excavator from Caterpillar
for 3 years. Because the lease term exceeds one year, Lennar must show the
excavator as an asset on its Balance Sheet. Moreover, it must recognize the present
value of the minimum lease payments as a liability on its Balance Sheet.

26. What’s the difference between a finance lease and an operating lease?

Both finance leases and operating leases must be capitalized if the lease term exceeds one
year. But there are differences in accounting for finance leases and operating leases.

For a finance lease…

The total expense related to the lease is different each period
a. Amortization Expense is recorded to reduce the value of the asset
b. Interest Expense on the lease liability is recorded

For an operating lease…

The total expense related to the lease is the same each period
a. You record an account called Lease Expense each period
b. Interest Expense is not reported; interest is part of Lease Expense
c. Amortization Expense is not reported; a plug amount keeps Lease Expense the same
each period; the plug amount reduces the asset’s book value

27. How do you calculate Earnings Per Share?

Net Income−Dividends Paid to Preferred Shareholders
Earnings Per Share = Weighted−average of Common Shares Outstanding

32
To “lease” something means to rent it from someone. If you’re renting an apartment, you probably signed a
lease agreement with your landlord.
FREQUENTLY ASKED QUESTIONS EDSPIRA 51

28. What is Diluted Earnings Per Share?

Some companies have issued (a) stock options or (b) bonds that are convertible to
common shares.

If the persons holding stock options choose to exercise those options, the company might
issue more common shares. This would decrease the company’s Earnings Per Share (the
denominator in the formula would increase, thus decreasing EPS). Thus, when firms
disclose their Earnings Per Share, they must also disclose the hypothetical, lower Earnings
Per Share that would occur if all the options holders exercised their options. This
hypothetical, lower Earnings Per Share is called Diluted Earnings Per Share.

Similarly, if people holding convertible bonds choose to convert those bonds to common shares,
the company might have to issue new shares, potentially diluting the Earnings Per Share.33

29. What is a deferred tax asset?

A deferred tax asset represents a decrease in income tax payable at some point in the
future due to a temporary difference between book34 and tax accounting.

A deferred tax asset could arise for many reasons.35 For example, GAAP requires
companies to estimate and recognize future warranty expenses in the period they
sell the product. The federal tax code in the United States, however, does not permit
companies to take a tax deduction for warranty expenses until those expenses are
actually incurred. Thus, a firm that has $100,000 in revenue this period, estimates
$40,000 in future warranty costs, has no other expenses, and faces an income tax
rate of 20% would in the current period report the following for book purposes:

33
With convertible bonds, the company would have lower interest expense (and thus higher Net Income) if the
bondholders convert their bonds to common shares. Thus, it is theoretically possible that a bond conversion
would actually result in a higher Earnings Per Share (this is called “antidilutive”). In this unusual situation, the
company would NOT be required to report the higher Earnings Per Share from the bond conversion.
34
When someone talks about differences between book accounting and tax accounting, they’re referring to (a)
financial reporting for incomes taxes and (b) tax accounting (taxes paid to a governmental entity. Book and
tax accounting follow different rules, because book accounting is focused on providing useful information to
investors and creditors, whereas tax accounting is focused on raising revenue for the government (and,
occasionally, incentivizing certain types of behavior).
35
A common deferred tax asset is a Net Operating Loss (NOL). When a company posts a tax loss, it can carry
that loss forward to offset future taxable income.
FREQUENTLY ASKED QUESTIONS EDSPIRA 52

• Recognize $12,000 of Income Tax Expense [($100,000 - $40,000) * 20%]36

• Recognize an $8,000 Deferred Tax Asset ($40,000 * 20%)37
• Increase Income Tax Payable by $20,000 ($100,000 * 20%)

30. What is a deferred tax liability?

A deferred tax liability represents an increase in income tax payable at some point in
the future due to a temporary difference between book and tax accounting.

A deferred tax liability could arise for many reasons, but the most common reason is a
difference between book and tax depreciation. In the U.S., for example, most companies
use straight-line depreciation for financial reporting purposes, but use an accelerated
depreciation method for purposes of calculating their federal income taxes. This will
result in tax depreciation exceeding book depreciation in the early years of the asset.

Thus, a firm that has $100,000 in revenue this period, records $50,000 of tax
depreciation, records $20,000 of book depreciation, has no other expenses, and
faces an income tax rate of 20% would in the current period report the following for
book purposes:

• Recognize $16,000 of Income Tax Expense [($100,000 - $20,000) * 20%]

• Recognize a $6,000 Deferred Tax Liability [($50,000 - $20,000) * 20%)
• Increase Income Tax Payable by $10,000 [($100,000 - $50,000) * 20%)

The $6,000 Deferred Tax Liability is recognizing that, even though the company only paid
$10,000 in taxes this year, at some point in the future it will have to pay an additional
$6,000 in taxes. This is why Income Tax Expense of $16,000 is recorded (and this is what
affects Net Income in the current period); the $6,000 tax savings is only temporary.38

36
This is the Income Tax Expense shown on the Income Statement for financial reporting. The amount actually
due to the government, however, is $20,000; which is why Income Tax Payable increases by $20,000.
37
This means that in a future period (when the company actually incurs the $40,000 in warranty costs) the
company will pay $8,000 less in incomes taxes that period because it will be able to take the tax deduction for
warranty costs in that period.
38
Even though you get the same total amount of depreciation either way, companies generally prefer to take
tax deductions sooner due to the time value of money.
CONCLUSION EDSPIRA 53

I hope you found this guide helpful. I encourage you to:

Connect with Edspira:

• Website (https://www.edspira.com)

• Instagram (https://www.instagram.com/edspiradotcom)

• LinkedIn (https://www.linkedin.com/company/edspira)

• Facebook (https://www.facebook.com/Edspira)

• Reddit (https://www.reddit.com/r/edspira)

• TikTok (https://www.tiktok.com/@edspira)

Connect with Michael:

• LinkedIn (https://www.linkedin.com/in/prof-michael-mclaughlin)

• Twitter (https://twitter.com/Prof_McLaughlin)

• Instagram (https://www.instagram.com/prof_mclaughlin)

• Snapchat (https://www.snapchat.com/add/prof_mclaughlin)

• TikTok (https://www.tiktok.com/@prof_mclaughlin)

Check out Michael’s Scheme podcast:

• Apple Podcasts (https://podcasts.apple.com/us/podcast/scheme/id1522352725)

• Spotify (https://open.spotify.com/show/4WaNTqVFxISHlgcSWNT1kc)

• Website (https://www.edspira.com/podcast-2/)