PART A: INTRODUCTION

- CHAPTER I: INTRODUCTION A. ACCOUNTANCY? – – –
– – – – Accounting: The process of analyzing and justifying one’s actions to another Trust Accounting: How a trustee explains their actions to the beneficiaries Financial Accounting: How managers of for-profit businesses report to shareholders and others about the management of the business (by preparing and distributing financial statements Lawyers need a working familiarity with accounting, they should understand accounting and the rules of it Accounting numbers can be factually relevant to a legal issue Accounting terms and concepts can be used in controlling law In this chapter: 1. Introduction of accounting and preliminary comments on accounting’s relationship to finance 2. History of accounting (accounting’s role) 3. Current practice of accounting (how accounting plays its role) 4. Reflection on the nature of corporate finance 5. Additional thoughts of the general relevance of accounting to lawyers Accounting became needed as businesses increasingly used capital owned by others (lenders, shareholders) Capital owners required reports detailing how their capital was being used and accountants became necessary to evaluate management’s performance since capital users could not be wholly trusted to provide faithful accounts Public Capitalism: Individuals investing directly in stocks and bonds (developed in the American capital markets in the early 20th Century) Individuals depend on accounting to help them make decisions on where to invest Securities laws in 1933 and 1934 created the regulatory regime called the Securities and Exchange Commission (SEC), which allows the market to set prices while ensuring that it functions properly (corporate insiders are not allowed to inside trade) Accountings of public businesses are filed with the SEC and available tot the public Generally Accepted Accounting Principles (GAAP): Rules that control basic financial statements Financial Accounting Standards Board (FASB): Responsible for setting out what accounting rules are “generally acceptable,” originally known as the Committee on Accounting Procedure (CAP) The lack of real regulation of accounting rules means that they continue as a common-law discipline, as new procedures develop into industry customs they get written into professional journals and eventually become codified in the industry as an acceptable standard Recently capital markets are becoming increasingly international, non-U.S. companies are traded in overseas markets and overseas companies are traded in U.S. markets International Accounting Standards Board (IASB): The international version of FASB, headquartered in London, pushing for an international convergence of accounting principles IASB rules are required by the EU for European companies and American companies like the more flexible rules used by IASB compared to FASB but convergence has had limited success

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B. HISTORY


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C. ACCOUNTING –
– – Financial Accounting: Way in which capital users (business managers) report on hoe they are managing investors’ money Financial accounting consists of financial statements and the procedure for their preparation Four financial statements: 1. Income statement 2. Balance sheet 3. Cash flows statement 4. Equity statement (little interest to lawyers and is not discussed in detail) Accounts: Basic books and records a business keeps itself Management analyzes these records and condenses them into a draft of the financial statements Outside independent auditors (public accountants) are then brought in to complete the process


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Auditing firms are similar to law firms, a practice dominated by four enormous firms known as the “Big 4,” these auditors serve two functions 1. Audit the financial statements to ensure that the facts represented by the management are true, they check assets and confirm liabilities 2. Condense books and records into financial statements, after determining whether management has correctly applied the applicable accounting principles that control how the books and records are analyzed Opinion Letter: Certification that the independent auditors have ensured the facts’ legitimacy subject to two conditions 1. Certified statements are not what the auditors would have prepared had they done the management’s job, just that they are not materially different from GAAP numbers 2. Not tested by one standard set of rules, there are a variety of acceptable ways to account for items Arthur Anderson was Enron’s independent auditor and Enron was their biggest client, conflicts of interest between the two are believed to have led to the misrepresented documentation of Enron’s financials

(1) Did you expect financial accounting to be scientifically precise? Computer languages are precise because they have a self-defined, closed function. Is the same true of financial accounting? (2) What should a business language talk about? Assets? Liabilities? People? Activities? Knowledge? Reputation? Goals? History? (3) Do languages usually develop in a common-law fashion? Is this the way that financial accounting principles should develop? (4) Would you expect a language developed for businesses centuries ago to be a good way to talk about businesses in the current, increasingly knowledge-based, economy? (5) Would you let a business’s management report on themselves? Would you let them hire their own policemen? Would you let the accountants set their own guiding principles? (6) Do you think that it was a good idea for the SEC to leave the regulation of accounting principles to the accounting industry? – In the broadest sense finance is the study of money and monetary transactions, how businesses get money and use the money they get Public Finance: Examines governments Corporate Finance: Examines private businesses and is what is covered in this text Not only does finance study the markets but the markets study finance Financial analysts look to financial accounting for one number called “profit,” “income,” “net income,” or “earnings” Finance depends on, and therefore necessarily provides support for, financial accounting

D. DISCUSSION PROBLEMS: THE NATURE OF ACCOUNTING

E. FINANCE AND ACCOUNTING

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(1) Should the same set of financial reports be provided for the public as for market professionals (like pension fund managers, mutual fund managers, investment advisors, the financial press, and brokers)? (2) Should the same financial accounting rules apply to privately-held and public companies? (3) Ina computerized world, do you think that market professionals need businesses to analyze and condense the businesses’ raw financial data into financial statements for the market professionals? Rather, would it make more sense for businesses to just make their raw financial data available on line? (4) Should accountants, who are self-interested technicians after all, control the language by which business speaks to the public (who are not technicians)? Is it likely that technicians can ignore their training and speak clearly to the average investor?

F. DISCUSSION PROBLEMS: ACCOUNTING AND FINANCE

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(5) What kind of accounting rules would you expect accountants to write? Would you expect rules written by accountants help or hurt their fellow accountants’ investment in current practice? Would you expect rules that limit the risks of accountants?

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The law, lawyers, and legal instruments frequently make use of financial accounting concepts and, on occasion, the rules of GAAP themselves The general concepts underlying GAAP seem to be a natural way to think about various aspects of business The principle purpose of this text is to give the student the understanding and motivation to use, and not use, GAAP effectively

G. RELEVENCE TO LAWYERS

H. CLASS NOTES – – –
– – – – – Idea of the course is to be able to understand the numbers and value of the business and to talk about business using accounting and financial information Cooperation and partnerships allow people to pool resources together and then divide them up to save time and money and increase profits In a mortgage: Before you or your creditors can get any value out of your house the bank gets the first cut which means you can get a lower interest rate because it is less risky for them. If a company goes broke they owe money first to creditors before shareholders Equity holders are shareholders or stockholders, they have an interest in the residue, whatever is left over after paying the creditors Accounting plays the central role in reporting information to the shareholders There are a lot of people who can arguably be considered owners of a company, workers, shareholders, etc Modern Securities Market: Stocks, bonds, you give money to someone and they use it to give you money back You buy stock or bonds originally from a company and then to get out you sell your stock to another guy in the market who replaces you as the shareholder or bondholder, if there was not a way to get out people would have to use banks Called “Capital Markets” because it allows people to put capital into the market The Great Depression 1. Managements of corporations were lying 2. America had to decide how to proceed, they had two options: (i) The European system was that banks do the investing and the little guys had to put their money into the banks, or (ii) have a government agency regulate the markets To be public is expensive but it allows you to sell stock on the market Accounting information is what allows investors to decide if they want to or should invest in a company, it is the heart of modern capitalism The largest market in the world is the foreign exchange, stock markets are the third largest Mergers and Acquisitions: One company acquires another for financial or tax reasons by purchasing stock or buying them out 1. Who or what survives the merger—the management, the name, etc. (in the Bank of America merger North Carolina National acquired Bank of America but kept the name because it was better, however the National management was the one that stayed in charge) 2. Frequently destroys jobs The books that companies keep are so extensive that an average investor cannot reasonably go through it and understand it (after the great depression government agencies began going through these books to make sure that they are right) Private companies also go through the books and get them certified, and now companies must have certified financial statements To be a public company you have to get a letter from an audit firm that your books are in standard accordance with the laws of the US


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Deferred interest: Interest to be paid after accrual 4. Selling goods or services 4. Buying property 5.00 $0. Finance’s basic approach to valuation The closer an asset is to resembling cash the easier it is to determine the valuation “Money today is worth more than money tomorrow”: Money today can be invested and earn a return so as to grow to a larger sum tomorrow – – – B.55 365 … … $1105. A BASIC EXAMPLE EXAMPLE $1000 Bank Account Growth at 10% Interest Year Opening Balance 1 $1000 2 $1100 3 $1210 4 $1331 5 $1464 Interest Earned $100 $110 $121 $133 $146 Closing Balance $1100 $1210 $1331 $1464 $1611 – – – – – – Principal: The amount originally lent.CHAPTER II: TIME VALUE OF MONEY A.27 $0. Buying services In this chapter: 1. Earning of interest: What is owed if the borrower defaults on its obligations under the loan terms Types of Interest: 1. and decreased for payments Interest: Paid by the borrower to the lender to compensate the lender for borrower’s use of the lender’s funds Amortization Schedule: The terms of a loan that control when principle is to be repaid Compounding: Interest that is reinvested and earns interest (compounding period in the example above is one year) Three Concepts of Interest: 1. Accrued or Economic interest: Earned interest regardless of its payment date 2. Borrowing goods or services 3.PART B: FINANCIAL VALUATION .274 $1000.27 2 $1000. Compounding of interest: How interest is calculated 3. NOMINAL AND EFFECTIVE INTEREST – – Nominal Interest Rate or APR: The annual interest rate before compounding Effective Interest Rate or Yield: The interest rate after the nominal interest rate has been compounded EXAMPLE Nominal interest rate of 10% compounded daily is 10% / 365 days = 0.20 1 . INTRODUCTION – Corporate Finance: Studies how businesses acquire and use money 1.274 $1000. increased to reflect subsequent additional lendings. Issuing stock 2. Simple interest: Interest determined without compounding (interest to be paid as it accrues) C. Prepaid interest: Interest to be paid before it accrues 3. Payment of interest: When the borrower is required to provide cash to the lender 2.0274% each day Day Opening Balance Interest Earned Closing Balance 1 $1000.

The effective interest rate on a nominal interest rate of 10% compounded daily is therefore 10. People have to foreclose because they can not afford the double in cost when interest rates double. The following two cases suggest how the New York courts have dealt with it. The sanctions for usury vary from the lender losing any excessive interest. Many states have statutes that outlaw “usury:” lending to individuals at a rate of interest above a statutorily-prescribed rate (today. Arnow “Effective Interest Exceeds Usury Limit but Nominal Does Not” Without quarterly payments.86% (APR is an effective rate displayed in its nominal form) – Adjustable-rate or Variable-rate loans: Loans that provide for interest rate adjustments that reflect the current market conditions A fad in very active (“bubble”) real estate markets is buying homes using money borrowed under mortgage loans that provide for variable interest (currently. Under these cases (which are not a complete picture of even New York law). Since no payment was due until “one year from date” and no quarterly payments were ever due the compounding was solely a means of increasing the interest rate and must be considered usury.45% per month) so the effective rate on 17. Usury law allows the credit card companies to bring suit in the state the card is issued (usually DE). measuring interest is quite important in usury law. over the years. Thus.5% but the promissory note that indicated the interest rate set it at a nominal 7. If you have to pay a really high rate of interest then you probably shouldn’t borrow. PROBLEM: USURY F. most states try to accommodate some compounding with the policy against charging individuals unduly burdensome interest. “discounting” 2. today. You are also not getting any investment from the house because you are still paying off the interest.72%. This old law flew in the face of customary business practice. Estate of Jackson “Compounding Interest” Compounding is legal if a debtor has the option of paying interest as it accrues or when the principle is due No agreement to pay compound interest was made. many states held compound interest against public policy per se. you have not been paying off any of the principle. The borrower had the option of paying interest as it became due or waiting until the end of maturity. Future Value – The value of the present value of money in X number of years Based on the 10% interest example in three years $1000 would be worth $1331 so it would be foolish to pay any more than $1000 for a promise of $1331 in three years time D. Compounding interest is a legitimate method of computing interest when the debtor has the option of not paying interest until the principal balance is due. you have only been paying off the interest. usually between 16% and 18%).52% per year – Annual Percentage Rate (APR): Computed by multiplying each compounding periodic rate by the number of compounding periods in a year. quite low) and require only interest payments monthly until the entire principle is due in 20 years. DISCUSSION PROBLEM: THERE’S INTEREST AND THEN THERE’S INTEREST E. quarterly compounding was only a means to get around the usury limit and illegal The maximum rate of interest was 7. What do you tell him? As interest rates increase peoples’ interest-only loans increase and people are shocked by the amount they owe. These statutes are intended to protect individuals from taking on debt that they cannot handle.5% interest compounded quarterly which was an effective interest rate of 7.4% is 18. to criminal sanctions. which allows them to charge more interest than what most states usury statutes allow. PRESENT AND FUTURE VALUE OF ONE PAYMENT 1 . At common law. Present Value – The future value shrunk to reflect the time value of money. an APR of 17. Another interesting context where compounding can have legal significance is under state usury statutes.000 because with interest-only loans. when is compounding reflected in determining whether interest is usurious? Does this rule make finance sense? How does it fit with a policy of protecting debtors from running up debt? – – The two most important finance application of the time value of money: 1. CASES Giventer v. In 20 years you will still have to come up with the principle of $300.4% means that each month 1/12 of that percentage is owed (1. A friend comes to you saying that this creative financing makes it possible for him to buy more home: The current payments under such a borrowing are so small that he can handle borrowing more. in which case the interest would be added to the principle and future interest computed on the new sum. Given the potential bite of such sanctions. State usury statutes are designed to prevent predatory lending and keeping people from buying houses that they cannot afford. to the lender losing the principal on a usurious loan.

1 / 1. it all depends on the terms of the loan which may not allow you to pay off the principle or penalize you if you do.10. which translates to the Future Value after “n” compounds of the Present Value equals the Present Value times the interest rate “r” compounded “n” times Present and future values mirror each other.1)1 = $1. A relative of the student dies and leaves her a few thousand dollars. no payments are due for one year.1)3 = 0. (1) Many employees set up their income tax withholding so that their employers withhold more than is legally required and the employees get an interest-free refund when they file their return.7513 (2) What is the present value today determined using a 10% annual yield of $1 to be pad in 5 years? $0. (3) An appliance store has a sale.10 in one year is $1. which makes it possible to reverse the future value formula to get a present value formula: PV(FVn) = FVn / (1 + r)n EXAMPLE If r = 0.1)2 = 0. CLASS NOTES 1 . PROBLEMS: TIME VALUE H.1)1 = $1 Since the future value in one year of $1 today is $1.8264 1 / (1.7513 1 / (1. When does it make finance sense for her to prepay the student loans? The student should pay back her loans if the amount of interest she would pay by paying off her debt over the longest period of time allowed would be less than the interest that she would earn by holding onto and investing the money that she inherited. If a consumer opens a charge account and buys using such credit.10) = $1.6830 1 / (1.1)5 = 0. if Y is the future value of X.6209 (3) What is the present value today determined using a 10% annual yield of a promise to make two payments: $1 to be paid in 3 years and another to be paid in 5 years? $1. What does finance say to such employees? Withholding money is only worthwhile if you lack the self control to manage your money throughout the year and invest the extra money. then at the end of the year they can pay off the debt and keep the interest they earned but if the card accrues interest its probably not worth it. The following table shows numbers that are useful in discounting by a 10% annual yield. if the card does not charge you interest over the period that you do not have to make payments and you are able to keep your money invested in order to earn interest on it for the year.3722 G. Is the store doing consumers a favor? This all depends on the terms of the card.1 (10%). PROBLEMS: PRESENT VALUE OF A SINGLE PAYMENT I. the present value today of $1. yes.1 = 0.10 / (1 + 0. then X is the present value of Y. for these people the system is forced savings which can help them payoff debts when they get a large tax return (2) A student has substantial student loans.6209 (1) What is the present value today determined using a 10% annual yield of $1 to be pad in 3 years? $0. what is the present value of $1. what is the future value of $1 one year from now? FV1($1) = 1 x (1 + 0.10 If r = 0.1)4 = 0.10 to be paid one year from now? PV1($1.– – Written as an equation the future value of money would look like this: FVn(PV) = PV x (1 + r) n .1 (10%).9090 1 / (1.

365 EFF= 20. however adding a little bit of compounding periods makes a big difference but a lot of extra compounding doesn’t make much more of a difference NOM = 19 .1])] = 1000(1 + 0.7 .000) with a (200. GIVENTER v. companies would money from paychecks under the Federal income tax withholding and send it on your behalf to the federal government (small businesses got in trouble for not sending the money. they would use the money instead to fund the business.17 The more compounding periods the more interest.– – – – – – – – – – – – – – – – – – – – – Time Value of Money: You would rather have a dollar today than have a dollar tomorrow because either (i) you can enjoy it today. 19 C/Y =4 .5 threshold.000. if the house goes up to (1. and keep the extra 700. now many people purposefully withhold extra money so that when they get their refund they get more money 1 . and were charged with felonies).000) and borrow (300. at the closing the bank gets a mortgage on your house so that if you sell the house they get paid before you do and if you default on your loans they can force you to sell your house if you default.1 * 1000) = 1000(1 + 0. ESTATE OF JACKSON: Compounding is okay. because it is a was being used to make the interest payments higher then the 7. so that you can put it in the bank and watch it grow to the future amount) Nominal or Named Rate: Stated rate dependant upon compounding Yield: The percentage that you are actually owed (in a 10% nominal interest rate compounded yearly. the plaintiff was not locked into the burden of the compounding because he can pay off the interest.1)2 FV after n years at 10 % interest = 1000(1 + 0. bigger than stock market): Banks sell the loan and collect your interest but the real owner would be an investment banker who sells it on the market.1) = [1000(1 + 0.1 x (1000[1 +0.9 Equity Loan: Buy a house (500.000) down payment.1)] + [0. Withholding: During WWII the US decided the best way to pay for the war was to tax wages.75 (effective interest rate) HOME LOAN EXAMPLE: NOM = 6 C/Y = 12 EFF = 6. 20.1%) Future Value after 1 year at 10% interest = 1000 + (0. you can pay the interest before it is due Amortization: The rate at which you pay down a loan Positive Amortization: Pay some of the principle plus the interest to avoid compounding Negative Amortization: Low payments with a high interest rate which gets added to principle and increases compounding To get the effective rate (EFF) you must divide the nominal rate (NOM) by C/Y add 1 and square it CREDIT CARD EXAMPLE NOM = 19 (nominal interest rate) C/Y = 12 (compounding periods per year) EFF = 20. after 3 years your yield would be 33. or (ii) put it in the bank and earn interest Dollars in the future have to be discounted because the present value of a future dollar is less than its current amount (you would be willing to take less dollars now.000) you can sell the house.000 Mortgage backed securities market (Second largest market in the world. ARNOW: Compounding is not okay. the bank then makes another loan with the money they were paid by the investment bankers. pay off the loan.1)n FV = PV (1 + r)n PV = FVn/ (1+ r)n Prepaid Interest: To an economist it is just reducing compounding.

with the buyer stepping into the shoes of the original lender with the same rights – B. the interest is specified and a payment schedule is provided (often the borrower will be required to retain certain assets in case of default) 1. whether principal or interest.000 827 3 1.000 3.000 principle at “maturity” or the end of the fifth year Year Payment Present Value 1 1.355 5 4.000 4. 10 year bond at 8% is worth $11.CHAPTER III: ASSET VALUATION A.279 2.000 683 5 11.000 The finance analysis does not distinguish between principle and interest. the more that discounting is reflected in the present value.472 change for the 10-year bond) 1.000 4.000 6.868 4 4. and the more that the value is sensitive to the interest rate used in discounting (a four percentage point difference causes a $1.335 533 1. to present value – The higher the interest rate the less a bond is worth 1. works by opening an account that will earn enough interest each year to withdraw $1000 each year for 10 years: Year Opening Balance + Interest Withdrawals = Closing Balance 1 6.870 – C. ANNUITY VALUATION – Simple Annuity: Pays a fixed amount per year (or other time period) for a fixed number of years (or other time period) EXAMPLE A ten year annuity allowing for 10 withdrawals of $10.. Interest only: Interest is paid at specified intervals with all of the principle due at a specified future date 2.335 3 5.759 576 1.279 The longer the remaining term.000: Using the interest only method the bond pays $1.520 change in value for the 5-year bond but a $2.790 1 .000 10.830 Total 15.868 487 1. At an 8% effective market annual discount rate the bond is worth $10. Introduction to financial valuation generally A bond represents a long term borrowing (usually by a corporation or government). it simply reduces the stream of future payments. At a 12% effective market annual discount rate the bond is worth $9. INTRODUCTION – – Debt Instrument: Proves the holder case payments at one or more specifies future times In this chapter: 1.799 and at 12% is worth $9.342 and at 12% is worth $8.000 at 10% annual yield.799 2.145 614 1.000 751 4 1. the lender gives the borrower money and the borrower issues the bond to the lender. VALUING A BOND – – EXAMPLE Market interest is a 10% annual yield and a five year bond has a face value of $10.355 435 1. 5-year bond at 8% is worth $10. at which time the lender may impose the sanctions specified in the lending contract Many loan contracts allow the lender to sell their rights.000 909 2 1.000 5.759 2 5. Level payments: The same amount consisting of interest and principle is paid at the specified intervals Default: The failure of a borrower to fulfill an obligation.000 at the end of each five years and the $10.000 5. Expanding the time value of money analysis in order to value debt instruments like bonds and annuities 2.

How so you analyze this offer? Figure out the present value of the two sets of rent and compare them to find out which is lower. Each payment would be the same as above.6 3.000 Subtract the PV of the first 6 months from the PV of the $10. year-end payments of $47. how are the burdens of your client different under the 10% documents? On the basis of the New York judicial opinions in Section II.705 per year. As a lawyer.735 909 0 Annuities are similar to bank accounts so buyers and sellers should compare the rates available and price them accordingly A level payment loan would work the same way paying $1. Drafting the loan this way.145 loan You are a lawyer. which is the better deal: (1) 5 years $10. – Legal terms of leases can vary widely from the amount of time they are for to the burdens they place on the parties Net Lease: Requires that the lessee provide repairs. in regards to the leased property Residual Value: The value of leased property at the end of the lease period The fundamental financial difference between a loan and a lease is that in a lease the property is returned to the lender at the end of the agreement.000 down.790 379 1. where if it says 10% it is not. BASIC LEASING – – – – You are negotiating a lease for new office space for your law firm. The rent seems high. The seller is willing to lend the remaining $200.000 PMT = 10000 FV = 0 P/Y = 12 C/Y = 12 PMT: BEGIN 2. the landlord offers a “rent holiday.000 she would owe $293.169 317 1.000 Starting with $6.486 249 1. however.000 each year for ten years to pay off a $6. The lawyer for the store suggests taking advantage of present value analysis to avoid the usury problem. which prohibits interest in excess of 18% per year.000 a year for ten years or $10.000 10 909 91 1. residual value. do you think New York courts would find usury in the restructured sale? If the document says 20% interest it is a violation of the usury statute.000 – – 3.169 2. A seller can charge whatever they want for the item so having a higher price is not illegal where having a higher interest rate is. you can withdraw $1.735 174 1. The resulting loan of $293. In negotiations. etc. The problem would be if your client defaulted and the value of the item needed to be turned over to the seller. $496. what is the difference between the documents saying $200. requiring 10 years of level.000 8 2. The purchase price would be changed to $343.000 payments over 5 years N = 60 I% = 8 PV = [SOLVE] = $496.705 per year. but reflect more nominal principal and less nominal interest.000 7 3. Compare some hypothetical law firm lease rates.000 at 20% or $293. instead of having to give them $200.126.000 a month at 8% APR or (2) 5 years no rent for first 6 months and $10.000. maintenance. and interest rate D. level payments would be $47. it follows that the final “payment” in a lease includes the residual value To calculate a non-net lease all that is required is the rent.000 Find the PV of the $10. She can pay $50.126. violates the applicable usury statute.126 would bear 10% annual effective interest. On paper she owes more money than she should technically (so if she defaults she gets screwed). A store is willing to sell her equipment that she needs for $250.000 9 1.500 payments over 5 years F. PROBLEM: LEASING 1 . taxes.000 at 20% interest.126 at 10% when either way the annual payments are the same? In particular. PROBLEM: A LEGAL PRESENT VALUE ISSUE E. above.500 thereafter at 8% APR 1.D.” under which no rent is owed for the first six months. $459.145 and a 10% yield.486 1. With the new loan amount and interest rates. You have a client who hopes to start a new business as a proprietorship.

interest yield.000 – $62. PROBLEMS: PERPERTUITY 1 . VALUING A PERPETUITY – – – – Pure Perpetuity: Promise to pay a periodic sum certain in perpetuity (forever) Under a discounted present value analysis.20 = 5 $5 = $1 / 20% VALUE = $5 J.000 less than option number one. AUTO LEASING H. what is the value of $1 a year at year end forever? VALUE = PMT / r 1 / . it is important to make the dealer disclose the car’s price.000 PMT = 10500 FV = 0 P/Y = 12 C/Y = 12 PMT: BEGIN N=6 I% = 8 PV = [SOLVE] = $62. where r is the periodic return (interest rate) and PMT is the periodic payment (VALUE x r) – – (1) Assuming a market rate of interest (yield) of %5 a year. theft or damage I. FINANCIAL VALUATION OF NONFINANCIAL ASSETS – – Economic Value: The estimated value of the use of the machine Risks with owing a leased machine include nonpayment. technology making the machine obsolete. difficulty finding lessees.N = 60 I% = 8 PV = [SOLVE] = $521.000 = $459. the present value gets so small so fast that their sum is finite Beginning-of-period payments have a higher present value The higher the interest rate the smaller the discounted present value of the perpetuity is needed to generate the desired return (and vice versa) End of the Period Payments: VALUE = PMT / r. a perpetuity does not have an infinite value. thanks to the 6 months free at the beginning of the lease – – – The difference between higher monthly costs for a loan to buy a car versus to lease it is just the fact that at the end of the lease the lessor will retain the residual value When pricing a car lease.000 PMT = 10500 FV = 0 P/Y = 12 C/Y = 12 PMT: BEGIN $521. and the estimated residual value used to determine the rent Factoring in mileage and damage adjustments can become burdensome G. where r is the periodic return (interest rate) and PMT is the periodic payment (VALUE x r) Beginning of the Period Payments: VALUE = (1 + r) x (PMT / r).000 The best option turns out to be option number two which will cost $37. what is the value of $1 a year at year end forever? VALUE = PMT / r 1 / .05 = 20 $20 = $1 / 5% VALUE = $20 (2) Assuming a market rate of interest (yield) of %20 a year.

of which the true value is only really reflected at the mid-point of the instruments life When borrowing to acquire an asset. Payments of $2. airlines agreeing to purchase X amount of fuel at Y price over Z years) Hedge Fund: Investors buy shares of the fund. DERIVATIVES AND OTHER HYBRID INSTRUMENTS – – – – – Derivatives: Financial instrument whose value derives from something outside the bargain Option Contract: The “holder” has the right to buy from or sell to the “writer” certain property at a set price at some point in the future. which invests in primarily dividends – – – – – N.000 PMT = -300 FV = 0 – – 1 . if the stock goes up or the investment goes down they will lose money) Interest charges compensate the broker for the time value of money and any dividends that the stock pays must be paid to the lending broker K.76 Months I% = 19 PV = 10.000 loan with 19% interest and payments of $300) N = [SOLVE] = 47. borrowing an extra $100 doubles your potential gain or loss) Short Sale: An investor borrows stock from his broker and sells it.000 principle at the end 2. (A $10. however the holder is not required to exercise their right while the writer must comply Call: Option to buy (increases profit as value goes up) Put: Option to sell (increases profit as value goes down) The risk to the writer of the holder not exercising their right to buy is offset by a fee designed to compensate him Forward Contract: One party unconditionally agrees to sell to the other party (and the other to buy) a fixed quantity of some asset at a fixed price at some point in the future (i.000 at a 7% APR: 1. one must take into account the economics of the entire transaction not just the ownership of the asset Leverage: Borrowing to buy an asset In leverage the borrowing aspect multiplies the potential profit and loss (if you have $100 dollars and can invest it.917 a month if you do interest only and pay off the $500.327 a month if you pay off the principle and interest over 30 years At the end of a loan you pay off more principle because the interest is lower since you have been paying off principle bit by bit Sample Exam Question: Assume you know how much money you can come up with each month how long would it take you to pay off your loan? Some calculator examples: 1. LIMITATIONS (RISK EFFECTS.e. CLASS NOTES Bonds issued with higher interest rates are worth more (you would pay more for a bond that pays 10% then one that pays 8%) Annuity means level payments Home loan for $500. LEVERAGE – – – – M. then at a later point the investor must return the same amount of stock as was originally borrowed (if the stock goes down or their investment goes up the investor will make money.(Putting $5 in the bank at 20% interest is worth the same as $20 at 5% interest if you wanted to pull $1 out of the bank at the end of each year) – – – – – – Limitations on the finance analysis include the risk and the interest rate Higher interest rate compensates investors for taking greater risk Investors generally do not like being locked into investments because it decreases liquidity and increases risk Risks include those related to the transaction like a borrower going bankrupt and those related to the market in general like better options becoming available Long-term debt usually pays a higher interest than short-term debt In a long-term debt instrument the yield is a time-adjusted average. IN PARTICULAR) – L. Payments of $3.

000 PMT = [SOLVE] = $190.57 N = 36 I% = 9.000 down payment? ►Nom(15.89 1.12 [ENTER] = 14.12 [ENTER] = 9.000 lease with a 15% yield over 2 years with a $16. What payment will you owe at the beginning of each month paying a $25.21 Monthly Payments FV = -16.000 loan with a 10% yield over 3 years with a $16.57 N = 36 I% = 9.000 loan with a 10% yield over 3 years with a $16.57 PV = 18.73 Monthly Payments FV = -16000 P/Y = 12 C/Y = 12 PMT: END 3.06 N = 24 1 .000 loan with a 10% yield over 3 years with a $16.57 PV = 25000 PMT = [SOLVE] = $412.75 1.– – – – – P/Y = 12 C/Y = 12 2. First number (9) = percentage 2. Second number (12) = compounds per year or C/Y Lease examples on the calculator: 1.12 [ENTER] = 20.57 N = 36 I% = 9.12 [ENTER] = 4.000 residual value? ►Nom(10.57 PV = 18000 PMT = [SOLVE] = $191. First number (5) = percentage 2.000 residual value and $7.000 residual value? ►Nom(10.12 [ENTER] = 9. (A $10.000 PMT = -400 FV = 0 P/Y = 12 C/Y = 12 For cars the difference between leasing and lending is that at the end of the lease you return the car to the lessor (if you do not return the car in good condition you can end up owing more than the car is worth when you return it).000 residual value? ►Nom(10.90 Monthly Payments FV = -16000 P/Y = 12 C/Y = 12 PMT: BEGIN 4. What payment will you owe at the end of each month paying a $25.12 [ENTER] = 9. serious work is covered by the manufacturer but the lessee is responsible for maintenance and insurance A lessor has better rights than a lender because they can take the item back whereas a lender must wade through bankruptcy rules How to convert nominal to effective (APR of a 5% yield): ►Nom(5.000 P/Y = 12 C/Y = 12 PMT: BEGIN 2.000 loan with 19% interest and payments of $400) N = [SOLVE] = 32. What payment will you owe at the beginning of each month paying an $18. What payment will you owe at the end of each month paying an $18. Second number (12) = compounds per year or C/Y How to convert effective to nominal (yield of a 19% APR): ►Eff(19.08 Months I% = 19 PV = 10.

known as a short position Call: Option to buy something at a later date at a set price (you are betting that the stock will go up) no capital is invested in the property.000 residual value and no down payment? ►Nom(15. when buying a put you are betting that something will go down. value of car) Perpetuity is the amount (Value) you would be willing to pay to be paid a different amount (PMT) over a certain period of time and can be viewed as PMT = Value x r (where r is the rate for the period) or Value = PMT / r (assuming PMT is at the END of period) What would you be willing to pay someone now in order for them to give you a dollar every year forever: The Value should be the same as putting Value into the bank at r interest and taking out a dollar a year at the end of every year.06 N = 36 I% = 14.06 PV = 25000 PMT = [SOLVE] = $619. therefore to fine the VALUE you divide the yearly payment by the interest rate Leverage: By borrowing to buy you increase the risk of gains and loses. the lender gets interest and commission Short Sales: Borrowing stock from your broker and selling it.12 [ENTER] = 14.55 Monthly Payments FV = -16000 P/Y = 12 C/Y = 12 PMT: END 5.12 [ENTER] = 14.84 Monthly Payments FV = -16000 P/Y = 12 C/Y = 12 PMT: END 6. What payment will you owe at the end of each month paying a $25. it is a pure bet In a forward contract the seller is short the commodity and the buyer is long the commodity 1 . i. What payment will you owe at the beginning of each month paying a $25.000 lease with a 15% yield over 2 years with a $16.000 lease with a 15% yield over 3 years with a $12.06 N = 24 I% = 14.000 residual value and no down payment? ►Nom(15.06 PV = 25000 PMT = [SOLVE] = $578.e. so if it goes down you make money but if it goes up you lose money (usually you cannot go out more than a year) Put: Option to sell something at a fixed price at a future date (if the underlying stock goes down then the value of the put goes up).06 PV = 18000 PMT = [SOLVE] = $283.– – – – – – – – I% = 14. X months from now you must return the same amount of shares.51 Monthly Payments FV = -12000 P/Y = 12 C/Y = 12 PMT: BEGIN Make sure that future value is negative when it is residual value (left over value at the end of the lease.

therefore. Relationship of the finance methodology to financial accounting Finance values businesses by analogizing them to a perpetuity A business throws off cash flow each year and the more consistent the level of cash flow the more it resembles a perpetuity If one share of stock provided the shareholder with $1 worth of dividends each year. INTRODUCTION – – – B. but the 2003 reduction on the tax rate may change that Profit: Measure of how much better off the owners of a business are as a result of that business’s operations over a period of time (usually a year) Finance needs the information that accounting provides in order to value businesses.CHAPTER IV: BUISNESS VALUATION – – – – A business’s value is not as simple as the sum of the value of its assets. a 5% annual yield (1 / . and the stock goes up with anticipation that company growth means that dividends will increase in the future A company’s total stock value should equal their total net (of debt) value Ex-Dividend Day: Day on which holders of stock are locked in to receive a dividend regardless of if they sell it before the day the dividend is actually paid. A 10% annual yield (1 / . and irrational factors (those that cannot be captured in a discounted present value analysis) do not affect prices 2. CAP RATE = PMT / VALUE) Multiple: Ratio of the capitalized value to the annual future payments 1. THE PERPETUITY APPROACH – – – – – – – – – – – – – – C. accounting by contrast looks exclusively to the past A business can announce a profit but have its stock go down if it is not what finance had predicted. Finance methodology and its limitations 3. corporations frequently grow by retaining money that could have been paid out as dividends. that is to have higher returns than the market as a whole 1. forever. the present and past are just forecasts of a business’s future. stock usually drops on this day. How finance values businesses 2. Hypothesis is that it is not possible for an investor over time to beat an effective market. while retained earnings build up stock value until paid out Companies historically paid small dividends. etc.. MULTIPLE = 1 / CAP RATE 2.5) has a multiple of 20 Net cash flow is not perpetuity-like because cash must be set aside for value preserving purposes (replacing assets and funding debt obligations) Cannot value stock by only looking at recent dividends. THE FOUR APPENDIX COMPANIES – D. assuming a 10% annual yield that share would be worth $10 (disregarding capital gains. This is the theory behind having a highly diversified portfolio or alternatively “index investing” (buying mutual funds that track market indexes like the S&P 500) A. taxes. finance is the most important consumer of accounting information and accounting tries to accommodate this use Finance attempts to predict the future.10) has a multiple of 10. assets are only a part of the business valuation picture Stock is a thing that is distinct from the business’s assets Finance values stock and does not try to relate that value to underlying business assets In this chapter: 1.) Capitalizing: A stream of future payments reduced to the discounted present value Capitalization Rate or “Cap Rate”: The interest rate used in capitalizing future payments (VALUE = PMT / CAP RATE. Market prices rationally reflect all available information. GE RESEMBLES A PERPETUITY? 1 . while a company can announce a loss and have its stock go up if it is less than finance predicted The market is impossible to predict with 100% accuracy or security The market was wrongfully optimistic about Enron and not pessimistic enough about WorldCom in the time prior to their collapse Strong support for the discounted present value analysis comes from the “efficient capital markets hypothesis” 1.

What do you see yourself as buying? How do you decide if the stock is a good buy? What analysis do you use? What information do you use? What additional information would you like? Who do you talk to? How do you think that others value stock? How do you think that the market values stock? Do you think that you can beat the market? If you accept the discounted present value approach. a building. 2000 WorldCom was a pessimistic 9. In the late 1970’s companies would retain cash and buy back stock rather than pay out dividends. why was the market so optimistic: They tricked the market into believing they were a high tech company that had a high prospective for the future despite a shaky past. Asset Account: Record in respect to an asset (with student loans. and present it 2. 2000 GE and Microsoft were more stable companies that had proven themselves consistent in earnings so their price-earnings ratios were more conservative at 17. as you take money out the asset goes up as you pay them back the asset goes down) 4. By buying one index the investor reduces transaction costs of having to buy all the individual stocks that index owns and therefore over time should have more returns than active investment strategies like day trading Think about buying a share of stock of a public company. In-house accountants take the raw information and condense. the advantage of this to investors is that those who don’t want cash get an increase in stock value and those who want cash can sell shares 7. because if you have 51% you have most of the say in what happens within the company 2. 31. Presentation is a way of organizing the information in order to condense it into something easy to review.7 because of the telecommunications trouble Accounting is necessary when companies open separate facilities in order to keep track of the business as a whole or when the owners (investors) are not directly involved in the organization and running of the business 1. Cap Rate = PMT x Multiple… 1 / Cap Rate = Multiple 6. 31. DISCUSSION PROBLEM: WHAT A SHAREHOLDER BUYS F. 2000 Enron was trading at 71.2. Dividends: Money that the company does not need is paid out to its investors in the form of a dividend 4. Most of the difficulty in accounting is figuring out which accounts to put the transaction in 6. THE MARKET DON’T NEED NO STINKIN’ ACCOUNTING? – G. There is a difference in value between the total value of a business’s stock shares and what one would pay to buy the whole company 3. do you believe the large multiples seen with the four companies whose financial statements are in the Appendix? – – The market looks to financial statements for information. There is a big difference between owning one share of stock and owning 51% of the stock. analyze. Value = PMT / r … Value = PMT / Cap Rate 5. Account: Running record of transactions affecting one item (a bank account. Balance Sheet: A useful way of summarizing all the accounts at an instant in time E. even though most of the information needed to discover the bad accounting was publicly available Valuing a business: 1.1 times its earnings. On Dec. CLASS NOTES – 1 .7 9.) 3. On Dec. 31. etc. Equity: What is left over for the shareholders when the creditors are all paid off 5.2 and 18. similar types of accounts are added together (instead of listing every bank account businesses lump them all into one group called “cash”) 7. not for measurement The market was fooled by bad accounting in the case of Enron. On Dec. investors were gambling on their growth ability 8.

and presentation of that information 3. Introduction to the analysis. Equity Statement Balance: Amount in an account at a given time EQUITY = ASSETS – LIABILTIES (for example your equity in your house would be the amount you would receive from selling the house and paying off any mortgages from the sale proceeds) From the previous equation we can extrapolate that ASSETS = LIABILITIES + EQUITY to form a more useful equation Customarily assets are listed starting with the most liquid and ending with the least liquid.e. Asset: Shows all items affecting an associated asset (i. Equity: Value of assets minus the value of liabilities Financial accounting is how the business analyzes and organizes the accounts in order to present this massive amount of information in a concise and useful form Four basic financial statements: 1.000 Retained 850. based on the calendar year or another approximately 12-month period) 2.PART C: BASIC ACCOUNTING . formal journals that record transactions in chronological order Businesses keep ledgers that contain the central accounts of the business An account is kept for every asset. organization. its financial records 2. loans) 3.000 2. finance is a mode of analysis for answering questions while financial accounting tries to describe the information In order to start a discussion of accounting it is necessary to explore the nature of information that motivates the discipline In this chapter: 1. while liabilities are listed by the earliest due to the last due A.000 Payables 300.e. THE BASIC IDEA – – – – – – EXAMPLE The following balance sheet is of a a small corporation that manufactures bolts: BALANCE SHHET The Bolt Company Assets Liabilities Cash 100. Cash Flow Statement 4. liability. prepared at the end of each reporting period (most commonly the fiscal year.000 and Equipment 1. the balance sheet A business transfers their informal information to centralized.000 950.000 Bonds 750.000 Shareholders’ Equity Paid-in 100. bank accounts) 2.150. or the like for as long as they continue to be relevant to the business Three basic types of accounts: 1.200. Liability: Shows all items affecting an associated liability (i.000 Inventory 500.000 Receivables 300. INTRODUCTION – – – – B.CHAPTER V: THE BALANCE SHEET – – – – The previous three chapters have laid out the basics of finance as business valuation using information organized by financial accounting Financial accounting is very different from finance. A business’s core information. Income Statement: 3.000 1 . Balance Sheet: A snapshot of the amounts in the financial accounts of a business at an instant in the past.000 Notes 100. Plant 1.100.000 Property. The historical heart of financial accounting.

what was WorldCom’s most valuable asset? How much of the property. Do not be concerned about consolidation at this point. plant. what business was Enron in? Risk Management.9 billion. and equipment or (b) investments? PP&E. – Balance sheets contain a wealth of information D. GECS. plant.5 billion).6 billion (from $2. the cash account must go down $100. WHAT THE BALANCE SHEET SAYS 1 .000) Debit: An adjustment in a pair of entries that increases assets or decreases liabilities or equity Credit: An adjustment in a pair of entries that increases liabilities or equity or decreases assets A debit increases assets while a credit decreases assets.78 billion). what was Enron’s most valuable asset? Based on its property. (4) The GE financial statements break GE into two big pieces: regular GE and GECS (GE Capital Services). which were the bigger part of Enron’s business : (a) property. (3) What were Enron’s biggest liabilities and how had they changed from 1999 to 2000? “Risk management” increased $8. “accounts payable” increased $7.84 billion to $10.000% increase. and equipment.– – – – – – – – – – – – To reduce the number of accounts shown on the balance sheet.000 is spent on a machine. which should be automatic because of double-entry bookkeeping requires that each transaction be reflected in both sides of the exchange (for example when $100.7 billion (from $1. GECS: Financial receivables. contrary to our general notion of a credit and debit since debit and credit card usage is named from the banks perspective not the customers Left-Hand Entry: A debit. and “short-term debt” increased $3. (5) How much did GE’s shareholders’ equity change from 2001 to 2002? Up $8. $6 billion.15 billion to $9. the right side must equal the left side (ASSETS must equal LIABLITIES + EQUITY). Gas & Electric. which reduce cash but also reduce equity so the balance sheet balances) These problems concern the balance sheets in the Appendix. (6) What was Microsoft’s biggest asset on its balance sheet? What was Microsoft’s long-term debt? Does this resemble any of the businesses previously examined? Cash. and equipment was not in progress? Goodwill (88%).) On GE’s books. the balances in many accounts of the same type are usually added together and presented as one balance in a more general account Cash: Amount of cash in the bank Receivables or Accounts Receivable: Amount a business is owed for products and services delivered but not yet paid for Payables or Accounts Payable: Amount a business owes for products and services received but not yet paid for The two sides of a balance sheet must balance. so named because the liabilities and equities appear on the right-hand side of the balance sheet Double-Entry Bookkeeping: Assures that the balance sheet balances by providing a limited check on arithmetic and transcription errors but says nothing about whether the entries are correct The most important adjustment to equity is for profits and losses a profit is booked as an increase to equity and losses are booked as decreases (a common adjustment is payment of dividends to shareholders. so named because asset accounts appear on the left-hand side of the balance sheet Right-Hand Entry: A credit. which piece had more assets? Which piece contributed more to the overall consolidated GE equity? What was the biggest asset of each piece? GECS. (7) At book value. C. (Chapter XIII discuses how the pieces fit together on the consolidated financial statements. plant.28 billion) that is around a 10.000 and the machine account must go up $100. PROBLEMS: READING BALANCE SHEETS (1) At book value. GE: Goodwill. (2) On its balance sheet.8 billion (from $44 million to $4.

cash goes up $1 million and liability goes up by $1 million. PROBLEM: BOOK VS. buying property together and cutting a deal of how to split up the property use or profits If a Company goes under. what has happened is that the company made money. many people can have claims to a businesses assets 1. The property settlement negotiations have begun. even when it measures value badly. Preferred Stock 4. Short-term trade creditors with no specific instrument evidencing the debt are owed payables 2. its investors and debtors receive payments in this order: 1. or depreciation The liabilities section of the balance sheet can run into problems when the value of a fixed rate interest loan varies based on interest rate increases and decreases Overstating assets overstates equity and vise versa. cash goes down $1 million and liability goes down $1 million If the company buys an asset for $100 and sells it for $150 it doesn’t balance. the future value from dividends and gains are not taken into account. whose balance sheet appears in Section V. E. The company has been paying dividends of $200.000 book value. The book value is only the value of the stock at that point in time.000.B. if you pay down debt. Short-term creditors who hold instruments are owed on notes 3. while overstating liabilities understates equity and vise versa Company’s Market Value: Determined by multiplying the number of shares outstanding at the end of its most recent fiscal year. so there is clear reason to believe that The Bolt Company is worth more than the $950. because it provides much important information about a business that is available nowhere else in as useful a form You are a divorce lawyer. a stock that pays $200. Your client is the impecunious soon-to-be-ex-spouse of the woman who is the sole shareholder of The Bolt Company.000 per year for as long as your client can remember and probably will forever. Secured Debt (an asset such as a machine the lender holds the title to) 2. MARKET VALUE F. the right-hand side shows the claims to these resources.– – – – – – – – – – The left-hand side show the assets or resources of the business. CLASS NOTES – – The balance sheet shows a snap shot of the company’s standing at 11:59PM of the fiscal year Partnership: a group of people getting together. Common Stock For every action there is an equal and opposite reaction: If you borrow $1 million. obsolescence.000 annually is worth $2. to compensate equity has to go up by $50 (the company has made money meaning the shareholders have made money) Liabilities: Money owed to creditors Equity: Residual money owed to shareholders Credit: Increase in a liability (bad thing) Debit: Decrease in a liability (good thing) – – – – – – – 1 . as above.) In a divorce the goal is to split up resources not just divide current monetary value. What do you tell opposing counsel? (A market rate if interest is a 10% annual yield. by the market price for one share on that day Few take the equity section of a balance sheet seriously as a precise measure of the market value of the business’s total equity The balance sheet is useful. Unsecured Debt 3. She argues that this process that her client’s stock is worth $950. At a 10% market rate. Business equity owners receive whatever is left over of the assets after the creditors claims are paid off As far as accounting is concerned only creditors (with fixed legal liabilities) and owners (with equity) have claims on business resources Balance sheets help value businesses by providing information that allows one to determine the amount that would be left over for the shareholders (equity) if the business’s assets were sold at their book value and the liabilities paid off at their book amount Equity is in this sense the value of the shareholders’ stock Book Value: Historical cost with some adjustments for things like wear and tear.000. conversely. Long-term creditors (evidenced by instruments) are owed on bonds 4. above.000. The woman’s divorce lawyer has given you the most recent balance sheet of Bolt.

000 10.CHAPTER VI: THE INCOME STATEMENT – – – Accountancy and finance focus on the income statement as a better way to get a handle on a business’s valuation rather than the balance sheet The numbers on the income statement provide good.000 250. no changes resulting from transactions with the equity owners (dividends.000 100.000 150.500. A RECORD OF CHANGES – – – – – – – – – – – This income statement contains considerable information: 1.000 1. Basics of the income statement Profit and loss represent adjustments to the equity section of the balance sheet. INTRODUCTION – – – B.000 10.000 400. Net Revenue. Compensation – Only compensation not included elsewhere on the income statement (mostly wages charged for services) 2..000 1.000 200.300. if not great information to use in a finance-type perpetuitylike valuation In this chapter: 1.000 A.000 1.000 13.000 85. Income: Other ways of referring to profit INCOME STATEMENT The Bolt Company (Fiscal Year Ended 12/31/2007) Revenues Sales Services Expenses Cost of Goods Sold Selling Expense Executive Salaries Compensation Depreciation Interest Taxes Supplies Utilities Insurance Profit (Loss) – 500.250. new stock issuance. a summary of changes to equity over the year Only consequences of business and investment are reflected on the income statement. Costs of Goods Sold and Depreciation – Discussed in next chapter Income statements can vary in form considerably 3 .000 27. but businesses do not directly adjust equity for each item of profit and loss A business only determines profit or loss and adjusts equity yearly (or on another periodic basis) During the year a business keeps track of “revenue” and “expense” and records them in non-balance sheet accounts Revenue: A gross amount earned from the sale of a good or service Expense: A cost of earning revenue Cost Accounting: A business’s internal accounting that measures profit on a product or service line A business with a string of losses can deplete assets so much that liabilities exceed assets and equity is negative At year end the business “closes” its books for the year and the profit or loss is entered into the equity When revenues exceed expenses the business has earned a profit When expenses exceed revenues the business has incurred a loss The income statement is a presentation of the calculation of profit or loss for the year.000 5. stock bought back) are included Net Income.

C and XII. Selling & Admin. (4) What were WorldCom’s Principal items of expense? (The student should note that the biggest private bankruptcy in history is buried in these expenses.000 (pg 321). PROBLEM: CLOSING 1 . RETAIL’s accounts and their balances are as follows: Cash Cost of Goods Sold Expense General.000 75.000 40. which is bigger: GE’s sales of goods or its sales of services? Sale of goods (Revenue – Costs and Expenses).000 30.000 150.000) Balance Sheet: Assets Cash: Inventory: PP&E: Receivables: Liabilities 50. research and development (pg. but prior to closing revenues and expenses into equity for the year. Goods = 16.000 100. RETAIL. 397). Inventory Misc.” which is the portion of the income attributable to one share of stock and are of great importance to financial analysts but little use to lawyers Borrowing (principal) and repaying (principal) loans have no impact on profit or loss Interest represents a service charge for the use of money which is treated as an expense in most cases These problems concern the income statements in the Appendix.000 15. Inc.000 CGSE: 75.000 D.000 25.000 $50. PROBLEMS: READING INCOME STATEMENTS (1) What were Enron’s revenues and expenses? (The student should note that the second biggest private bankruptcy in history is buried in the word “other. Expenses Paid-In Equity Capital (Equity) Payables Property.– – – The income statements in the appendix break down the total earnings into “earnings per share.000 20. Services = 7.000 75. Plant & Equipment (Net) Receivables Retained Earnings (Equity) Sales Prepare RETAIL’s year-end balance sheet and income statement.) Line costs (pg.000 75. (2) From an income statement point of view.) “Other” is the sole source of profit. C. 374). (3) What do Microsoft’s expenses say about how the business makes money? Marketing.000 Expenses Misc: 15. Exp.000 25.000 (The business made 20. sells goods at retail from a small store that is rented. as discussed below.000 30.D. After reviewing its books (to assure that all accruals and deferrals are proper.000 40. but not relevant here).” as discussed in Section XIII.H. No dividends were paid (or other transaction with shareholders engaged in) during the year. as discussed in Sections VIII.000 GS&AE: 40.000. Income Statement: Revenue Sales: 150.

(The present value of the $1. profit approximates the net excess cash flow that the business could use for perpetuity. view of business 2. historical.000. a corporation could issue today a bond that pays $1. the best time to recognize revenue from sale of goods is when the sale occurs (regardless of whether or not cash changes hands at that point) Accruing: Booking a revenue or expense for the sale of goods before cash changes hands Deferring: Booking a revenue or expense for the sale of goods after cash changes hands GAAP uses accrual accounting F.) The $331 discount between the issue price and the amount owed at maturity represents hidden. (The sole shareholder is also the sole executive.000 For “RE” you add in the profit from the income statement. How should the investor of such a bond (the borrower) account for it? How should a buyer (the lender)? – When a seller agrees to wait for payment the seller provides two functions: 1. SELLER FINANCING 3 . if revenue is booked as cash is received. The Balance Sheet – Has a liquidation-value perspective. a huge payment is due at maturity. it shows what the equity would be worth if the assets were sold (at book value) and the debts paid (at book value). Selling: The goods sold I.E in light of the additional information reflected on The Bolt Company’s income statement shown in the preceding section. BOOKING ACCRUAL – Under GAAP. it is a static.331 is $1. equity increases by the amount of the cash and if an expense is booked as cash is paid. The Income Sheet – Focused on a going-concern and shows how the business is doing. unstated. – The income sheet and balance sheet tell two very different stories 1.) – – The most important issue in modern financial accounting is when revenues and expenses are taken into account for financial accounting purposes. PROBLEMS: INTEREST ACCRUAL J. and a financial analyst can value a business by viewing income as a perpetuity and capitalizing it E. WHAT THE INCOME STATEMENT SAYS – – – Reconsider your analysis of Problem V. using the assumptions in the basic example in Chapter II. For example. cash and equity go down in tandem either way the balance sheet balances. later when the cash is received the “Cash” assets increase and the “Receivables” decreases by the same amount again balancing the balance sheet (the cumulative effect being cash assets and revenue increase by the sale amount. it is dynamic and by showing change. but if revenue or expense is booked at some time other than when cash changes hands an adjustment to an asset other than cash or a liability is required to make the balance sheet balance At the time of sale two accounts increase.331 three years from today for $1. REVENUE RECOGNITION – – – H. Rather.000 RE: 120. known as “recognized” or “realized” so as to be booked Revenue and expenses are not necessarily recognized at the same time that cash changes hands.000 PIEC: 20. PROBLEM: THE BOLT INCOME STATEMENT G. economic interest.Payables: Equity 40.000. “Receivables” and “Sales Revenues.” thus assets and equity both increase and the balance sheet balances. with the change to receivables being temporary) “Realization” and “Recognition” have the same meaning to accountants but have different meanings in tax law Employers treat wages as a loan from the employee or borrowing the services to be paid at a later date – – – (1) How should the bank in the basic example in Chapter II Account for the borrowing represented by the customer’s account? How should a business depositor? (2) A “zero coupon” bond provides for no express payment of interest. suggests the future Income statement information is useful in financial valuation Profit is a measure of the net growth in resources generated by business operations throughout the year Profit can be pulled out of the business without depleting it and if things continue.

Lending: The purchase price to the buyer These two functions can be and are frequently blurred together by increasing the purchase price and reducing interest or vice versa Installment Sale: A seller financing.000. a firm of certified public accountants. the accrual and deferral of revenue Contract and tort law make it difficult for anyone but the business for which the financial statements are prepared to sue accountants for fraud Federal securities law provides the most important source of accounting liability. so that it should be taken in account in a financial valuation of the firm? – – – – – – It is useful to look briefly at how the law looks at accountant’s numbers Herzfeld pertains to how an investor reads and understands financial statements. Laventhol.030. Neither of these transactions had been consummated by the time FGL published the documents yet they generated them as if they had been. since the sale price would be booked that year while the interest would be booked in later years GAAP accounts for this manipulation by making the sale price the present value of all future payments discounted at roughly the rate of interest the buyer/borrower pays on similar borrowings K. 1 . Herzfeld was not required to prove that Laventhol was the sole cause of his action only that it was a substantial factor. is appealing a judgment against them for $153.000 in assets. Herzfeld sued the firm after spending $510.S. since the price is to be paid in installments over time A high price is more attractive to a seller looking to book a high profit.000.000. some are deferred and not currently charged against revenues. Ltd. In the end the two transactions were calculated to produce a $2. expenditures not deferred are “expenses” Deferred revenue is a liability Deferred expense is an asset Accrual and deferral are central to GAAP. they accept payment for future delivery of the goods Expenditure: Any amount incurred.7 million and an after-tax income of $310. Inc. L. Krekstein. and rest on a central assumption that the business will continue since items can only be deferred into the future or accrue them from the future From an accounting point of view. These numbers also are going to be capitalized by financial analysts in valuing companies. DEFERRAL – – – – – – Deferral: Cash changes hands prior to the time when revenue or expense is recognized Magazine publishers operate by deferral. however. booking revenue and expense only as recognized makes great sense. under which buyers and sellers of the business’s securities may sue accountants who prepare the financial statements The SEC requires that businesses file GAAP financial statements but compliance with GAAP is not an absolute protection from liability Herzfeld is a lawsuit against (at the time) one of the premier accounting firms in the U. Horwath & Horwath “Accounting Firm Misleads Investor with False Finances” Misleading omissions and misrepresentations of financial figures are a violation of the SEA Laventhol.000 on Firestone Group.– – – – 2. Is the moment when GAAP recognize revenue the time when the associated positive (negative) cash flow most resembles a perpetuity. PROBLEM: RECOGNITION AND FINANCE M.000 in sales. Accountants should not represent on an audited statement that income and profit exist without facts justifying it and revenue should not be booked until the earning process is complete.500 profit for FGL. THE LAW MEETS ACCRUAL AND DEFERRAL OF REVENUE CASES Herzfeld v. As per the Securities Exchange Act of 1934 Laventhol was required to make available all the facts that they had which would help investors make intelligent investment decisions. (“Continental”). a net worth of over a million dollars. Based on these figures Herzfeld decided to purchase the units of FGL. The balance sheet and income statement that Laventhol prepared for FGL purported that the company was strikingly profitable with over $20. The basis for Herzfeld’s claim is the misrepresentation of two real estate transactions: (1) FGL’s agreement to purchase 23 nursing homes from Monterey Nursing Inns. a deferred income of $2. (“Monterey”) and (2) FGL’s agreement to sell the 23 nursing homes to Continental Recreation Company. specifically. Neither transaction ended up going through and FGL eventually filed bankruptcy. LTD (“FGL”) stocks and bonds based on representations made to him by Laventhol that were materially misleading and omitted material facts.000. $17. The Laventhol report contained materially misleading omissions and misrepresentations and nor does Herzfeld’s failure to read an opinion letter or “explanatory” footnote violate his reliance on the figures since they were just as misleading as the report.

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Client pressure on accounting firms to cook books is not unusual, Laventhol was careful not to roll over completely but had they not agreed to include the figures in some way Laventhol would have fired them and sued them, while shopping around for a firm that would have done it Herzfeld was harmed when he bought FGL securities without having the proper information required to evaluate the investment Most investors are not capable of deciphering financial records to the point that failure to follow GAAP requirements would automatically be misleading, therefore technical violations of GAAP should not be relevant

N. NOTES AND PROBLEMS: HERZFELD

O. THE LAW MEETS ACCRUAL OF EXPENSES – – –
– Herzfeld involves the booking of revenue in financial statements that are subject to the federal securities laws, which impacted an investor’s decision Guernsey Memorial Hospital deals with expense issues Guernsey deals with the Department of Health and Human Services’ reimbursement of a hospital for the costs of care provided to Medicare patients As interest rates dropped the burden of the old debt increased in present value, the GAAP booked this loss when realized through the advance refunding, if there had been no advance refunding this loss would have been realized over time up until the retirement of the old debt

CASES Shalala v. Guernsey Memorial Hospital “Health Care Provider Challenges Medicare Reimbursement” GAAP guidelines that are set in stone, the alternative set forth for reimbursement is sensible and a legitimate alternative Guernsey Memorial Hospital (“Hospital”) is challenging the Medicare regulations, set for the by the Secretary of Health and Human Services (“Shalala”), on the basis that they do not comply with the generally accepted accounting principals (“GAAP”). The court held that the reimbursement did not need to follow the GAAP guidelines. Hospital’s refinanced its bonded debt by issuing new bonds, while a future saving of $12 million was expected, it incurred an accounting loss of $673,000, and was entitled to $314,000 in Medicare reimbursement for the loss. Hospital contended that it should receive the refund in one year since the accounting loss took place that year, while Shalala argued the reimbursement should be amortized over the life of the old bonds (in accordance with an informal Medicare reimbursement guideline). It was required that Hospital maintain sufficient financial records and statistical data for proper determination of costs payable under Medicare, and even if those records are interpreted to mean GAAP standards, the Court does not interpret it to mean that the Secretary must also reimburse by per GAAP. While a one time payout is more valuable to investors’ understanding of the business’s year, Shalala determined that amortization was appropriate to ensure that Medicare only reimbursed its fair share. Shalala must calculate how much of Hospital’s total allowable costs are attributable to Medicare services, which entails calculating what proportion of the provider’s services were delivered to Medicare patients. If hospital took all the money in the first year it is possible for them to drop out of the program and not provide the services that Medicare beneficiaries are entitled to. Financial accounting is not a science and GAAP is only generally accepted not a hard and fast rule. The framework followed in this case is a sensible structure for the complex Medicare reimbursement process. Dissent (O’Connor): The Medicare reimbursement must follow the GAAP. Courts are to hold unlawful and set aside an agency action that is arbitrary, capricious, and an abuse of discretion. It is important to give deference to an agency’s interpretation of its own regulations but it cannot be sustained when that interpretation is plainly erroneous or inconsistent with the regulation, as in this case. After reviewing the regulations that Shalala adopted, it is concluded that Shalala has incorporated GAAP as the reimbursement default rule. (1) Both opinions in Guernsey miss the point that, financially, the defeasance loss occurred prior to the advance refunding. In other words, the Justices, while talking accrual accounting, were assuming GAAP-like recognition-based accounting, and not full economic accrual accounting. Applying this economic view rigidly, the portion of the loss, whenever realized, subject to reimbursement should be measured by Medicare patient usage in the past, not by usage in the future (Justice Kennedy) or in the year of the refinancing (Justice O’Connor). This analysis may be too rigid, however, since the defeasance loss did not relate to the ordinary business operations of the hospital prior to defeasance. (2) Justices Kennedy and O’Connor have fundamentally different views of accounting indeterminacy. Justice Kennedy sees GAAP, and all accounting, as indeterminate, and, thus gives the regulators considerable slack. Justice O’Connor sees the GAAP as fairly well defined, so that she wants the regulators to at least follow GAAP until something better comes along. Which view is right? Was it appropriate for Justice Kennedy to resolve this factual issue by judicial notice?

P. NOTES AND PROBLEMS: GUERNSEY

1

(3) As a policy matter, how should Guernsey account for borrowing, including the defeasance loss, for purposes of determining Medicare reimbursement? Your analysis should reflect that Medicare patient usage of hospital varies over the years. Also think about the accounting if Guernsey had not engaged in the advance refunding and if it had used variable-rate debt. (4) Note how these issues require the lawyer to understand both finance and accounting. How many lawyers (or Supreme Court Justices) do you think are up to the challenge?

Q. CLASS NOTES –
– – Income statement shows change in equity, during a period of time (usually a year) Items of revenue are booked when earned Items of expense are booked when incurred Deferral: Book the transaction after cash changes hands Accrual: Book the transaction before cash changes hands Booking accrual: 1. Accrual revenue: Assets Sale: Receivables +60 Revenue Payment: Cash Receivables Accrual expense: Assets Sale: Expense: Payables: Payment: Cash Assets Sale: Cash +12

– –

Equity +60

+60 -60 Equity +10 +10 -10 Payables -10 Equity -12 -1 -1

2.

3. Deferred revenue (liability), for example a magazine subscription:

Deferred Revenue Payment (Monthly): Revenue Deferred Revenue 4. Deferred expense: Assets Sale: Cash Deferred Expense Payment:

Equity -1,000 +1,000

Expense -1,000 Deferred Expense -1,000 HERZFELD: Accountants were liable if the knowingly painted a false picture 1. FGL was going to buy the nursing homes (from Monterey) and they expected to get paid by the company they were selling them to (Continental) 2. Continental was only worth $100,000 however and could not come up with the $5,000,000 to pay FGL for the nursing homes, and defaulted on the contract 3. FGL ended up going bankrupt and Herzfeld received 10 cents on his dollar in liquidated dividends

3

4. The only case in the book about regulation of accounting (accrual of revenue) –
Administrative law overview: 1. Congress cannot right laws to cover every situation, judges have no power to make law (but common law was judge made law) they only have the power to interpret and apply the laws that Congress creates. 2. Administrative agencies of the executive have the first cut at interpreting the law, the judicial polices the executive when someone claims that they have interpreted the laws incorrectly and in violation of their rights Regulations: Filing in the gaps in the statute Adjudication: Act like judiciary and decide the laws meaning SHALALA: Deals with when to book expenses, the issue is a defeasance loss 1. Borrowed a bunch of money and put it in the US treasury 2. Instead of looking to the hospital for payment they released the hospital and made the treasury pay 3. Interest rates went down and they could not afford the interest on the borrowed money because the interest of the treasury bonds were not high enough 4. They would have had to add a substantial amount of money to the account to pay off the debt they were incurring 5. Loss in defeasance is calculated by the present value of the difference between the interest rate borrowed at and the interest rate they are receiving on the money 6. The hospital could not pay off their debt 7. There was no prepayment allowed 8. In this case the manual that the administrative agency released was not a rule it was a press release, they did not have regulations directly on point so they were held to the press release 9. Kennedy dissent: There is nothing right about GAAP it is not a concrete way of doing things, and is meant to apply only if the Secretary does not specify their own rules, there is irony in the idea that the secretary has bound herself by the rules in GAAP and is unable to diverge from them when she feels they are wrong (accounting is not a science and GAAP is generally accepted rules not the only acceptable rules, there are 19 different GAAP sources, any number of which may create different accounting solutions) Defease: Release the original borrower from the debt, usually done when interest rates go up Ideal income statements are perpetuity like and would show things that the company can do again and again

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1

whose inventory only includes a few items at any given time 2. like yacht dealers.. (ii) keep a running total of all inventory purchases during the period. therefore at any given time a previously acquired item is either still on hand (not delivered) or has been sold (delivered) a. neither year is accurately representative of the business’s operations and fails to assist in perpetuity-like financial valuation Matching is employed in circumstance when a business provides a service or good in one year and is paid by the customer in another year. All that is necessary to determine the cost of goods sold is to (i) remember last period’s closing inventory. it is the difference between revenue and expenses. and financial services. while being relatively simple Financial accounting works the least well with regard to service businesses. otherwise the business would look like a complete loser in the first year and a complete winner in the next year Income is a small number that represents the difference between two large numbers (revenue and expense). relatively small changes to these large numbers can cause relatively large changes to net income In this chapter: 1. Perpetual Inventory: Keep track of the actual costs of specific goods and expense these actual costs when the associated goods are sold and revenue is recognized. Periodic Inventory: Takes advantage of the two facts that (i) the cost of goods sold only needs to be determined once per period and (ii) since sales revenue is booked when goods are delivered to customers only costs related to goods delivered during the period are relevant. and (iii) take a closing inventory The simplicity and accuracy of periodic inventory confirms the wisdom of determining profit or loss periodically rather than on a transactional basis because it achieves an elegant matching. determined by physically counting the number of goods on hand Closing inventory necessarily equals the opening inventory There are two approaches to the cost of goods sold problem: 1. GOODS ACQUIRED = GOODS ON HAND + GOODS SOLD b. to obtain a proper net income the revenues must be matched with the expenses they incurred When revenues are recognized in one year and expenses in another. focusing on the most important matching rules: inventory accounting Historically the most important type of transaction affecting the income statement was the sale of goods. CLOSING PERIODIC INVENTORY 3 . it is therefore very important to have good accounting rules for sale-of-goods transactions Generally revenue for the sale of a good is recognized when delivery occurs Inventory: A business’s stock of goods held for sale to customers Opening Inventory: Goods left over from prior periods Closing Inventory: Goods left over at the end of a period. where the sale of goods rules do not answer the bulk of profit and loss questions A. which can lead to misleading numbers when timing of the recognition does not coincide with the underlying economic activity Income is a net number. MATCHING – – – – – – – B. Problem is that it is difficult to keep track of each individual item b. COST OF GOODS SOLD = OPENING INVENTORY + PERIOD PURCHASES – CLOSING INVENTORY e. GOODS SOLD = GOODS ACQUIRED – GOODS ON HAND c. Exploration of matching. high-tech firms. requiring the business to keep track of the cost of each inventory item in perpetuity a. assuring acceptable profit and loss numbers. Used primarily by businesses.CHAPTER VII: MATCHING AND INVENTORY – – – – – – GAAP only reflects revenue and expense when recognized. When this formula is adjusted to account for multiple accounting periods the result is: GOODS SOLD IN PERIOD = GOODS AVAILABLE TO SELL IN PERIOD – GOODS ON HAND AT END OF PERIOD (“goods available to sell in period” includes goods left over from prior periods and goods acquired during the period) d. THE SALE OF GOODS – – C.

2 to keep your COGS down. the first items acquired are the first items sold (the natural flow of a seller of perishable goods who wants to get rid of older goods before they go bad). and a retail method that determines cost by reversing an average mark-up from wholesale to retail The most important practical difference between FIFO and LIFO are that when prices are rising. FIFO 1 . (3) If the wholesaler purchased 25 widgets at $60 each during the year. at the beginning of the current year.– – – – – – – The problem we now have to deal with is the valuation of the closing inventory. one would expect managements to prefer FIFO. During the current year. goods are sold in the order that they are acquired. this can result in a stale inventory on the balance sheet nearly forever 3. LIFO 25 x 60 + 25 x 50 = 2750 D. respectively? Open + Purchase – Close = COGS Open = 5000 ($50 x 100 widgets) Purchase = 1500 ($60 x 25 widgets) Close = Amount left in inventory COGS: FIFO 50 x 50 = 2500. what is its cost of goods sold expense for the year under FIFO and LIFO. respectively? Open + Purchase – Close = COGS Open = 5000 ($50 x 100 widgets) Purchase = 0 Close = Amount left in inventory COGS: FIFO and LIFO 50 x 50 = 2500 Under FIFO and LIFO the same widgets are sold 5000 + 0 – 2500 = 2500 In LIFO if you do not purchase new goods you can manipulate your COGS because you know what you are selling. No items in inventory were stolen. and if you wait to buy expense items until Jan. it sold 50 widgets. First-in-first-out (“FIFO”): FIFO is the older method and the most obvious. of which there are two common methods: 1. LIFO. goods removed for sale are taken out from the newer goods first. destroyed. Other methods include an average cost method that falls between FIFO and LIFO. (1) If the wholesaler purchased 50 widgets at $60 each during the year. what is its cost of goods sold expense for the year under FIFO and LIFO. LIFO 50 x 60 = 3000 Under FIFO it is assumed the new widgets were sold 5000 + 3000 – 5500 = 2500 Under LIFO it is assumed the old widgets were sold 5000 + 3000 – 5000 = 3000 (2) If the wholesaler purchased no widgets during the year. nevertheless companies use a mix of FIFO. what is its cost of goods sold expense for the year under FIFO and LIFO. had an opening inventory that contained 100 widgets at $50 each. PROBLEMS: LIFO VS. which can have little bearing on how the company is currently doing Current rules require that the inventory be valued by comparing cost and market value and using the lower of the two Market Value: The wholesale cost to replace the inventory An wholesaler. which is the general case. the balance sheet reflects the most recently purchased inventory 2. Last-in-first-out (“LIFO”): LIFO is the newer method. or damaged. respectively? Open + Purchase – Close = COGS Open = 5000 ($50 x 100 widgets) Purchase = 3000 ($60 x 50 widgets) Close = Amount left in inventory COGS: FIFO 50 x 50 = 2500. LIFO results in a larger cost of goods sold and a smaller closing inventory Since FIFO usually results in bigger profits. and other methods LIFO does a better job of showing how the business operations are currently doing. and more perpetuity like profit numbers for analysts to use in valuating the business FIFO can result in booking large profits as a result of purchasing items for a comparatively small amount years back and selling them at a general price rise.

by including a broad range of inventory-related costs GAAP provides more comparable books for those businesses that manufacture their inventory and those that buy their inventory For manufacturers the inventory is subdivided into three categories that represent the three stages of the manufacturing process: 1. Situation 1: N manufactured its product at Site X and discharges hazardous waste as a result of that activity. THE BOLT COMPANY INVENTORY F. N continues to manufacture at Site X. during. – E. Solution 1: Because the environmental remediation costs to clean up Site X are incurred in 2005. but when is the appropriate time to realize them? The cost of cleanup is more along the line of repairs than improvements since the land value does not increase by the cleanup. even though the repairs may have been necessitated by use of the equipment (land) in prior taxable years. Repair costs are allocable to the property produced during the taxable year in which the costs are incurred. except that N temporarily ceases its manufacturing activities at Site X during a part of 2005 while it remediates the contaminated soil and groundwater. Situation 3: Same as Situation 1. Solution 2: Because the environmental remediation costs to clean up Site X are incurred in 2005. Whether or not the costs are incurred before. Goods in progress: Raw materials are a cost of goods in progress 3. Raw materials: 2. which defers the expense until the associated goods are sold. Therefore they must be included in inventory costs. There are five different situations to consider with individual solutions. they are properly allocable to the inventory produced by N in 2005.E assuming that The Bolt Company uses LIFO. this deferral matches the expense with the revenue Inventory Costs: The applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location A broad range of costs are inventoried. under LIFO you can manipulate figures with the amount of purchases you make Reconsider you analysis of Problem V. the manufacturer is in effect borrowing the workers’ services in the last pay period CASES Revenue Ruling 2005-42 “Realization of Environmental Cleanup Costs” Environmental clean-up costs are allocable to the inventory produced during the taxable year the costs were incurred When a business contaminates land through its manufacturing process there are cleanup costs that must be booked. N now incurs costs in 2005 to remediate the contaminated soil and groundwater at Site X from its previous manufacturing. the cash and offsetting liability are shown on the balance sheet Revenue only appears on the income statement once it is earned Inventory costs are increased by accrued-but-unpaid wages. goods in progress are a cost of finished goods A decision to book an item does not require that the item have an immediate income statement. 1 . COSTS INCLUDED IN INVENTORY – – – – – – – Inventorying an amount treats it as asset-related. Situation 2: Same as Situation 1 but N manufactures a different product now then when the ground was contaminated.Under FIFO it is assumed the new widgets were sold 5000 + 1500 – 4000 = 2500 Under LIFO it is assumed the old widgets were sold 5000 + 1500 – 3750 = 2750 In FIFO purchases do not matter to the COGS. Therefore environmental remediation costs are allocable to the products manufactured in 2005 by N. Therefore environmental remediation costs are allocable to the products manufactured in 2005 by N regardless of the fact that they are manufacturing different products. they are properly allocable to the inventory produced by N in 2005. Finished goods: Only category treated as sold and charged to cost of goods sold. During and after the remediation. when cash is received prior to being earned. or after manufacture they are incurred as a result of the manufacturing process and must be accounted for. this advances matching by driving numerous expenditures through GAAP’s best matching mechanism: inventory accounting Ideally financial statement results should not differ based on whether a company manufactures or buys inventory.

lawyer expenses arose because of the manufacturing. (1) The management of a company engaged in manufacturing wants to book profit as quickly as possible. that they did not own or otherwise use in the manufacturing activities. G. LIFO AND THE FINANCIAL MARKETS 3 . Situation 5: Same as Situation 1. Yes. so that costs can be pushed into the future (as long as the sale of inventory does not occur rapidly). Solution 5: The cost of cleaning up Site Y is still incurred as a result of their manufacturing process and the remediation is allocable to the products manufactured in 2005. cost of insuring the item is incurred during production and increases the value because it is less risky to build and transport (b) Storage costs of finished goods. No.Solution 3: Even though during part of the year Site X is idle the costs are still incurred due to the production activities of X during the rest of the year. except that N buried the waste on site Y. the problem whether or not manufacturing was taking place during the trial and the cost is probably related to inventory that is no longer around because law suits take a long time and inventory doesn’t last that long A business may include in inventory their costs of building and transporting goods. Solution 4: Even thought Site X is no longer used costs are incurred in 2005 due to the continuance of manufacturing at another site. Does this management prefer to charge a cost to inventory rather than expense the cost? Inventory. Situation 4: Same as Situation 1. during and after the remediation N continues to manufacture at Site X but has permanently stopped using Site Y. As per the rule on pages 95 and 96. except that N has permanently ceased its manufacturing activities at Site X and manufactures at another site. which means that the statements err on the side of caution by understating assets and overstating liabilities Inventories are written down when prices go down but are written up when prices go up Conservatism protects investors and protects accounts from being sued by those investors Hurts stock if it sells at a low price caused by the market respecting over-conservative financial statements – – Most evidence says that the market values a company the same regardless of if it uses LIFO or FIFO This fact that capital markets look through the details of LIFO and FIFO is important support for the efficient capital markets hypothesis I. No (d) Attorneys fees related to a dispute over the cost of supplies used in manufacturing. (2) Which of the following costs are charged to inventory: (a) Insurance on raw materials. CONSERVATISM – – – – Conservatism: Requires accountants to prepare conservative financial statements. Yes. PROBLEMS: INVENTORY COSTING H. Environmental remediation costs that are incurred to clean up land that a taxpayer contaminated with hazardous waste by the operation of the taxpayer’s manufacturing activities are incurred by reason of the taxpayer’s production activities and are properly allocable to the inventory produced during the taxable year the costs are incurred. inventory includes costs directly or indirectly incurred in bringing an article to its existing condition and location. do not want to include storage because it decreases the value of the good by adding to its cost (c) A holiday bonus paid to the chief financial officer.

old. Transactions that are spread over years can create lumps in the balance sheet. Raw Materials and Work in Process: Items used to make the goods and goods in production 2. etc. + PURCHASES – CLOSING INV. to avoid this you must recognize parts of the sale over the years not all at once 2. First Out (the first items you put in are the first you pull out) 1. Revenue and expense must be in the same period. Commissioner of Internal Revenue (Not Required) K. Advantages: 2. 342) 1. expensive). Advantages: When prices rise the new items are the stuff that is closest to the current value so your closing inventory will be closest to the fair market value 2. FIFO and LIFO FIFO: First In. First Out (the first items you put in are the last you pull out) 1. GOODS AQUIRED = GOODS SOLD + GOODS ON HAND 2. CLASS NOTES 1 .) GE Inventory (pg. otherwise one period would show the time you expensed the product and the next would show the revenue from it Companies that sell goods are most concerned with the cost of making those goods It is difficult to know when to book expenses as well as revenues There is a desire to match revenue with the expense that each project creates Perpetual Inventory: Keep track of each cost of item (airplane. yacht) and then when you sell them book the gain or loss Periodic Inventory: Take inventory at the end of the period rather than keeping track of every item. You only have to keep track of two things: (i) the inventory taken at the end of the year and (ii) the cost of your inventory Over the life of a business (this is not useful for our purpose. NOTES AND PROBLEMS: THOR POWER (Not Required) – – – – – – – – – – – – – – Ideal income statements are perpetuity like and would show things that the company can do again and again 1. two methods are used to figure this out. COST OF GOODS SOLD = OPENING INV. Unbilled Shipments: Items shipped but have not been paid for L. cheap. Disadvantages: When prices go way up the pre-fluctuation cost is what is on the balance sheet so the true value is not as closely represented as in FIFO Inflation: It takes more money this year than last year to buy the same basket of goods (a dollar this year has a different value than a dollar this year) When prices are rising LIFO understates inventory and FIFO understates revenue Inventory includes the cost of bringing the item to its existing condition and location (shipping. 3. which is why we inventory periodically): 1. Finished Goods: Goods that have been processed and completed 3. MATCHING IS IN THE EYE OF THE BEHOLDER (Not Required) CASES Thor Power Tool Company v. GOODS SOLD = GOODS AVAILABLE – GOODS ON HAND AT END 2. GOODS SOLD = GOODS AQUIRED – GOODS ON HAND When you have a mass of bolts how do you know which ones are left (the new. wages. you group them all together 1.J. Disadvantages: LIFO: Last In.

conversely an expenditure for current insurance is an expense and is not added to an asset account The definition of assets as deferred expenses leads to a prominent feature of accounting: An asset’s book value is its historic cost(the cost deferred).” One cannot distinguish between repairs and improvement based solely on the basis of their contribution to value. accounting rules required WorldCom to recognize their operating expenses immediately 3. INTORDUCTION – – – – B. not the asset’s current fair market value An asset is only revalued from its historic cost if a gain or loss is recognized as a consequence of a sale or other event A given expense is “capitalized” or expensed so as to be deferred. while those labeled “improvements” are capitalized (the basic issue again being whether to defer or not defer) Repair or improvement decisions come down to a judgment call as to which treatment measures profit best and is first made by management then reviewed by auditors (auditors give management substantial leeway) A federal income tax regulation explanation of the difference between repair and improvement states: “The cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life. but keep it in an ordinarily efficient operating condition [is expensed].. an improvement goes beyond those expectations and increases future expectations Financial accounting values assets at their historic cost. aside from inventory. 89-101 (2003)” made the following findings: 1. they instead appear as assets on the balance sheet and by capitalizing certain operating expenses WorldCom improperly shifted expenditures from the A. By capitalizing these line costs WorldCom avoided recognizing standard operating expenses when they were incurred and instead postponed them into the future. and are expensed. the single largest accounting restatement in history involved WorldCom whose biggest error was improperly capitalizing (and therefore deferring) rather than immediately expensing $3. the present value hinges on future cash flow and makes perfect sense to relate assetness to future events. but. round-dollar amounts after the close of the quarter and on ly a few days before the company’s earnings announcement 2. expenditures that are consistent with these historic expectations do not require an adjustment. Accounting for other types of assets. REPAIR OR IMPROVEMENT – – – – C.. Inc.5 billion during five quarters The “Report of Investigation by the Special Investigative Committee of the Board of Directors of WorldCom. the distinction rests on expectations: A repair is required to keep a property’s value in line with expectations.CHAPTER VIII: NON-INVENTORY ASSETS – – – – – – – – The law can have difficulty determining what constitutes property and accounting has similar problems but accounting’s basic idea is clear: An asset is an expenditure incurred that is not expensed currently. as GAAP do In this chapter: 1.. or deferred. expenditures that are inconsistent with these historic expectations and relate to new value are capitalized Costs that should be treated as asset-related are not just academic concerns. . expenses) An expenditure to purchase a machine is not expensed but is treated as the cost of an asset. WorldCom improperly capitalized approximately $3. Capitalizing line costs exaggerated WorldCom’s pre-tax income (pre-tax income is calculated by subtracting period expenses from revenues and is reflected on the company’s income statement).5 billion of operating line costs in violation of well-established accounting standards and WorldCom’s own capitalization policy. be capitalized. is deferred (a pool of future. to the extent that they arrest deterioration and appreciably prolong the life of the property. which were made in large. thus assetness for accounting purposes depends upon a determination of the connection between an expenditure and future revenues Traditional legal notions of property have limited relevance to the accounting issue Finance is in tandem with accountings approach to assetness. Repairs in the nature of replacements. capital expenditures do not appear on the income statement and do not immediately reduce pre-tax income. WORLDCOM 3 .. which reflects the expectations at the time of acquisition. shall . used in accounting When an expenditure is incurred to make an asset more useful or valuable it can be difficult to decide whether to expense or capitalize the expenditure Expenditures that are labeled “repairs” are expensed..

Under matching. and economically. PROBLEM: WORLDCOM E. the initial book value (cost) of a purchased plant should at least equal construction cost plus interest Self constructed plants also include costs plus interest. the company signs a five-year lease today that is effective immediately. and not earning revenue. increasing current income and postponing the time when these costs would offset revenue WorldCom CFO Scott Sullivan was given the opportunity to justify the capitalized expenses but his explanation lacked any substantive accounting basis for the capitalization The WorldCom Special Committee. the seller’s price should be no less than its cost plus interest). over which time the business incurs $100. Actually. accounting for the cost of equity capital tied up in construction is considered in Section VIII. not lost revenue. Is this wrong? Is WorldCom distinguishable? Should treat the first six months as acquiring the warehouse for when you are going to use it. easily discards Sullivan’s argument. it should be treated as an indirect cost of the goods manufactured in the factory and expensed Construction-period interest rules are perhaps the least conservative feature of GAAP. How should the first six months’ rent be accounted for? In the company’s mind. the first six months’ rent should be deferred.000 of interest on the $1 million debt. but two details of GAAP construction period interest of particular note: 1. management is allowed to defer interest including interest on borrowings with no direct connection to construction.000 construction cost similar to other more obvious construction costs like materials and labor. however.000 of interest should be deferred. income statement to the balance sheet. – Capitalization issues are presented when a business borrows money in order to construct a new plant or other property D. therefore.4. This deferral is effected by capitalizing the interest as an additional $100.P. INTEREST CAPITALIZATION EXAMPLE A business borrows $1 million to build a factory whose construction will takes 1 year. The perfect supplemental warehouse is available for rent right now. only costs incurred during construction would have been recovered by a seller if the project had been purchased The amount of interest treated as construction period interest equal (i) all interest on any debt specifically connected with the project plus (ii) a portion of the interest on the general debt of the business Current construction-period interest rules also prohibit inventorying interest. rather than being included indirectly through the price paid. as with a purchase FASB adopted this it-must-be-worth-what-it-cost-to-build approach: “At the time of the decision to acquire an asset the enterprise believes that the present value of its cash flow service potential is at least as great as the sum of the costs that will have to be incurred to acquire it. this rent relates to the future when the newly-rented warehouse is to be used in the business. The company is not going to move into the newly rented warehouse for six months. any interest accrued later is not construction-period interest.. with self construction they are included directly. the argument is quite interesting.. Only construction period interest is capitalized (interest related to the periods prior to and after construction is expensed. The underlying land is treated as part of the period (the land is as much tied up in construction. DEPRECIATION BASICS 2 . after all was created to assign blame. because it is expected that there will be related value in the constructed project The cost of assets are deferred in order to be matched with future revenues – – – – – – – F. and you spread out the cost over the years that you actually do use the warehouse. as are the bricks and mortar 2. To assure the availability of the warehouse in six months. which. Matching principles suggest that the $100. – Another reason to capitalize construction-period interest is that it helps to equalize the accounting for selfconstructed and purchased assets (if a business buys a new plant. the enterprise’s commitment of cash or other resources to acquire the asset provides the best available objective evidence of an asset’s cash flow service potential at the time of acquisition” Current GAAP only capitalize interest. Consider a simple example: A company knows that it will run out of warehouse space in six months.

The machine will work for exactly five years. buildings.” when using the word “accelerated” it is being compared to the straight-line method because they are faster than straight-line depreciation Salvage Value: Value left over at the end of the machine’s life Accounting depreciation takes salvage value into account. etc. sum-of-the-years-digits. instead showing the “net asset” amount equal to the asset’s historic cost reduced by accumulated depreciation) Most businesses use straight-line depreciation but is not the only type of depreciation. instead the $20 of accumulated depreciation is added to a separate “contra” asset account that functions like a negative asset account (most businesses omit this detail from the balance sheet. the $20 of depreciation is an estimate. the first method is referred to as “accelerated” of “faster” and the second as “slower. others include. therefore the accountants do not write down the machine’s assets account down to $80. declining balance. real estate. i.e. 1.) EXAMPLE A business purchases a machine for $100 and starts using it on Jan. The $100 that the machine cost relates directly to the revenues that will be earned over the five years of its use. equipment. while the $100 cost is a hard number. and double declining balance – – – – – – – The non-straight line methods are just fancier mathematical formulae for allocating the $100 cost of the machine among the five years of its useful life When a depreciation method allocates more depreciation to the earlier years of an asset’s life (and less to the later years) than a second depreciation method.– – Inventory matching is achieved by booking the associated cost when the revenue is booked (as the goods are delivered to the customer). many assets used in business generate revenue by being used rather than by being sold Depreciation: The collection of accounting rules that provide how the costs of assets consumed in business are matched with revenues (not all assets are depreciated but most must be. improvements. at the end of which it will die and have no value. which can be illustrated by modifying the example by assuming that the machine will be worth $5 as junk after five years of use 1 . Cost 100-Useful Life: 5 Years Salvage Value: 0 Placed in Service: 1st Day of Year 1 Straight-Line Depreciation – Pro-rata depreciation graphs as a straight line. machinery. which is why it is often referred to as “straight-line depreciation” Businesses often use an averaging convention when figuring depreciation to help avoid determining depreciation on a daily or other burdensome basis Bookkeeping for depreciation is archaic: Using the example above. Using straight line depreciation there is a $20 depreciation expense each year for the five years of the machines usefulness.

but this greater expense is averaged away by less expense with respect to older assets.80 5 100 0 10 0 6 100 0 10 0 7 100 0 10 0 8 100 0 10 0 9 100 0 10 0 Total Effect 100 100 100 No matter how the machines are depreciated. when one depreciation method is accelerated compared to a second. although there are three variables at management’s discretion (although choice has not resulted in much controversy) 1.40 3 100 20 10 10. the total depreciation expense each year is eventually $100 – With level purchases. This 100 20 10 40 Last 100 20 10 24 2 100 20 10 14. depreciation methods have the most effect on businesses whose expenditures on depreciable property vary from year to year because depreciation from earlier purchases cannot perfectly average with depreciation from later purchases Depreciation is important to GAAP because there are numerous businesses for which depreciation methods matter Averaging effect illustrates why GAAP has strict rules on temporal consistency. 10-Yr. S/L Dep. S/L Dep. DEPRECIATION: AVERAGING EXAMPLE By modifying the no salvage value example so that the business buys and starts using one of the $100 machines at the beginning of each year. Method For many businesses. VIEWS OF DEPRECIATION – – 1 .80 4 100 20 10 10. the accelerated method provides a greater expense with respect to recently purchased assets. which it did so without disclosing the change) Accounting rules generally prevent changes and require companies to disclose any allowable changes they make Under GAAP depreciation is a reasonable method for allocating costs among years so as to achieve an acceptable method of matching Economic Depreciation: Exact actual decline in assets’ value (usually faster than GAAP straight-line depreciation) Historically depreciation looked at depreciation with the understanding that businesses should set aside resources to replace depreciating assets. making opportunities for management to manipulate depreciation limited. ACCOUNTING CONSISTENCY – – I. Balance Dep. so that both depreciation methods result in the same total expense (taking all assets whenever acquired into account) So long as the same accounting method is applied constantly there is little effect on net profits. accounting rules must be applied the same from year to year otherwise inaccuracies could compound rather than average and there would be considerable opportunities for management to manipulate their books (Halliburton was able to double revenues one year by changing their accounting method. Life (can cause difficulties) 2. 2X Decl. the method used in determining depreciation has little net effect on profit or loss – G. we can create a table that will show the effect three different depreciation methods would have Year Machine Purchased Cost 5-Yr.– GAAP depreciation is based on management’s expectations at the time that an asset is acquired. Salvage Value (can cause difficulties) 3. and such amounts should not be viewed as profit even if they are not specifically ear-marked for replacement of deteriorating property – – – H.

it is inventoried.25 million per year. $8 million per year. useful life or salvage value? Useful Life (Years) 40 50 60 Avg. $20 million salvage value. PROBLEMS: DEPRECIATION K. A little change on useful life has more effect than a little change on salvage value. no salvage value. thus an improvement is an expenditure that is not consistent with the assumptions and expectation underlying the depreciation method Depreciation can also be used to think about the leasing transactions from Chapter III: Rent in a net lease depends solely on (i) the cost of the leased asset.25 Avg. $50 million salvage value. $12 million per year. 11. (7) 50-year life. (9) 60-year life. $50 million salvage value.5 10 8. in other words rent pays the lessor solely for (a) the use of money over the lease term and (b) for the decline in value of the leased asset over the lease term (from cost to residual value). (8) 40-year life. $9 million per year. when compared to the same amount of useful life with higher salvage values.6 8 9. INVENTORIED DEPRECIATION 1 . $0 12. (5) 40-year life.25 9 7.5 9. (6) 60-year life.27 $20 12 9. no salvage value.53 7. (10) Which seems more important.91 9. $8. $11. $50 million salvage value.87 $50 11. since most depreciable property is used in manufacturing and all direct and indirect cost of producing inventory (except interest) are capitalized Salvage Value (Millions) J. Calculate the straight-line depreciation each year under the following alternative assumptions: (1) 50-year life. and (iv) the discount rate . (3) 60-year life. therefore rent should equal depreciation plus interest A manufacturer builds a plant with a total capitalized cost of $500 million. – The single most important fact about depreciation is that much of depreciation in America is not expensed. $7. $20 million salvage value. $10 million per year.33 million per year. (2) 40-year life. no salvage value. (4) 50-year life. $12.5 million per year. $9.33 10.– – – Reserve or Sinking Fund View: Depreciation is the amount set aside (held in reserve) to replace deteriorating assets (technically a “sinking fund” is a separate cash account that is funded over time in order to assure that a business will have enough money to retire long-term debt that requires a large payment of principle maturity) Understanding depreciation is useful in distinguishing repairs from improvements: Normally one would assume lower depreciation based on regular maintenance. $20 million salvage value. (ii) the lease term.94 Useful life is more important because the more years the machine is useful the greater difference there is between the per year depreciation value.6 million per year.5 million per year. (iii) the asset’s residual value.

and other goods and services provided by regulated for-profit utilities Medicare reimbursement is similar to ratemaking except that the money is paid by the government rather than customers (a hospital that had 100% Medicare usage would receive all its funds from the government. GAINS AND LOSSES EXAMPLE A business that purchases land for $75. with no effect on expenses – Bookkeeping for gain or loss with respect to depreciable assets is a bit tricky because of archaic bookkeeping for depreciation EXAMPLE A business that retires (discards as worthless) an asset with no salvage value and has depreciated the entire cost: The only bookkeeping required upon the retirement is the elimination of the asset account for the asset. in a cost plus profit format) Public policy problem underlying utility ratemaking is that some goods and services are provided best by a monopoly. PROBLEMS: SALE OF DEPRECIATED PROPERTY N. (2) The plant is sold at the end of the 20th year for $308 million. above.000 profit would be revenue. telephone services. and a reduction in the accumulated depreciation account by the same amount – – – – Bookkeeping for the retirement of worthless machines is accomplished by eliminating offsetting balances. the book value of the sold item is an expense. The cost rests in the asset account for a depreciable asset 2.– – The path that depreciable property takes from the time it is incurred to the income statement is winding and once again inventory accounting affects matching 1. which held the asset’s historical cost. because the public interest is served. As the asset is depreciated the cost is moved to an inventory account 3.000: If the land is in perpetual inventory the $100. because financial accounting does not recognize profit until it is objectified by a transaction.000 would be revenue and the $75.000 and sells it for $100. The cost is removed from inventory and expensed on the income statement as part of cost of goods sold expense When depreciation is inventoried it hits the income statement only when the associated goods are treated as sold under the manufacturer’s accounting method. describe the effects on the income statement and the balance sheet under each of the nine depreciation methods described there of each of the following: (1) The plant is abandoned as worthless at the end of the 50th year. cash increases or decreases and a gain or loss must be booked Gains and losses are usually small and amount from changes in economic conditions that differ from those that were expected when the asset was placed in service Bookkeeping for gain or loss on non-inventory assets highlights one very significant feature of financial accounting: The amount of gain or loss booked in a given year can relate economically to a number of years (when land that has been in use for years is sold.000 an expense. soon under LIFO and later under FIFO The gross sale price is revenue. water. the profit from it which has accumulated over time is booked all at once). – – – In ratemaking accounting rules determine the rates paid by consumers and businesses for electricity. as to the disposition or retirement of non-inventory assets the accounting is different but has the same effect: Gain or loss is determined on an asset-by-asset basis and only the net gain (revenue) or loss (expense) of each item hits the income statement – L. which means that book profit for a year can vary considerably from economic profit for that year As to the plant considered in Problems VIII. since there is still no gain or loss Matters become involved when the sale price differs from net book value: When the sale price does not equal the net book value. but if the land is used in business (but not inventoried) only the $25.J. UTILITY RATEMAKING 1 . the same goes for when an asset has salvage value but is sold for that exact amount. by preventing the monopoly from exploiting the market. accomplished by regulating the monopoly’s profits so that they do not exceed a reasonable return on (net equity) capital M. no adjustment to any other account is necessary.

however. Time value issues that need to take into account the present value of the liability is increasing. which is referred to as “decommissioning” the plant. in ratemaking charging expenses to a year automatically generates matching revenues (it is perfect) – – Under federal law. (2) Under a 25year.9 million a year to compensate for the clean up costs that will be incurred per year over the 34 years of revenue that the plant will generate. this complex goal is achieved by two accounting adjustments: 1. discussed in Section VIII. but supplement accountancy’s rules in order to achieve more clarity and detail Since rates are set to limit profits both revenues and expenses affect the rate charged (revenue is relatively easy compared to expenses) and while the depreciation method will affect ratepayers there is no obvious correct choice EXAMPLE An electric company issues $250 million worth of new stock and buys a plant: (1) Under a 15. for 15 years. How should the relevant public utilities commission account for the $200 million for making purposes? (Hint: this context gives poignance to the notion of a sinking fund. therefore a customer that expects to pay for electricity for a short period of time would prefer a slower depreciation method (so that future customers pay for more of the plant). or even whether. On the day they open the plant the present value of the cost of the clean up is a liability and the liability grows each year as the current value increases. straight-line. the utility could have kept that money in the bank and generated revenues that would count toward the return on capital provided to the shareholders and the ratepayers would not have to pay a return on that capital through higher rates Ratepayers should not pay higher rates solely to provide shareholders a current return on capital tied up in building the new plant because it is not currently being used to generate electricity it is being used to construct a plant. The business puts the money in a trust fund so it is there when the cleanup needs to take place. while a customer that expects to pay for electricity for a long period of time with increasing usage would prefer a faster depreciation method (so that more of the plant is paid for in the earlier years) Shareholders should be indifferent to the depreciation method since they will get their capital back one way or another In financial accounting. no salvage.) Based on the sinking fund theory and using straight line depreciation. depreciation the result would be an increase in rates of $10 million per year (plus interest).7 million per year (plus interest). The utility is treated as if it earned a fair return on capital tied up in the construction (the same as if the capital had been in the bank) 2. PROBLEM: NUCLEAR DECOMMISSIONING P. depreciation the result would be an increase in rates of $16. the utility must clean up the nuclear mess. regardless of how long. which generally start with GAAP. no salvage. This clean-up becomes necessary the moment the reactor is first run. matching in generally done by booking revenue and then the expenses are matched (on occasion. revenue is differed in order to match it with associated expenses). straight-line. such as when payment is received. this assures that the lost current revenues are repaid (plus interest) by future ratepayers O. – – – Ratemaking helps to advance the analysis of equity-financed construction Assuming a utility could finance the construction of a plant out of equity capital. the utility should decrease revenue by $5. the plant is actually used to generate power for consumers.year. In exchange for cleaning up the mess the company is allowed to run a nuclear plant. The utility is treated as reinvesting the imputed earnings in the plant and capital is increased. Assume that a utility fires up a new nuclear plant for the first time today. but at the same time the shareholders should not lose money because that would discourage growth and construction “Lost” earnings on money tied up in construction should be paid for by the future consumers who will actually benefit from the new plant.– – The way that the utility measures profit directly determines rates and utilities commissions provide elaborate accounting rules for ratemaking purposes. The utility expects to pay $200 million to decommission the plant in 35 years (after one year of testing and 34 years of use).I. RATEMAKING FOR EQUITY-FINANCED CONSTRUCTION – 1 . when an electric utility retires a nuclear power plant from service. for 25 years – Customers pay the interest through higher rates on any capital that the utility shareholders have not recovered by billing its customers. the asset is their license from the government.

particularly growth in EBITDA over time. MARK-TO-MARKET ACCOUNTING – Mark-To-Market Accounting: An alternative to GAAP’s historical cost (recognition-based) accounting. A nice Illustration of the power of EBITDA in the 1990’s comes from Kurt Eichenwald’s book about Enron. depreciation. DISCUSSION PROBLEM: EBITDA S. so that current customers pay the same rates as if the money had stayed in the bank – – – – – Q. rather than profit. 8% in this example or $1. bonds.66 million. Merrill Lynch says out valuation is all about EBITDA. The idea is that EBITDA is a better predictor of the future. due to extraordinary events booked. as having been sold for their fair market values. Conspiracy of Fools. etc. then the head of Enron’s international operations. particularly in light of accounting’s conservatism EXAMPLE A company finances a $10 million project by taking the money out of the bank: (1) A GAAP analysis would consider the cost of the construction as $10 million (2) Under ratemaking the cost would be the $10 million plus the annual interest yield. then the President: Mark [noted:] “We need to keep investigating to grow as fast as possible. depreciation of intangible assets. because the values of most assets (readily-valuable stocks. and Amortization (EBITDA). as having been repurchased at these new values (liabilities are adjusted to reflect any change in their economic burden. the more valuable you are?” Skilling said. He recreates the following 1997 board meeting discussed between Rebecca Mark. Depreciation. matching is less important than in ratemaking. resulting in gain or loss) At the end of the year a balance sheet is prepared and lists assets and liabilities at their fair market value. and (2) why the pro-forma version is preferable) One fad in the 1990s was to measure firms’ performance using. options. and Jeffrey Skilling. commodities futures. That’s what our investors are looking for. and amortization (basically. at the end of the year assets are treated. so that to GAAP the burden of imputation outweighs matching benefits.66 million. EXTRAORDINARY ITEMS. see Section XI. first. AND PRO-FORMA STATEMENTS – Certain gains or losses. Taxes.) are easily determinable – – – 1 .” What do you think of EBITDA? R. and second. therefore ratemaking would consider the cost of the project cost $11. not earnings” This is ludicrous! “So the more money you lose. since interest. taxes. “Our bankers tell us we have to grow EBITDA.– For financial accounting. the difference between the two is the equity and any increase or decrease in equity between consecutive years is the profit or loss Similar balance-sheet-driven accounting is used in high inflation countries because it is easier to adjust for inflation under this accounting than under a transactional method Securities and commodities brokers have long used mark-to-market accounting for assets. in a given year may say little about how the business actually did in that year (a car dealership falls into a sink hole) A loss could by-pass the income statement by being booked as a direct reduction of equity. but it would remove an important event in the life of the business from the income statement GAAP try to balance concerns that the income statement should reflect only how things are going for the business’s operations against concerns that omitting non-operating events can tell an incomplete story The number of items that by-pass the income statement is small. Earnings Before Interest. the value the capital would have increased by had it been left in the bank. BY-PASSING. “That’s nuts!” Mark didn’t give an inch.C) do not relate to the to the day-to-day of the business and are not cash-like. nonetheless FASB remains concerned and as a consequence businesses are required to present “other comprehensive income” that reflects these extraordinary items An extraordinary item is both unusual in nature and infrequent in occurrence (losses that are so rare it would be unreasonable to insure against them) Pro-forma: Non-GAAP financial statements released in addition to GAAP statements that do not include certain expense items that do not qualify as extraordinary under GAAP (limited in that management must explain: (1) the difference between their pro-forma and GAAP.

not by being sold (depreciation is needed to account for their use. CLASS NOTES – – – – – – Tangible Assets: Assets such as buildings. Enron booked profit on its long term energy contracts with increased value. A company that buys the same amount of equipment each year not a lot. depreciation is $95.. but the problem was there was no real market for the contracts so the “values” were based on Enron’s own questionable valuation methodology (when the market learned Enron was a house of cards the company lost their ability to borrow an pushed it into bankruptcy) Despite the Enron debacle the SEC has recommended all financial instruments be accounted for using mark-tomarket accounting FASB’s most authoritative pronouncements are its Statements of Financial Accounting Standards (SFASs). so that they do not earn a monopoly profit – – – – 1 . they value the business by being consumed over time and we need to match the revenues from the machine with the expenditure of the use of the machine Straight line depreciation: Start with the original value and a junk or scrap value (what it will be worth at the end of its life). which require businesses to provide considerable detail in the footnotes to the financial statements of the current values of financial assets and liabilities 1. land. The business abandons the machine for $0 in cash: Depreciation is $95 and the business has to take a $5 loss (expense) 3. still it reflects considerable skepticism about the desirability of mark-to-market accounting because changes in the fair market value of investments are beyond the control of businesses and thus do not resemble ordinary business profits. machines. One provider of electricity is much more effective and efficient than having multiple providers all running lines across town 2. The business sells the machine for $5 in cash: Cash goes up $5. 380) What is at stake with depreciation: 1. State regulates these monopolies so that they can be efficient while not overcharging. then draw a straight line over the life of the item to figure out how much it will be worth (how much it will depreciate) every year Accelerated (curved line) depreciation: Takes into account the fact that most machines depreciate quicker in the earlier years of their life Microsoft uses straight-line depreciation (pg. a shrinking company is going to have more income (they will have already expensed most of their depreciation) If we did not account for machine depreciation over time it would not be perpetuity-like because over time you would be liquidating Inventoried depreciation: A depreciating factory or machine is considered a cost of production (all expenses incurred either directly or indirectly in bringing an article to its existing state and location). etc. Depreciation matters most for growing and shrinking businesses: A company that is growing and uses an accelerated method is going to have less income (money is spent buying assets that are depreciating quickly). SFAS 121: A business that makes tremendously optimistic assumptions in determining depreciation must catch up with special write-down when facts make clear that those assumptions were wrong T. assets that are valuable to a business by being used.– – – – Savings and Loan scandals in the 1980’s made mark-to-market fashionable because its use would have helped many of the S&Ls from going broke Enron slowed the movement towards mark-to-market. economically they only lost $90 but since $95 loss was already booked they book $5 profit instead of $90 depreciation Utility ratemaking (regulated monopolies): 1. SFAS 115: Applies mark-to-market accounting to some of a regular business’s investments. a way of matching use) All tangible assets other than land depreciates. and the machine total is $100 2. The business sells the machine for $10 in cash: Depreciation is $95 and the business takes a $5 gain (revenue). and the fluctuation of market values from year to year means full mark-to-market accounting can have erratic effects on the income statement 2. as to non-inventory assets (the sale of which is not the core of the business) you account for transactions on a net basis Gains and losses (the residual value of a machine is $5): 1. with an accelerated method new machines will go faster and older ones slower so they will balance out 2.

“Total rate effect” is “depreciation” plus the interest on “unrecovered cost” There are some items that bypass the income statement 1. Reverse engineer a market price by saying it is a cost plus a profit 5. so their business is mark-to-market Enron: Convinced the FCC and Arthur Anderson that their contracts were like stocks and bonds and valued their contracts subjectively.e. tornadoes in the mid-west) are not sufficiently infrequent and unusual Extraordinary items are so rare that none of our example companies have any extraordinary items other than accounting changes EBITDA: Principle focus is on amortization. there is no market price because there is no competition 4. Critics say that this method is only reflective of how well the market is doing since a company can fluctuate with the current value of their assets 2. If rates are too low the business will not be able to raise capital and will go out of business 6.S. natural disasters in areas they are expected to occur (hurricanes in the Gulf of Mexico. With long depreciation they must wait longer to get their money back Guide to the chart in footnote 23 on pg. 1 . but it is not shown on the income statement 2. so investors could not tell that the banks were in trouble (as interest rates rise the value of a bank goes down and as interest rates go down the value goes up. dollar so they made a billion dollar income. if a casino you own is underwater in Louisiana you have to take a write-down even if there has not been an event. such as demolition. but this is not perpetuity like. “Interest on unrecovered cost” is the 8% of “unrecovered costs” 2. the market recognizes that EBITDA is not earnings and allow it because it is so well established Savings and Loans: Banks were borrowing at 12% but their loans were at 5%. 375) Extraordinary Items: Items that are booked in a special area of the income statement that are infrequent and unusual in occurrence (a car dealership falling into a sinkhole). enough so that they can provide power but not so much they are making an unreasonable profit 7. that would technically create a reason to book it) 3.– – – – – – – – – – State sets electric rates so that the companies get their costs back plus a reasonable profit. which focuses on current market values at the end of each period rather than waiting for a transaction to book the value 1. The hardest part is figuring out what a reasonable return is. when there was really no market at all for them FSAF 115: Not responsible for knowing FSAF 121: If there is an asset that is clearly not worth what they paid for it. they have to take a write-down (i. Microsoft’s other comprehensive income of $587 million went down 4 million from 2001 to 2002 (pg. GE’s foreign currency beat the U. interest rates went up so the value of their loans went down and accounting statements did not reflect this. Securities traders’ (or a bank that sells securities on the side) business is managing stocks and bonds. 127: 1. it has nothing to do with management) Mark-to-Market: Solution to the Savings and Loan problem was mark-to-market accounting.

borrowing or issuing stock generates cash flow. Utility and significance of the cash flows statement 3. Charge Issuing Stock (Equity) Nothing Immed. consists of cash in less cash out from ordinary business activities 2. Indirect: Reverse-engineers net operating cash flow from net income without identifying receipts and payments. but companies have figured out how to manipulate it just as they do the income statement) In this chapter: 1. Receipt Repaying Debt Nothing Immed. WHAT THE CASH FLOWS STATEMENT SAYS – – – Cash Flows: Cash (or the equivalent) received by the business less cash (or the equivalent) paid out (a checking account statement is a simple cash flows statement) Cash flows accounting does not match by accruing and deferring. Operating (distinguishes direct from indirect cash flows statements): Resembles income without accrual or deferral. Charge Inventory Cost Deferred Immed. INTRODUCTION B. Charge Almost from the outset. Charge Non-Business asset Sale Gain Only Entire Sale Price Borrowing (Principal) Nothing Immed. it is also the newest and most primitive (it was introduced in 1978 as a hoped-for solution to the problems with the income statement.CHAPTER IX: . Comparison between the cash flows statement and the income statement 4. Financing: Dealings with the business’s lenders and equity. which is then sold at a loss and still generate large amounts of operating cash) It is useful to contrast the income statement and cash flows statement: Income Cash Flows Receivables Revenue Nothing Payables Expense Nothing Prepaid Revenue Deferred Immed. Receipt Dividends (and the Like) Nothing Immed. BACK TO THE FUTURE 1 . All cash expended is a payment There are two forms of cash flows statements that differ only in how the determine “operating cash flow” 1. Charge Non-Business Asset Cost Depreciated Immed. showing separately cash in and cash out. Investing: Ownership of any type of asset other than inventory (not just things commonly viewed as investments. Receipt Prepaid Expense Deferred Immed. Basics of the cash flow statement 2. this is the preferred method but rare 2. while amounts received increase cash flow 3. accountancy believed that accrued net income was a better measure of the economic performance of a business than cash flow and so it focused on the income statement with little concern for cash flow – – – – C. amounts paid for assets reduce net cash flow. like stocks and bonds). while paying debts and distributions to equity (such as dividends) consumes cash There are numerous problems with cash flow especially its three-part presentation (a business can borrow to buy inventory. there are no assets or liabilities 1.THE CASH FLOWS STATEMENT – – The cash flows statement is the last of the three basic financial statements to be discussed. Direct: Presents the operating cash flow explicitly.. most businesses use indirect because internal records are set up with accrual in mind and do not have direct operating cash flows information readily available Cash flows are divided among three activities that are distinct enough that classifying cash flows with reference to them provides useful information 1. All cash taken in is a receipt 2. Discussion of the non-GAAP form of income accounting called the “cash method” that is different from the cash flows statement A.

other than inventory.000 F. Bank Equity Liabilities 35. Your client still is owed a considerable sum. Which of (i) GAAP income statements. which is typical for small service businesses. the greater a business’s financial flexibility the better able it is to deal with change and unforeseen circumstances Difficulties with cash flow can indicate problems. The balance sheet looks as follows: Assets Cash Supplies Prepaid Rent 10. No dividends are paid.000 The CPA’s opinion letter. including Betty. looking at only income can cause investors to miss valuable information about a business Financial flexibility is the key to business and income does not reflect a business’s ability to generate income over medium periods of time (over long periods income and cash flow are much more useful). All material property. failing businesses frequently get into cash flow trouble before income starts to plummet (income statements are more misleading about failing businesses since they assume an indefinitely ongoing business) For a healthy business the cash flows statement is best viewed as a presentation of useful information. so it is not available for the owners to consume outside the business) The general trend in financial accounting is to provide more types of information. Our examinations were made in accordance with generally accepted auditing standards and. Books expenses only when paid: Payables (for expenses) do not appear on cash method financial statements Betty is a very successful orthodontist who operates as a corporation. accordingly. MIDDLE issues no stock. and the income statement which measures profit or loss) The MIDDLE Company is a wholesaler.000 45.000 30. in order to get one of the firm’s creditors to delay foreclosing on a loan in default. granted (non-recourse) security interests in some of their personal assets. At one point in the past. MIDDLE does not buy its stock back from shareholders. You informed Betty’s attorney that you want the orthodontia stock. It buys goods from manufacturers and sells them to retailers. included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances. MIDDLE has no obligations other than accounts payable. One of the assets that Betty pledged was all of her stock in the orthodontia corporation. The gene splicing firm has gone out of business. He sends you the most recent audited financial statements of the orthodontia corporation. and (iii) cash basis income statements best describe the success of MIDDLE’s business operations and why? D. (ii) GAAP cash flow statements.– – – – – Under a finance analysis the value of a business should be the present value of all expected future distributions of cash to the equity owners.000 Common Stock 10. THE CASH METHOD – Cash Method or Cash Basis: A type of income accounting most used in preparing income tax returns. more closely resembles the accounting on the GAAO income statement than that on the cash flows statement (basically GAAP that ignores receivables and payables) 1. is leased. The firm got in financial trouble. the firm’s investors. PROBLEM: VALUING A SERVICE BUSINESS 1 . Books revenue only when cash is received: Receivables (for revenue) are viewed as unrealized and not booked 2. The corporation pays her for her services as cash is available. PROBLEM: INCOME V. CASH FLOW E. and not measuring anything (compared to the balance sheet which measures equity.000 5. You represent the creditor of the gene splicing firm that has a lien on Betty’s orthodontia stock. All of its assets have been picked over by its creditors. provides as follows: We have examined the statements of assets and equity of Betty’s Orthodontia Corporation and the related statements of revenues and expenses and changes in shareholders’ equity. cash flows show on the cash flows statement bear little resemblance to these future distributions (borrowing generates cash but must be repaid. Betty personally invested in an otherwise unrelated gene splicing firm.

What do you say to him? – – The Enron mess gave a nice example of potential problems in the cash flow statement. using the following options: (i) Sell its hard assets. using a device called “prepay”) Based on testimony of Robert Roach the Chief Investigator for the Subcommittee on Investigations: 1. which it was unwilling to do. Cash flow was seen as the most reliable measure of a company’s performance. having a direct impact on the value equity analysis assigned to Enron. ENRON’S OPERATING CASH FLOW 3 . (ii) sell the value (and risks) of specific trades in its trading book to collect cash proceeds. who must have an ordinary business reason for purchasing the gas G.000. the aforementioned statements present fairly the assets.000 in exchange for you client relinquishing its security interest. holding off trading partners contractual rights to close out existing claims and demanding payment. such as power plants and pipelines. using their trades and their promise of delivering cash a few years down the road as collateral (this third option is the focus of Roach’s testimony) 5. He offers you $10. particularly the operating portion: Enron used mark-to-market accounting for many of its activities and its aggressive valuations enabled it to book paper profits without any cash to back them up (Enron borrowed to but assets that were sold to generate operating cash flow. and (iii) borrow money from a bank. and shareholders’ equity of the company and its revenues and expenses and changes in its equity on the basis of the accounting described in the notes mentioned in the preceding paragraph. or make any reference to each other. the aforementioned statements have been prepared on the cash receipts and disbursements method of accounting. Prepay: Paying in advance for a service or product to be delivered at a later date. instead it used a complex prepay system to hide its debt: Enron booked the advance of cash as a trading activity rather than as a loan and proceeds from the loan as cash from operations rather than cash from financing. and kept debt holders from demanding payment 7. as earnings grew. the lending bank. had investors known that Enron was not $12 billion in debt but rather closer to $17 billion they would have sold off stock until the price was consistent with that level of indebtedness 8. Betty’s lawyer says that these financial statements show that Betty’s stock is worth $10. By using prepay transaction s to generate cash flow from operations. In our opinion. By borrowing cash against Enron’s trades they would have to record the amount as debt. This method also drove Enron’s stock price. cost of borrowing remained lower. and was the best indication of a company’s ability to meet its obligations 4. liabilities. By using this method Enron was able to keep a better credit rating allowing it to borrow more money. because it was believed this number could not be as easily manipulated as earnings. Enterprise Value: A measure of what the market believes a company’s ongoing operations are worth (assumes that the market has a knowledge of the company’s indebtedness and preferred equity obligations) 9. which allowed Enron to build a trading business that was the engine behind Enron’s income growth. Enron was able to maintain its investment grade ratings. and by doing so was able to raise $8 billion worth of funds 6. and gave management cash flow numbers they were expected to meet. Enron had two major reasons to reduce its balance sheet debt and increase cash flow from operations: (i) to improve Enron’s credit rating. making it a more attractive trading partner. and a third-party) and none of the individual agreements could be linked commercially. used to receive money up-front for services to be rendered in the future (used in a complex form by Enron as a source of financing to mislead investors) 2. and do not purport to present the company’s financial position or results of operations in conformity with generally accepted accounting principles. they all had to stand alone: This would be accomplished by transferring the price risk from the gas supplier to the purchaser.As described in the notes to the financial statements. Enron placed heavy emphasis on generating operating cash flow. so did Enron’s share price 10. and (ii) to support and even boost Enron’s share price 3. To legally structure the prepays in order to be treated as contracts there must be parties (Enron.

Go through Microsoft’s cash flows statement in the Appendix and explain the import of each line. accrual or deferral Cash flows statement consists of three sections: 1. commissioning of stock. PROBLEM: MORE BOLT DIVORCE I. The value assed by accountants is in accruing cash receipts and disbursements so as to attain a more useful measure of firm performance over short intervals Even true believers in the efficient capital markets hypothesis can find utility in accrual accounting This is the end of the introduction to the basic financial statements The next section looks at situations where GAAP has difficulties (both practical and theoretical) H. The banks had the option to sell back the power at a certain price at a later point in time 4. Investing: Money spent to buy back stock. subtract increase in inventory. INCOME: WHY BOTHER? – – – L.”) Review Section VIII. liabilities. CONCLUSION: INTO THE FRAY M.E in light of The Bolt Company cash flows statement above.11. there are no assets. proceeds from sales of assets 2. regarding EBITDA. one can conclude that the accountants were wrong and should have saved the effort spent developing the income statement and have been satisfied with the cash flows statement. Citibank) for future delivery. if you are not getting cash it is an early sign of trouble When cash problems start a business can continue selling but to lousier buyers and for longer contract (they can book the revenue from the sale and still look alright when in truth they are not receiving cash as consistently or quickly) Cash flows is anti-mark-to-market. Enron was really borrowing money. borrowing 3. All the operating cash flow was based on these prepay borrowing transactions – – – – 1 . Operating: Any purchase of assets other than inventory. the third-party would then enter into the same deal with Enron. CLASS NOTES – – – – Cash flows statement is most important in measuring cash or liquidity (a business can have lots of assets but no cash and not be able to pay its employees) Enron had cash flow problems Cash is the lubricant of business. the cash that came in should have been in finance. If all users of a business’s financial information are just going to measure income. Do not analyze the lines “Stock option income tax benefits” and “Sales/(repurchases) of put warrants. increase less decrease in payables Most companies do not keep cash flow records Enron could borrow and generate cash flow but had to manufacture operating cash flow 1. (Assume that “other current assets” means inventory. Income measurements by management may provide important information not discernable from cash flows 3. The banks and third-parties were all aware of the entire structure and its accounting purposes Reconsider your analysis of Problem V. but there are a few contrary arguments 1. PROBLEM: MICROSOFT CASH FLOWS STATEMENT J. They would “sell” power to other businesses (Chase. EBITDA K. but the banks did not want power they wanted money 2. Is EBITDA more useful in valuing a business than the cash flows statement? – If one believes the efficient capital market hypothesis to be correct. Enron blatantly contradicted this criteria by having the bank send their money to a third-party in exchange for a commodity to be paid in the future. it makes sense to do it once for everybody 2. Indirect: start with net income. but they were operating as if they had sold power 3. PROBLEM: CASH FLOW V. add depreciation because it does not reduce cash. then Enron would negate any risk to the parties of the commodity’s price changing by exchanging with the bank the floating price of the commodity for the fixed price of the commodity 12.R. decrease less increase in receivables.

which says you earn revenue and gain expense when you write the check (i.e. not when you work and earn the money.– Method of the cash flow statement is different from the cash method. you get taxed when you get paid. so your last paycheck of the year could be taxed in the following year) 1 .

Idea for the product 2. Payment is received 13.PART D: DIFFICULT ACCOUNTING . Persuasive evidence of an arrangement exists (assures that the transaction is sufficiently real to support revenue recognition A. Accounting for revenues from personal services Revenue earned by the sale of goods is relatively straight forward yet it still provides some difficult theoretical problems. Manufacturing begins 5. General concerns regarding revenue recognition 4. the SEC put out a rare substantive accounting pronouncement called Staff Accounting Bulletin 101 (SAB 101) which provided the following rules for recognition (all conditions must be met): 1. but accountancy has developed a practical solution: Book revenue when the good is delivered Recognition (timing) is do central to accounting that many use the word “accounting” to refer to timing In most sales the key point is when the order is received. Return period for full refund expires 15. Period in which seller can be sued with respect to the product lapses GAAP uses the delivery rule for two reasons: (i) It is easy and clear to apply. Marketing of product 4. Check clears 14. accountants need an event that is clearly defined and verifiable on audit to demonstrate both that economic activity has occurred and that there is a clear value associated with that activity Delivery demonstrates that most of the earning underlying the sale has been completed and that a third person has put a price on that activity The terms under which a business sells and acquires goods and services can be quite manipulable. Good is shipped 9. and (ii) it facilitates matching sales revenues with cost of goods sold expense (determined using a periodic inventory accounting method that is based on counting a physical inventory) GAAP’s recognition rule reflects a compromise between measuring economic activity and just reporting cash flows. particularly for businesses that earn money other than by selling goods. Development of product 3. Order is received 8. Invoice is sent to customer 11. accounting rules that put endue emphasis on when cash changes hands would allow businesses considerable flexibility and would result in books differing between firms solely as a consequence of payment terms In 1999. Exploration of revenue recognition 2. an argument can be made that revenue is earned at any points in time: 1. INTRODUCTION: HARD NUMBERS IN A VIRTUAL ECONOMY – – – B. Customer mails payment 12. GENERAL REVENUE RECOGNITION PRINCIPLES 3 . is the most important context where uncertainty troubles accounting Most of the recent accounting problems in the telecommunication industry involved the booking of revenue that had not been earned. Good is delivered 10. Analysis of in-kind property exchanges 5. Order is solicited 7.CHAPTER X: REVENUE RECOGNITION – – – – Risk (uncertainty) presents the most challenging problem in finance. Specific good is made 6. consider the timeline of a simple sale of a good. and is the central concern of accounting Revenue recognition. Problems that can be presented even with a simple sale of goods 3. SALE OF GOODS – – – – – C. Warranty period lapses 16. and that most likely was not going to be earned In this chapter: 1.

The seller’s price to the buyer is fixed or determinable (functions similar to those served by the first rule. the customer has the unilateral right to cancel the arrangement at any time during its term and receive a full refund of the initial fee. Company Z delivers product to Customer A under the terms of their arrangement. Company R does not require the customer to enter into an installment note or other fixed payment commitment or agreement when the initial deposit is received. having more than sufficient inventory in their distribution channel. Company M’s data for the past five years indicates that significant variations between actual and estimated cancellations have not occurred. Company R either must refund the cash deposit to the customer or provide replacement merchandise. damaged. recognition is to occur when there is evidence of value from a transaction with a third party. and collects cash deposit from the customer. May Company M recognize in earnings the revenue for the membership fees and accrue the costs to provide membership services at the outset of the arrangement? (6) The preceding five questions came from SAB 101. (1) Company A has a product available to ship to customers prior to the end of its current fiscal year. only when a third party where its mouth is does a transaction support booking revenue) 4. or destroyed. Customer Beta does not sign the agreement because Customer Beta’s purchasing department has orally agreed to the sale and states that it is highly likely that the contract will be approved the first week of Company A’s next fiscal year. However. and Company A delivers the product prior to the end of its current year.g. Customer A is a consignee. sets it aside in its inventory. Pursuant to the term of the arrangement. It generates revenue from annual membership fees it charges customers to shop at its stores and from the sale of products at a discount price to those customers. May Company A recognize revenue for the sale of its products once it has completed manufacturing if it segregates the inventory of the products in its own warehouse from its own products? (4) Company R is a retailer what offers “layaway” sales to its customers. and private standard-setting in general. but are not limited to. the customer forfeits its cash deposit. What does it say about FASB. May Company Z recognize revenue upon delivery of its product to Customer A? (3) Company A receives purchase orders for the products it manufactures. that these questions were unanswered in 1999? D. Company A prepares a written sales agreement. In the event that the customer fails to pay the remaining purchase price. However. and title to the products does not pass from Company Z to Customer A until Customer A consumes the products in its operations. In the event the merchandise is lost. PROBLEMS: RECOGNITION 1 . Collectibility is reasonably assured (assures that the value in the transaction is real. and Company M does not expect significant variations to occur in the foreseeable future. When may Company R recognize revenue f r merchandise sold under its layaway program? (5) Company M is a discount retailer.. Based on historical data collected over time for a large number of homogeneous transactions. Customer Beta places an order for the product. Although Company R may set a time period within which the customer must finalize the purchase. The membership arrangements with retail customers require the customer to pay the entire membership fee (e. Company T retains the merchandise. $35) at the outset of the arrangement. These reasons may include. or delays in customers’ production schedules. and its authorized representative signs the agreement before the end of the year. Company M estimates that approximately 40% of the customers will request a refund before the end of the membership contract term. Company A’s normal and customary business practice for this class of customer is to enter into a written sales agreement that requires the signatures of the authorized representatives of the Company and its customer to be binding. customers may not yet be ready to take delivery of the products for various reasons. a lack of available space for inventory. Herzfeld illustrates the problems when there is a reasonable possibility that the buyer might not pay) Channel Surfing: A manufacturer or wholesaler stuffs its distribution channel by delivering more goods to its customers than it knows that the customers can sell in order to book the revenue (the extra goods probably will be returned so the revenue is not really earned. At the end of a given year. practical considerations have demonstrated that it is the right rule here) 3. but the practice is hard to police) 2.– Delivery has occurred or services have been rendered (the work horse of the four. May Company A recognize the revenue in the current year for the sale of the product to Customer Beta when (1) the product is delivered by the end of its current fiscal year and (2) the final written sales agreement is executed by Customer Beta’s authorized representative within a few days after the end of the current year? (2) Company Z enters into an arrangement with Customer A to deliver Company Z’s products to Customer A on a consignment basis. The merchandise generally is not released to the customer until the customer pays the full purchase price.

when an asset is sold for above cost profit is accrued. Percival Co. it must have been received. which must be calculated by consummated sales. and this was certainly not within the contemplation of the parties or the terms of the contract. 31 st 1916. Therefore the court finds no justification for either the inventory or balance sheet taking a different form for the year of the plaintiff’s termination.16 the difference between the cost price and the market value of merchandise on hand in the department. on how using GAAP to evaluate management—effects management’s behavior.69 (the cost of the merchandise purchased during his last year of employment but not delivered until the year later) and (2) 25% of $18. INCENTIVE COMPENSATION: STOCK OPTIONS AND RESTRICTED STOCK – Stock Options: An employer awards an employee an option to buy stock of the employer at some price above that at which the stock was trading on the grant date. is Tooey properly decided? F. Undelivered goods and differences between purchase price and market values of merchandise are not considered profit except in a speculative sense.? If not. generally. These contractual incentives are not reflected in the efficient capital markets hypothesis.L. During other periods of Tooey’s employment the 25% was figured without these additional figures. in the form of cash or completed sales.G discussed Halliburton’s accounting for cost overruns covered by government contracts.(7) Section VIII. Percival Co. Note that if the hypothesis is wrong and the market relies heavily on book earnings (regardless of their content) in valuing corporate stick. C. Tooey is claiming that he is entitled to a percentage of net profits that might be expected to appear in the next year’s financial statements. These contentions are not consistent with practical bookkeeping.L. when terms of a contract are in dispute the court should enforce the practical construction that the parties placed upon those terms during execution of the contract. Do you think Tooey’s counsel thought that she was getting anything but GAAP earnings? If so.781. Reflect on how using GAAP in such contracts—and. The word “income” means what has come in. ACCOUNTING AS NATURAL LAW CASES Tooey v. his contract was terminated on Dec. assume that Tooey had counsel. To think otherwise would be to confuse profits with property. The term “net profits” as used by the parties was never defined or discussed by them. Was the method that Halliburton changed to proper? – GAAP require that a transaction with a third party demonstrate that earning really has occurred before the revenue can be booked E. neither of these values would appear on nor be a factor in the company’s balance sheet. (1) As a matter of contract law. avoid the need to draft complicated provisions to measure an employee’s effectiveness 1 . One of Tooey’s duties included purchasing merchandise. profit is not accrued because an asset could be sold for above cost. After the defendant quit. “Net profit” means the difference between income and outgo. NOTES AND PROBLEMS: TOOEY AND INCENTIVE COMPENSATION (2) Although it is not likely. is the Tooey contract. the contract that you would draft to give Mr. “Dispute Over Definition of ‘Net Profits’ in Employment Contract” The term “net profits” only applies to profits from recognized earned income during the year The plaintiff Tooey (“Tooey”) was hired as the manager of the paper and woodenware department at the defendant’s company at which time they entered a contract that would pay a weekly salary plus 25% of the net profits of his department. Tooey contends that the term “net profits” requires him to be paid two additional sums: (1) an extra 25% of $8. as interpreted by the court. G. In the science of bookkeeping net profits of a business are reduced to actual possession. Tooey a piece of his economic contribution to the C. what would you do differently? Think through the incentives for Tooey (the company) to modify behavior in order to increase (decrease) Tooey’s compensation under various contract provisions. (4) Designing incentive compensation for key employees of businesses is a difficult art.788. how could she have made the intent more clear? Would competent counsel have let Tooey sign the contract? (3) As a business matter. For the last year of Tooey’s employment. shareholders would want management to focus on book earning. In addition. Remember to be practical. and the company stopped paying both his salary and the 25% net profits. so that incenting senior management (those in a position to have a material impact on book earnings) to increase GAAP earnings would make perfect sense.

trading one advertisement for another) The most important accounting issue is what dollar amount is to be placed on the transaction. for which he must stay five years. CALPERS has so much clout that it can influence the policies of public corporations. but the SEC delayed the effective date of the rule. there is a $20 compensation amount (usually an expense) each year Assume that you are in charge of CALPERS (the California Public Employees Retirement System). notwithstanding hard-working and effective employees many companies’ stock plummeted in the recent recession. Some companies have solved this problem. no expense is ever required when stock compensation is used (Microsoft’s 2002 income was 45% higher than it would be with expensing of all stock-based compensation) In 2004. FASB adopted mandatory expensing of compensatory options. How would you want companies that you invest in to compensate key employees? – – Cash is not the only thing that goods can be sold for such as in-kind trades where on good is traded for another for another (common in the entertainment and dot-com industries. An exchange of a productive asset not held for sale in the ordinary course of business for a similar productive asset H. managers are viewed as being more concerned with protecting the value of their options than with managing the company (options also give managers reason to manipulate the books and mislead investors). Revenues are an important number for some businesses 2. they provide that exchanges of nonmonetary assets that do not culminate the earning process have no book effect so that the asset receives is treated as a substitute for the asset surrendered): 1. most prominently Microsoft.– – – – – – – – In the last economic boom the most popular form of incentive compensation was stock options. but bear no loss once the stock value goes below the exercise price specified in their option There are also problems with trying to evaluate employee performing by using stock options. and to avoid alienating the employees the companies had to reduce the exercise price on the options. An exchange of a product or property held for sale in the ordinary course of business for a product or property to be sold in the same line of business to facilitate sales to customers other than parties to the exchange 2. the more remote is the connection between the employee’s performance and the employer’s stock value and the less incentive the stock option provides for the employee to do their job better Stock options cost the employer no cash and there are tax and accounting advantages to using them: for financial accounting purposes. this means that the employee gains even if the stock goes down but benefits more if the stock goes up Under GAAP the value of the stock at the time that the option was granted is treated as an expense pro-rated over the restriction period (if an employee is granted $100 of stock. the companies entered into contracts in which one would allow the other to use its excess capacity in one region in exchange for the same use in another and booked large valuations as revenue even though nothing was sold to a customer and probably never would be The exchange does not complete the earnings process and revenue was being booked that had not been earned. and may do so indefinitely Stock options have been blamed for some recent economic ills. options also encourage risk taking since if managers win the stock value goes up. employees were rewarded for the general performance of the employer The smaller the role of an employee in the total corporate business. since no cash is involved the businesses are probably giving each other a discount. who then paid the same amount right back in a market transaction This may seem worthless since the revenue would have an offsetting expense and the transaction could basically be ignored but there are reasons for it 1. The two parts of the exchange may not offset (a radio station that trades an ad for a new roof from a construction company may gain an improvement rather than a repair and the offsetting expense would be deferred) Another problem with associated exchanges is illustrated by the bad accounting that got many telecommunications companies in trouble (including Enron and WorldCom): Huge amounts of fiber optic cable capacity were acquires and the demand was never realized. but the current accounting practice is to value the exchange as if one party paid cash market price to the other. by switching to restricted stock plans which issue employees shares that need to be returned if the employee quits within a certain time period. IN-KIND EXCHANGES OF PRODUCTIVE ASSETS – – – 1 . It provides pensions for all employees of the State of California and is one of the largest institutional investors. PROBLEM: INCENTIVE COMPENSATION TODAY I. the following two nonmonetary exchange transaction do not culminate an earnings process (these operate in addition to the general rules of SAB 101.

M? (The death penalty is not available for violations of the federal securities law.S. A tax sharing agreement allocates the group’s tax liability among the group’s members. airplanes in partial payment for 60 new planes. S&Ls took money (deposits) from the community and relent it as home loans 4. In light of the relationship between GAAP and the federal securities laws (as discussed in Sections VI. (3) A tax sharing agreement is required whenever a group of corporations file a consolidated federal income tax return. Many people lost lots of money when ACC went broke. government charters banks and Savings and Loan institutions (S&Ls). and trashed the actual application of GAAP by Lincoln Savings and its auditors. would know this. Historically S&Ls were small and specialized in making home loans to the local community. why do you think that the former SEC enforcer wanted to make a point about GAAP in action? L. How do you think that he would have dealt with Herzfeld in Section V.M and VI. Institutions are required to have adequate capital (net worth) determined on a balance sheet (assets minus liabilities) basis 3. Wall “” (Not Required) (1) Before going on the bench. Stanley Sporkin was widely criticized as trying to convert the bar and accountancy into police.(Not Required) (1) Did the accounting for exchanges of excess capacity in the telecommunications industry prior to SAB 101. but fully depreciated (zero net book value). however.) (2) The Lincoln Savings opinion only scratches the surface of the exploits of Charles Keating. comply with the APB pronouncement quoted above? (2) Car dealers regularly swap cars when one has a car that the other has a customer for. Wall: 1. This view is evident in the Lincoln Savings opinion. referred to in the opinion. The Lincoln Savings tax sharing agreement’s allocation of federal income tax liability to Lincoln Savings based on its GAAP income would not have been respected under relevant federal income tax law. With a consolidated return. What is the accounting treatment? (Not Required) In an exchange both parties are a seller and a buyer. MULTIPLE ROLE TRANSACTIONS – – CASES Lincoln Savings and Loan Association v. What is the accounting treatment? (3) An airline trades in 60 valuable. Charles Keating running into Stanley Sporkin was a King Kong vs. Prior to 1989. duty to pursue the best interest of their clients. Another deed of Keating was arranging for Lincoln Savings to sell ACC junk bonds in a way that investors thought that the bonds were federally-insured certificates of deposit. The Lincoln Savings agreement’s inconsistency with tax standards alone would have made Judge Sporkin’s argument that the agreement demonstrated that Lincoln Savings’ management was operating the S&L inappropriately. whenever parties play both roles in a transaction they are related for purposes of accounting for a given piece of the transaction and it may not really demonstrate that earning has occurred Background for Lincoln Savings and Loan v. The U. Godzilla matchup for ‘80s. What is the accounting treatment? (4) A real estate development corporation exchanges some vacant land that it has held as an investment for land that it intends to build an office building on. He is most well known for his improper involvement with five senators (referred to by the media as the “Keating Five”) in order to get them to interfere with the investigation of Lincoln Savings. and to protect depositors the federal government provides insurance 2. Judge Sporkin took a different tack. and Judge Sporkin is a very good corporate lawyer. In this role. One consequence of this involvement was the Washington interference with the San Francisco FHLBB investigation. the tax owing is determined by the group and not separately for each corporation.N). Judge Sporkin was a very tough head of enforcement for the SEC. NOTES AND PROBLEMS: LINCOLN SAVINGS 1 . In short. Any good corporate lawyer. discussed above. the regulation of S&Ls was separate from and less rigorous than bank regulation J. PROBLEMS: EXCHANGES K. he was outspoken in advocating that lawyers and accountants involved in regulatory matters have a duty to protect the public good that can override the professionals.

The contract requires CONSULTING. financial accounting arose so that capital users could account to capital providers (accountancy only entered the big time when big corporations and public capital markets emerged and grew) Services businesses were different from big business. the language in SAB 101 does provide general guidelines but does not answer the hard questions in service transactions of when services are performed and when the price is fixed or determinable SAB has one example of when service should be rendered: 1. Services revenue should be recognized on a straight-line basis. to come up with a plan that will save HUGE at least $30 million in health care costs in 2006. Philip Gordon. since they do not usually need certified financial statements and are not required to use GAAP accrual accounting. and net leasing) Accounting has not been forced to fully confront services accounting. frequently they will use the cash method discussed in the preceding chapter – – (Not Required) The CONSULTING Corporation consults for various customers on a variety of matters. legal services. 2005 with HUGE. but there are problems: (i) The firm may not bill all of the time expended on a clients behalf (in which case it would be better to wait and book revenue when bills are sent out). accounting. which makes accounting for services difficult because there is no nice event that mark the recognition of services revenue M. CONSULTING is to receive an additional $5 million in 2007. (this does not include financial services like lending money. Inc. entertainment. software. so that they can book revenue. SERVICE BUSINESSES – – – – – EXAMPLE At a law firm economic earnings occur as the firm’s lawyers put in time. which ever is longer 2. CONSULTING must refund $500. and other investments Few service businesses have publicly traded stock but there is even talk of law firms going public. including health care. If the plan is submitted to HUGE in a timely fashion and is successful. over the contractual term of the arrangement or the expected period during which those specified services will be performed.(4) Were the four basic transactions (Wescon. consulting. there are many options but the general rule is upon delivery When you actually get something done (deliver the good. etc. and (iii) at the time a trial is won there may still be the possibility of appeals (in which case it would be best to wait to book revenue until all appeals are exhausted) – – The lack of guidance on GAAP for services is widely acknowledged. return) but by delivering you have done enough to book the revenue Channel stuffing allowed businesses to manipulate the delivery rule 3 .000 if the plan is not timely. taking risks. build the plant) things can still go wrong (lawsuit. It enters into one long-term contract on January 2. Memorex. transportation. CONSULTING is paid $1 million upon entering the contract. and GOSLP) booked improperly under GAAP? (Not Required) Despite the fact that service businesses have been around forever the applicable accounting rules are not completely settled and accounting for services under GAAP can be quite challenging. Should recognize revenue on a straight-line basis unless evidence suggest that the revenue is earned or obligations are fulfilled in a different pattern Standard accounting texts gloss over services Most service firms do not even try to apply GAAP . for example firms providing medical care. by the end of 2005. which suggests that the firm should accrue revenue as lawyers put in time. they were traditionally small and used little capital. CLASS NOTES – – – At what point does a business earn money. (ii) at the time services are provided there may not e a “fixed price” (in which case it would be best to wait and book revenue when payment is received). architecture. How should CONSULTING account for revenue from this contract and related expenses? N. unless evidence suggests that the revenue is earned or obligations are fulfilled in a different pattern. as they go public they will begin to require certified financial statements and GAAP will not be able to be ignored for much longer SAB 101 only requires that services be rendered. PROBLEM: ACCOUNTING FOR A CONSULTING BUSINESS O. but recently they have needed more capital for computers.

the contract never defined net profits 5. but since it was only a few months it became problematic) 8. If LIFO had been used it would not have been a big deal either. There is a real transaction 2. but FIFO was the standard and was what everyone used back then 9. Tooey was realized as an important driver of profit because he was the man buying and the company wanted to give him incentive to do his job well 1. Achieves matching because the revenue is booked with the expense of the employees who are providing the customer support When revenue recognition criteria is not met revenue is recognized as payments are received TOOEY: Percival Company hires a guy to be their buyer. that has to be returned if they leave within a certain time period Management manipulated this by backdating options Instead of paying employees cash. Lesson is to not leave any term definition to anyone other than yourself when drafting contracts Stock options and incentive compensations is when businesses give their management options to buy stock at today’s price at some point in the future (if stock goes up they can make money. which were not bought at the cheap prices that he bought the stuff at 4. You are probably going to get paid Microsoft sells a product license (the software) but they also sell the tech support and the updates 1. What are net profits in a legal sense. The reason it was never defined was because everyone knew what it meant. Defer the revenue that is for customer service and updates 2. They cut a deal that they are going to pay him 25% of the net profits 2. companies gave out stock options which made executives want to manipulate the stock Tax rule was that expense was booked at exercise but the theory of accounting was that it was capital Accounting rules are so bad for high tech markets that it is impossible to tell what companies are making money and what are losing money 1 . because while he was there the company was selling the products from his predecessor at a high price. For real money 3. the only problem was that no one expected him to quit so soon (over 20 years the difference would be minimal. which finally guided accounting as to when revenue can be recognized: 1. if it goes down they do not lose anything) The problem occurs when the stock goes down even though the management is doing a good job. When accountants talk about net profits it is reasonable to assume the are using standards from GAAP 7. want to make money by based on buying cheaply not selling expensively. the SEC put out SAB 101. Based on GAAP they pay him the 25% based on the stuff sold while he was there 3. He wants to be paid the profits of the future for the items he purchased. The principles of the science of the bookkeeping restrict the profits of any business to such profits that have been reduced to actual possession in the form of cash or its equivalent by completed sales 6. which can frustrate the employees: One solution has been to give the employees free stock.– – – – – – – – – – In 1999.

Non-Identifiable (goodwill and going concern value. whose balance sheet is set out above in Section V. Human capital. Assume that both firms will pay the same rate of interest. It plans to license the technology to an established manufacturer of similar tools so as to collect large royalties. and copyrights A. which are not represented by anything and cannot be sold separately from the company Under a finance valuation the value of a business is the present value of the expected future cash flow. and other intangibles can make one business more profitable than another with similar assets An asset appears on the books when an expenditure is deferred rather than immediately expensed. patents. therefore per se assets are irrelevant because two companies with the same assets can have two very different values depending on their earning potential A good reputation. Identifiable (patents. There are two prospective borrowers: The first is The Bolt Company.000 Inventory 800. you can make one more $1 million loan this year.000 2.900. The second is a high-tech firm that has no material assets other than a patent that it developed for a tool that radically simplifies genetic engineering. Plant and Equipment 1. know-how. although it may turn out to be more difficult than expected Research and development (“R&D”) expenditures present problems similar to those presented by advertising.65 million. receivables. but also the saleability and value of the borrower’s assets should the borrower default and a foreclosure sale be necessary.. THE CURRENT REGIME – – – – – – – EXAMPLE The Bolt Company is sold. bonds. which exists when the acquired business is not generating the excess earnings 3 . apply: The intangibles must be reviewed yearly for impairment. Intellectual property 3.000 If the company is sold for $5. and trademarks) 2. Under applicable rules of your bank. which is the value from having the business up and running). – Under SFAS 141 the basic principles of SFAS 121 discussed in Section VIII. mutual funds.000 Receivables 300. at which time its assets’ fair market value is as such: Cash 100. and training 4.000 Property. known as “intangibles”: 1. Your job is to make the loan that the bank is most likely to collect on. Prospects are quite good. Technology. intangibles are not so simple With intangibles the easy answer is to treat them like repairs and improvements by capitalizing those expenditures that are associated with value that will be realized in future years. copyrights. well-trained employees. DISCUSSION PROBLEM: A LOAN OFFICER MEETS INTANGIBLES C.CHAPTER XI: INTANGIBLES – – – Financial accounting developed to report on low-tech (by contemporary standards) businesses that sell goods Businesses in the new economy present tough accounting issues Modern day businesses make money in new ways.700. etc. to make things balance there must be $2.S. How do you decide which of the two businesses to lend to? – Usually lawyers think of intangibles as stocks. those unidentifiable assets are considered goodwill. To evaluate the likelihood that the borrower will have cash available and make required loan payments. successful advertising can be a gold mine. to accountants there are two types of intangibles: 1. but these are not called intangibles by accountants. but most either fails or has limited success (GAAP expenses all R&D) GAAP does book intangibles in one important situation: When a business is acquired at a purchase price that exceeds the total fair market value of identifiable assets (tangible and intangible).75 million accounted for. Marketing and branding 2. where the excess debit is accounted for by using “goodwill” Goodwill: A bookkeeping entry that is required so that the debits equal the credits B. VALUE IS GETTING HARDER TO SEE You are a loan officer at a bank.B. non-patentable technology.

PROBLEM: R&D G. and human capital The costs of intangibles are expensed so a high-tech company that is doing well economically shows as little profit on its financial statements as a business that is doing poorly Financial accounting for income does not help investors During the tech bubble investors gave up on financial accounting and SEC-required disclosures and instead bet on a company’s management team or product. (8) Testing the production model. while depreciation is an allowance for an anticipated loss in value) Intangibles generally are riskier and less fungible (marketable) than tangible assets 1. with an associated expense) In the case of intangibles depreciation is normally known as “amortization” (technically. until it was realized the companies were never going to throw off cash as to have real value FASB is doing little about self-developed intangibles (accountants lack the expertise to deal with them and companies do not want to release information that is not required out of fear of losing a competitive advantage) D.S. THE TECH BUBBLE – – – – – Review Section XI. for example IASB allows capitalization and amortization. Does this change your analysis as a loan officer? Would it if you knew little about the value of the high-tech firm’s patent? Do you think that the efficient capital markets hypothesis applies to loan officers? An automobile company undertakes the development of a new hybrid car that can use either electric batteries or fossil fuel. (3) Designing a prototype. know-how. amortization is just a cost allocation.S. the tech bubble and its demise all seem obvious because highs-tech companies invest in their businesses. rules for intangibles are more conservative than international rules for competitors. (2) Doing basic laboratory work on integrating the two power units. the high-tech firm’s financial statements show little net income (because of the expensing of all of the R&D associated with developing the patent) and report few assets and little net worth.– – – – for which the buyer paid a premium (if there is an impairment. not by buying machinery. Matching is more difficult with intangibles (when matching is unclear. Intangible value can seem less real and much less connected with related expenditures 2. of development (but not research) Tougher U. expensing is the default rule) The U.S. Expenditures are incurred as follows: (1) Doing basic laboratory work on electromagnetism. the intangibles must be written down accordingly. PROBLEM: THE INTANGIBLES OF THE BOLT DIVORCE 2 . but by building intangibles like technology. Under current GAAP.S. over five years or so. The project ultimately succeeds and an hybrid car is produced. (7) Engineering the production process. companies in competing for capital in the increasingly international capital markets In hindsight. (9) Doing further testing required by government agencies to be permitted to sell car in U. Do you want the other lawyer to understand the economics of intangibles? E. rules burden U. TO WIT. Which of these expenditures should be expensed? Which are expensed under SPAS 5 (as described in Note 5)? Reconsider the Bolt divorce described in Problem V.B.E. (4) Building a prototype. ACCOUNTING DIFFICULTIES FROM INTANGIBLES. (5) Testing a prototype. PROBLEM: ACCOUNTING AND THE REALITY OF INTANGIBLES F. (6) Designing the production model.

By adding the word “total” the parties meant to include the value of Triangle’s intangible assets.– Intangibles are of interest whenever one is trying to value businesses and interests therein H. and partner at Ernst & Ernst.270. The controversy in this case is over enforcement of Piedmont’s option and the formula to determine the purchase price to be paid by Piedmont: An amount per share of stock equal to the sum of the two following items. THE ECONOMIS OF PICKFORD – 2 .000 calculated by Borthwick (2) In computing the option price neither the accountants nor the trial court included goodwill in the total book value (3) The components of goodwill should include (i) the fair market value of the telecasting license. which means everyone intended to include goodwill. The network provides programming 2. which Piedmont exercised.000 not the $86. This case does not hold that goodwill must be included in all buyout options. Piedmont owned 1. only that the parties involved intended for it to be when they created the contract when the used the term “total book value. The court feels that Piedmont intended to pay Pickford a fair price for her involvement in securing the license and making the station a success. and NBC In markets where a greater number of stations exist each national network enters into an exclusive affiliation contract with one station in that market. and (2) An amount determined by multiplying the average net annual profits of Triangle by five. (“Piedmont”) and Mary Pickford Rogers (“Pickford”) were rival applicants for a license from the Federal Communications Commission for a television station in Winston-Salem.000 shares of stock. divided by the number of outstanding shares of the corporation: (1) An amount equal to the total book value at the beginning of any such period adjusted to reflect an annual depreciation and obsolescence charge of not over 10% against such tangible assets as having been depreciated on the books at a higher rate.548. Rogers “Television Station Buyout Option” Piedmont Publishing Co. Triangle was awarded the license and an exclusive local contract with the National Broadcasting Company (“NBC”).000 (in fraction form Piedmont owned 2/3 stake and Pickford 1/3 stake in Triangle). The two decided to pool their interests and organized a corporation. The trial court found: (1) Triangle’s accountants correctly interpreted the option. Since Borthwick gave no consideration to goodwill in his computation it must be reconfigured. Harry Borthwick (“Borthwick”) an accountant. The agreement gave Piedmont an option to buyout Pickford. Triangle Broadcasting Corporation (“Triangle”) under NC law in order to apply for the license together. however in contract law the parties’ intent controls the meaning of the contract terms. which is advantageous because: 1. Pickford alleged the purchase price computed by Triangle’s accountants was inadequate and unfair and the formula was inappropriately applied. The network promises the station to offer it first call for all programs broadcast in that community 3. The network pays the station a percentage of the national advertisement revenue Commercial television is dependant on advertising revenue I. and properly applied the formula Pickford contended that it was error in connection to: (1) The true market value of Triangle’s television station when the option was exercised was $1. (ii) the fair market value of the television station. The contract uses the words “total book value” in the formula. valued at $100.000 and Pickford owned 500 shares valued at $50. GOODWILL FOR AMERICA’S SWEETHEART CASES Piedmont Publishing Company v. CBS. Past decision appear to be in conflict about the answer. and (iii) the fair market value of Triangle’s contract with NBC The question presented is whether goodwill should be included in the book value of Triangle. NC.23.” – – Since 1955 there have only been three major television networks: ABC. which would make the Pickford’s option price around $400. computed the option price.

patents. PROBLEM: ADVERTISING EXPENDITURES O. CLASS NOTES – – Intangibles: Assets that aren’t represented by anything normally thought of as an asset 1. while Tooey was knowledgeable in accounting? (2) Why was Pickford involved in the television station in the first place? (3) In this light. it is very risky because if something happens and the company’s name is tarnished the value can drop excessively Non-identifiable: Goodwill. but they were lucky.– – Network programming has substantially exceeded local programming in attracting viewers Network affiliation has an intangible value associated with both attracting viewers and advertisers (1) Note that Judge Drapeau. covenants not to compete How do we account for intangibles. Without knowing accounting and finance. copyrights 2. Pickford presumably had very competent counsel. how would the contract have been drafted? Could Ernst & Ernst have determined fair market value? Would either party have trusted a formula or one person to determine market value? As a lawyer interested in a clear and workable contract. Is it relevant that Pickford involved valuation. would you prefer a book or market value option price? (6) Piedmont’s lawyers could not have been much clearer in saying that they wanted GAAP value. PRE-OPENING AND START-UP “EXPENSES” N. you cannot sell it or get rid of it the only way to sell it is to sell the entire business (can sell technology or knowledge but some stuff cannot be sold and that is goodwill) Problems include different accounting rules for tangibles and intangibles (if a business puts up a sign it has an asset. there is no real cash value since you can not sell a trained work force.E. they are also hard to value and once you do value it. copyrights. the lawyer cannot ask the right questions or be guaranteed of grasping the answers. trademarks. J. Identifiable: Trademarks. but the money spent on what to put on the sign is an expense) US rules are different that foreign rules (R&D must be expensed in the US) When you build inventory or a facility you capitalize all building costs When you build a patent you cannot capitalize R&D costs – – – – – – – 1 . Thus. NOTES AND PROBLEMS: PICKFORD K. Judge Drapeau saved them. why do you think that the option contract price was the sum of book value plus capitalized earnings? (4) Did matters play out as was expected at the time that the contract was drafted. particularly given the early exercise of the option? (5) If the parties had intended to use fair market value option prices. unlike the Iowa Supreme in Tooey in Section X. ignores GAAP when accounting is involved in interpreting a contract. is Judge Drapeau right as a matter of contract law? (7) Pickford’s lawyers probably did not understand what a bad contract she was signing. There is a message here: A lawyer cannot rely on others to understand a transaction and its accounting and explain it to the lawyer. ACCOUNTING IS POWER (Not Required) (Not Required) (Not Required) (Not Required) L. net profits? Is it relevant that Pickford presumably knew little accounting (although presumably her advisors did). Unidentifiable: Goodwill A company with incompetent employees and bad management is going to make less money than a business that has the exact same assets but well trained employees and good management Real technology is patents. NOTES AND PROBLEMS: WINSTAR M. while Tooey involved a more technical concept.

it is hard to come up with short term solutions using GAAP 1 . since goodwill is not included in the value they won arguments that they could not be held liable for judgments that were for more than the company was worth PICKFORD: Piedmont and Pickford enter a deal for 2/3 and 1/3 respectively and a buyout option Tooey and Pickford were both problems that occurred in a short period of time GAAP is not good in the short term Had the contracts in these cases lasted over a long period of time there would be less of an issue GAAP assumes long term.– – – – – – – – – – Businesses that grow by buying assets go up on the books while companies that build by advertising appear stagnant or go down When you buy a business there is a transaction and the accountants allow goodwill to be put on the books Under the 2002 rules you test the goodwill for impairments periodically Microsoft goodwill (pg. that businesses are going to continue. 375) Tobacco companies won their legal battle that accountings rules should apply and book value should be the value of the company.

Dreamworks stock value recently fell 14% in one day after the company announced unexpectedly high returns of the DVDs of Shark Tales and Shrek 2. reconsider the analysis in Section VII. The amount of loss can be reasonably estimated A statistician might want to book liability discounted by the risk. BAD DEBTS 3 . (3) SFAS 5 can apply to the same assets as SFAS 121. Accounting rules for certain specified contingencies (two most important contingencies: (i) Pension and retirement benefits and (ii) health care for retirees) 2. Basic approaches to SAFS 5 (SFAS 5’s two most common items: (i) Bad debts and (ii) lawsuits) 3. discussed in Chapter X. revenue cannot be booked at all unless “collectibility is reasonably assured”) When goods are delivered prior to cash being received accounting treats the associated receivable as a receipt (under SAB 101 questionable receivables and associated revenues cannot be booked) C. which was discussed in Section X. which when resolved in the future may result in either (i) legal liability or (ii) damage to or loss of an asset In this chapter: 1. which plays an important role in GAAP (uncertainties as to when revenue is earned cause considerable accounting indeterminacy) Contingencies: Uncertainties arising out of events that have occurred already.. a key financial accounting principle. but FASB books (i) the entire liability. What is the relationship between the two pronouncements? (4) What does SFAS 5 say about the accounting for an announcement by the reporting business’s sole supplier of some crucial commodity that the supplier will raise prices substantially next year? (5) If a company commits a tort and carries partial insurance with regard to any potential liability.C. if not probable Accountants interpret “probable” as 75% likely (a very high degree of certainty) Disclosure is not necessary if the matter is less than 20% likely If the probability is between 20% and 75% likely it must be discussed in the notes The right-or-zero approach to measurement leads to troubling outcomes: If a liability is huge and highly likely. or (ii) nothing. PROBLEMS: SFAS 5 D. discussed above in Chapters VIII and X.K(1)) (2) How should the possibility that goods will be returned be accounted for? What does this say about channel stuffing. INTRODUCTION – – – – B. but cannot be reasonably estimated. what is the accounting? – – The most important role of SFAS 5 is as a backstop to the basic revenue recognition rules discussed above in Chapter X (under SAB 101. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements 2. How GAAP’s rules for contingencies facilitated the troubling management of earnings by various companies The current rules for contingencies are contained in the very important SFAS 5 Consistent with accounting conservatism. SFAS 5 – – – – – – (1) How should possible warranty claims be accounted for? (In this light. zero is automatically the right estimate (why this is right is not obvious) Some of Enron’s games involved SFAS 5 A.CHAPTER XII: CONTINGENCIES – – – Conservatism. if probable. is an approach to uncertainty. gain contingencies—uncertain future gains—are not booked until recognized Loss contingencies are events that (i) occurred prior to the end of the reporting year and (ii) may result in a cash loss or an asset’s value being impaired at a future time The key rule of SFAS 5 is an estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met: 1.

if the business collects more than expected less will have to be added to the allowance at year end and profits will be bigger for the current year) To an accountant the allowance for estimated uncollectible amounts is analogous to depreciation: 1.000 % Collected 99% 90 85 60 35 E. revenue cannot be booked until cash or other property is received EXAMPLE A wholesaler’s experience may be as such: It will collect 97% of non-overdue amounts. actual.000 (total estimated uncollectible) $145.000 $200. A special write-down is made to reflect expectations 4.000 overdue two months or less (15% estimated uncollectible) $30. which causes a smaller current-year profit (conversely.– – Statistically even the best debtors sometimes do not pay their debts and SFAS 5 accommodates accrual accounting to this reality by reducing the total receivables. During the year.000 $100. An estimate based on past experience is made 3.” and most commonly “bad debit reserve”) If it is not possible to estimate future losses. and 15% of amounts overdue by more than two months. Allowance serves conservatism (it is overtly optimistic to book all current sales revenue when it is known that all will not be collected) Financial statements do not present an overly optimistic picture of the business – – – A firm’s allowance for estimated uncollectible amounts at the beginning of the year is $30. reducing the allowance. 85% of amounts overdue by two months or less. the excess losses are expensed when realized.000.000 non-overdue (3% estimated uncollectible) $30. $1.000 overdue by more than two months (85% estimated uncollectible) $85.000 – – – The wholesaler must fully account for its receivables with further adjustments for the books at the beginning of the current year that already reflected a write-down for the preceding year’s estimated amount of collectible amounts (during the current year. It effects matching (the portion of the allowance for a year that relates to sales made during the year thus matched the current year’s sales made during the year thus matches the current year’s sales revenues with the losses expected to be realized in the future as a consequence of the current sales) 2. as if the losses were payments on the allowance quasi-liability (at the end of the year the allowance is likely to have been nearly or completely exhausted by losses realized during the year) If the cumulative amount of bad debt losses realized during a year exceeds the beginning-of-year balance of the allowance for estimated uncollectible amounts. At the end of the year the wholesaler examines its receivables and breaks them down by whether they are overdue and by how long.000 20. The firm’s relevant collection experience is as follows: Age Under 1 Month Between 1 & 2 Months Between 2 & 3 Months Between 3 & 4 Months Over 6 Months Its year-end receivables are as follows: Age Under 1 Month Between 1 & 2 Months Between 2 & 3 Months Amount $1 Million 150.000. and thereby reducing profits to reflect the estimated portion of the receivables that will not be collected (known as “allowance for estimated uncollectible amounts. A business asset is worth less than its historical cost 2.000. rather than expensed. it’s actual losses are $29.” “allowance for estimated losses. specific receivables became wholly or partially worthless) Realized losses are charged against the allowance for estimated uncollectible amounts.” “allowance for doubtful accounts. Adjustments are made as matters play themselves out The allowance for uncollectible amounts serves two functions: 1. PROBLEM: ALLOWANCE FOR ESTIMATES UNCOLLECTABLE AMOUNTS 1 .

000 = $650 Total = $30. You represent EMERGING in defending high-profile product liability litigation. Now. including dollar amounts and probabilities.000 35% of $1. and asks for (i) either the attorney’s comments on the management-prepared list of asserted claims or the attorney’s own list of asserted claims and (ii) the attorney’s confirmation of the completeness of management’s list of asserted claims If the attorney does not reply or refuses to confirm the auditor will not certify the financial statements The ABA encourages attorneys to reply that they cannot evaluate a claim. balancing of (i) the concerns of the affected professions and (ii) of the public interest in meaningful financial statements.000 60% of $5. Paragraph 10 provides: Disclosure is not required of a loss contingency involving an unasserted claim or assessment when there has been no manifestation by a potential claimant of an awareness of a possible claim or assessment unless it is considered probable that a claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable An unasserted claim need not be booked or even disclosed as long as it is not “probable” that the potential claimant will assert the claim (a business could have a huge potential liability suit over a toxic waste spill.000 = $3. wants to make the new G.000 90% of $150. EMERGING has retained a Big 4 accounting firm. PROBLEM: AN ATTORNEY AND AN AUDIT 3 .000. the attorney should resign (which usually gives notice to auditors) Attorneys never have to deal directly with auditors and so the attorney-client relationship is protected The limited disclosure requirements in Paragraph 10 of SFAF 5 means that accountants do not find out about remote unasserted claims F. Because EMERGING is small.000 = $2. in order to facilitate SEC clearance of the IPO. if questionable. he will block certification of EMERGING’s financial statements and will report EMERGING to the SEC. He threatens that.000 – – – – – – – – – – – – – Lawyers run into accountants frequently when the accountants must reflect threatened or pending litigation on the financial statements SFAS 5 reflects a careful. the key to which is the “audit letter” sent by management to lawyers Audit Letter: List of all material asserted claims and unasserted claims (with descriptions and evaluations). based on matters to which the attorney gave substantive attention. just out of school. the Big 4 firm has assigned its most junior manager. to the firm’s first audit of EMERGING. if you do not comply.000 85% of $20. unless it is extraordinarily clear (if the attorney so declines to comment managements treatment is usually adopted) For unasserted claims the attorney must communicate to management. if they believe that the evaluation is incomplete If management does not disclose to the auditors facts involving matters to which the attorney gave substantive attention and believes must be disclosed.000 $1. thus.000 = $15.000 1. but so long as it is not probable the information will get out no accrual or disclosure is required) As to an asserted claim SFAS 5 provides that the claim is booked only if (i) it is probable that the business will lose the case and (ii) the amount of the judgment can be reasonably estimated Defense lawyers usually either think (i) they are going to win or (ii) they cannot guess what a judge or jury will award if they lose Very few reserves are established for litigation losses (if a pending lawsuit is not a joke a footnote is to the financial statement is required) The American Bar Association and the AICPA negotiated a 1976 “treaty” controlling the professions’ respective procedural responsibilities.650 – – 5.000 = $10. LITIGATION The EMERGING company is about to try to sell its stock to the public for the first time (an Initial Public Offering). EMERGING’s management really wants the IPO and. EMERGING has used a small accounting firm thus far.176.Between 3 & 4 Months Over 6 Months What is the firm’s total expense related to bad debts for the year? 99% of $1. management has decided must be disclosed under SFAF 5. but not the auditor. The rookie manager wants to review your entire file and demands a letter from you that provides your evaluation of the case. presented to the auditor during an audit (the auditor assumes management has consulted with its attorneys in connection with the list) Management sends an audit letter to the attorneys.

Inc. One of Freddie Mac’s principle financial goals was to achieve strong.3 billion over two years The Report of Investigation by the Special Investigative Committee of the Board of Directors of World Com. to smooth out the results of two or three years revenue can be deferred or expenses can be accelerated SFAS 5 is a perfect tool for overestimating the allowance for estimated uncollectible amounts. is similar to a bank account that does not appear on the financial statements. the excess is an expense in the year booked and in later years the losses realized can be charged against the excess allowance. like Freddie Mac for whom the Baker Botts law firm prepared an Internal Investigation of Certain Accounting Matters: 1. a violation of the accounting principle that reserve created for one expense type cannot be used to offset another expense WorldCom’s accrued line costs liability fell over $1 billion in 2001 Other companies managed earnings more systematically. reserves. the accruals should be increased (if lower. so as to artificially increase earnings $3. WorldCom manipulated this process in three ways: (i) Releasing accruals without any apparent analysis of whether the Company had actually had excess accruals in its accounts. when they had excess accruals. Line costs are immensely important to WorldCom’s profitability because they are its single largest expense (from 1999 to 2001 they accounted for approximately half of the Company’s total expenses) 4. tells the story of WorldCom’s reserve manipulation: 1. Line Costs: the costs of carrying a voice call or data transmission from its starting point to its ending point 2. and they had a long-standing practice of making discretionary accounting judgments to produce financial statements that closely approximated expert analyst’s estimates (they H. and managed earnings are therefore sometimes referred to as “cookie jar” accounting Big Bath Accounting: A company sets up a large reserve in an initial year (the big bath). Each month WorldCom had to estimate the cost associated with use of non-WorldCom lines and facilities.auditors happy in order to get them to certify EMERGING’s financial statements. In accordance with proper accounting procedures WorldCom set up a liability account known as an “accrual” on its balance sheet. which says the company does not need to disclose the information. Since accruals are based on estimates they must sometimes later be adjusted. and they must therefore pay an outside service provider for carrying some portion of its calls 3. Tell the client: They should call the manger’s boss and make noise about him trying to implicate them in problems that they do not legally need to disclose – SFAS 5 reflects conservatism since loss contingencies are booked while gain contingencies are not. Most of WorldCom’s residential and commercial calls outside urban areas must flow through non-WorldCom networks. just to be able to charge future costs to the reserve (the bath year is usually a year in which the market is already expecting bad news. (ii) not releasing accruals in the period in which they were identified. stable earnings growth. and (iii) reducing reported line costs by reducing accruals that had been established for other purposes. while technically a liability or an offset to an asset account. What do you tell your client about how you and it should deal with the new auditor? Tell the auditor: Read your own rules and the treaty. because more bad news till not hurt the stock price much) The most famous abuse of reserves occurred at WorldCom: WorldCom reduced accrued expenses. which increases profits in the later years A reserve. thereby taking expenses out of (or pushing revenues into) future years Many mangers believe that the market prefers companies whose earnings increase smoothly. they should be decreased) 7. although the relevant bills may not be realized or paid for several months (WorldCom was forced to recognize the estimated costs immediately and treat them as an expense for financial statement purposes) 5. EARNINGS MANAGEMENT – – – – – – – – – 2 . as bills arrived they WorldCom would pay them and reduce the accruals accordingly 6. however this conservatism also makes it much easier for management to engage in troubling earnings management Earnings Management: Management makes an early year look worse in order to make a later year or years look better by accelerating expenses into (of deferring revenues out of) the current year. and line costs accrual estimates are very difficult to make (particularly for foreign telecommunications) and if payments are running higher than the estimated amounts.

Microsoft: Anti-trust legislation in Europe. The general effect of this practice was to move their stock price to within one or two cents of the estimates 3. WorldCom: Regulations may increase operating costs (pg. and (iii) preserve earnings for use in later quarters so Enron could meet analysts’ expectations 3. If it is probably that the loss has impaired an asset it should be booked (probable means more then 75% likely) 2. 391) 4. When a loss is less than remote but more than likely (over 20% likely) it must at least be discussed in a footnote Likely losses are discussed: 1. Persuasive evidence of an arrangement exists 2. Microsoft denies these allegation and expects that they will not have an adverse effect on financials (pg. Collectibility is reasonably assured 5. 532) 3. Enron: “Enron believes that the ultimate resolution of these matters will not have a material adverse effect on its financial position or results of operation” (pg. DISCUSSION PROBLEMS: SMOOVE (Not required) – – – – Only book gain contingencies when they are recognized Loss contingencies are events that occur prior to the end of the reporting year and may have an effect on income 1. 415) Revenue recognition requires: 1. GE: We may have to clean up pollution (pg. SFAS 91 required that when actual payments differed from estimates a catch-up adjustment was to be made. Maintenance of SFAS 91 is problematic in two ways: (i) The existence of the reserve was not permitted under SFAS 91 and (ii) at one point the Company departed from its previous practice and used a different methodology in calculating the reserve 5. Due to rising energy costs Enron’s profitability quickly increased by over $1 billion during 2000 and 2001. A business is not required to book a liability unless there is both a 75% chance it will occur it and the loss is estimable 3. The seller’s price to the buyer is fixed or determinable 4. Delivery has occurred or services have been rendered 3.– believed they were free to do so under GAAP as long as the amounts were not quantitatively material) 2. especially the SFAS 91 amortization reserve. 310-1) 2. Does not count if you sell to a shell corporation or a sale that the buyer has the option to sell it back J. rather than a speculative trading company whose stock would trade much lower) 2. the legal or general contingency reserve. (ii) avoid reporting large losses in other areas of business. which if disclosed to the public would have made it apparent that Enron Wholesale’s revenue was closely tied to the market price for energy (this would undermine Enron’s description and presentation of itself as the dominant “intermediator” in the energy markets. This plan was done solely to accomplish the goal of reporting a higher earnings per share number than expected in order to artificially inflate Enron’s share price I. The practice was directed primarily at a series of reserve accounts. As the size of the reserve grew Arthur Anderson became uncomfortable with the process Enron is best known for cutting edge financial engineering but the first criminal indictment of Jeffery Skilling focused on old-school earnings management: 1. Skilling fraudulently used reserve accounts within Enron Wholesale to (i) mask the extent and volatility of Enron Wholesale’s windfall trading profits. CLASS NOTES 2 . The Chief Financial Officer enhanced the amortization model and the Company created a reserve to absorb the differences between the estimated and actual prepayments and recorded the catch-up adjustments to the reserve rather than booking them to the income statement as required by SFAS 91 7. so Freddie Mac created a model to estimate the level of anticipated prepayments and to calculate the amount of the catch-up amortization adjustments 6. and the tax reserve 4.

as opposed to GE who does not 1. if the business does not believe that they are going to be caught. they do not need to disclose it because otherwise plaintiff’s lawyers could use the financial statements as ads for lawsuits) 4. WorldCom sells to individuals so their paid-in capital is 53 billion with 3 billion debt reserve Microsoft views post-sale activity as a way they earn their money. Being a defendant in a lawsuit is a loss contingency (you only have to book if it is probable or 75% likely and you can estimate the cost of losing) 2.03 billion with 40 million questionable 2. they consider that a reason why you bought the product and they book at the time of purchase 2. GE only booked about 97% of receivables 3. Lawyers must communicate to management not the auditors about facts and unasserted claims they believe should be included in the statements WorldCom created over $3.3 billion in profits by manipulating their earnings management Enron did not want their earnings to go up too much in one year (when they ripped off California) so they manipulated their earnings to spread it out over future years Big bath accounting is purposely making a bad year look worse in order to make future years look better 1 . Enron 3. Disclosure is not required of a loss contingency involving an unasserted claim when there has not been a manifestation by a potential claimant unless it is considered probable that someone will assert a claim and there is a reasonable chance they will be successful (in other words. Microsoft sees themselves as making money on updates and they defer revenue they make on the products (allocate the purchase price to take into account how much of the price the buyer paid for the product and how much they paid for the updates) Lawyers do not want to have to deal with accountants directly so that they do not have to risk any violation of confidentiality ABA and AICPA came to a treaty about how lawyers and accountants would interact with each other during a companies audit 1. Very few lawsuits hit the income statement until after a judgment has been handed down and appeals have been exhausted (no defense lawyer is going to admit that either they will lose or that they know the extent of how badly they will lose) 3. they make money because of the warranty.– – – – – – – Even if you sell to the very best customers there is still a chance that you will not get paid (it may be only a small percentage but you need to take it into account) 1. GE charges warrant costs to their reserve.

CLASS NOTES 3 . INTER-BUSINESS EQUITY OWNERSHIP C. THE SEPARATE-ENTITY ASSUMPTION (Not Required) (Not Required) (Not Required) (Not Required) (Not Required) B.CHAPTER XIII: RELATED PARTIES A. SPECIAL PURPOSE ENTITIES E.. DISCUSSION PROBLEM “PRINCIPLES” AND FINANCIAL ENGINEERING F. PROBLEMS: STOCK OWNERSHIP ACCOUNTING D.

which deals with the third complexity of business. Finance is not the science it is supposed to be 2.) Businesses can acquire these resources in a variety of ways 1. Property can be obtained in infinite ways (purchased.. Individuals provide services 2.) Two businesses that start off with the same resources can turn out completely different based on the way they use their resources Chapters II through IV focused on finance’s endeavors to value all businesses using rigorous methods (basically comparing apples to oranges). The arrangements between those providing these resources 3. Current earnings are perpetuity-like. Accounting assumes that all transactions involve an even exchange. The basics of finance and accounting are reviewed one last time (emphasizing the useful information they provide) 2. Value earning capacity (goodwill. the numerous aspects of businesses (finance only has to deal with equity) 1. sold and consumed (property can be tangible like buildings and machines or intangible like stocks and bonds) 3. traded. Individuals can be employees or contractors 2. which incorporates powerful simplifying assumptions: 1. THINKING AND TALKING ABOUT BUSINESS – – – – – – 1 . in which complexities lie in: 1.SUMMARY AND CONCLUSION – – Finance and accounting have not turned out to be as clear cut as one would hope 1. Accounting starts with the business’s financial books and records 2. A business is viewed as a generator of cash flow over time 2. etc. Must adjust for the time value of money since a dollar today is worth more than a dollar tomorrow (done by discounting the future cash flow to the present) 3. The accounts are presented on a balance sheet to convey the information more efficiently. known as “double-entry bookkeeping” 3. TAKING STOCK – – B. The mix of resources used 2. how it uses its resources 1. Property is used. The most obvious source of new wealth for the equity is the business’s ordinary operations A. constructed. Accounting is not the mechanical rules it is supposed to be In this chapter: 1. each transaction is reflected in two mirroring entries: one for what is received and one for what is given up. How these resources are used Businesses use a variety of resources: 1. a business’s (equity) value is determined by simply dividing those earnings by the appropriate interest (capitalization) rate Chapter V focused on accounting’s difficult problem. A critique of modern finance and accounting (not to undermine their value but to increase knowledge of their usefulness to an attorney) This text has been about how one thinks and talks about businesses Businesses involve individuals pooling resources to produce (or acquire) and sell products or services. with assets on the left and liability and equity on the right 5. The income statement measures how much money the business is making for the owners of its equity or how equity increased over the course of the business year 2.CHAPTER XIV: . know-how. Similar accounts are added together as if they are one big account 4. etc. The balance sheet deals with the first two questions of complexity: (i) the variety of resources and (ii) the multiple types of claims thereon (the resources are the assets and the claims to the resources are the liabilities and equity) 6. Each side of the balance sheet must equal the other Chapter VI focused on the income statement.

Expenses are also booked on the income statement when incurred or accrued (when a business is paid in advance the charge is deferred until the expense is actually accrued) Chapter VII focused on the matching of revenues and expenses that are associated with each other. In most cases accounting recognizes delivery as the moment that all revenue is earned 3. in which the cost of such property needs to be matched to the revenues it generates over its useful life 3. which the rules of GAAP take into account 1. Losses that do not have to be shown on the financial statements but are not remote must be discussed in the notes to the statements Chapter XIII focused on the fact that financial accounting statements purport to report on independent businesses. The cost of non-operating assets are accounted for as negative investing cash flow 3. or the amount by which the total amount received for goods or services sold (“revenue”) exceeds the total costs associated with the sale of those goods and services (“expenses”) 4. non-patented technology. Operating profit is shown on the income statement 5. The most common method of depreciation is pro-rata or straight-line depreciation Chapter IX focused on the third type of useful financial statement known as the cash flows statement. Some property used in business is consumed over time and must be depreciated. GAAP’s most important mechanism for achieving matching is revenues and expenses is inventory accounting 2. on deliver. and average cost Chapter VIII focused on the important accounting problems represented by non-inventory assets and how to determine their book value 1. the goods remaining at year end are valued (priced) using various methods like FIFO. a comparatively primitive statement that only discloses the cash in less the cash out for the year (similar to a checking account) 1. and when the reporting business is not independent the statements should not be certified 3. under which the business determines the cost of goods sold expense for the year once a year. (ii) investing cash flows. which are reflected on the financial statements only if their future occurrence is probable and they are reasonably estimable 3. when in doubt resolve uncertainty in favor of making the business appear less well off 2. LIFO. There are detailed rules for dealing with uncertain future losses. 1 . usually accrual is when the goods are delivered 7. All direct and indirect costs of producing inventory (except interest) are treated as costs of goods sold 3. Borrowing has no effect on equity so is not shown on the income statement 6. know-how. In theory. A modified form of accrual accounting called “cash basis” or “cash method” resembles GAAP except that revenue is booked when received in cash and expenses are booked when paid in cash Chapter X focused on the heart of modern financial accounting. not financing.). the income statement reflects revenue as the company earns (“accrues”) it.– – – – – – – Profit is the increase in equity from one year to the next. GAAP’s rule for dealing with uncertainty is to be conservative.) Chapter XII focused on the fact that analysis underlying financial statements must deal with uncertainty 1. after later billing. and (iii) financing cash flows 2. More commonly used to time when costs are expensed is the periodic method. One difficulty is distinguishing costs of improvements (capitalized) and repairs (immediately expensed) 2. etc. a given good’s associated revenue is earned throughout its life from conception to the running of the statute of limitations on its liability for the company 2. Matters are more difficult with respect to the service industry Chapter XI focused on what an asset is 1. etc. cash flow 4. Interest payments reduce operating. Businesses differ as to when they actually get paid cash for goods or services sold (in advance. There are three parts to a cash flows statement: (i) operating cash flows. Modern businesses have considerable value that is attributable to resources not traditionally thought of as assets (goodwill. Some businesses use the perpetual inventory method to book costs as expenses. its recognition regime (the rules that determine when revenues and expenses are accounted for as such on the income statement 1. under which the cost of goods sold expense for year is the total cost of the specific goods delivered during the year 4.

Different books for different owners: When a business changes hands all assets are valued to reflect their cost at acquisition. Whether the information on GAAP financial statements good enough to be the heart of our disclosure-only (no price regulation) public capitalism 2. where the best source of information about them is their GAAP financial statements GAAP has well-known limitations that any lawyer using accounting information must understand to avoid using this information incorrectly C. Transaction between related parties are accounted for differently than similar transactions with third parties A corporation (the “parent”) with substantial stock holdings in another corporation (the “subsidiary”) may have to use special accounting due to the ownership Usually more than 20% ownership requires the use of the “equity method” for accounting for its relationship to the subsidiary Over 50% of the voting power obliges the statements to reflect the subsidiary on a “consolidated” basis. regulations. Historic costs: The biggest problem with financial accounting is the mismeasurement of assets and expenses as a consequence of the books using historic costs rather than current market values (GAAP financial statements can represent some stale numbers) 2. 3. and technology) 8. in particular. and GAAP has not worked well when dealing with transaction between parties that have common ownership 7. much depends on formal distinctions with little economic substance 4. human capital. Related parties: Accounting assumes that the reporting business is an independent enterprise as to every aspect of every transaction. this can make a business’s financial statements quite different in comparison to another similar business that has not changed hands 10. using assumptions that require it to simplify things and without a really good source to receive the necessary information from As to modern financial accounting there are a variety of difficulties 1. Services: The delivery-to-customers rule does not work well for service businesses that do not have a simple event like delivery to tell them when to book revenue 9. where the parent is treated as owning all of the subsidiary’s assets and debts and stock holders of the subsidiary are treated as stockholders of the parent – – – There are two fundamental issues this section is directed towards: 1. No improbable or hard-to-measure liabilities: GAAP financial statements show nothing for liabilities or expected losses related to past activities or assets already owned if either (i) the bad news is not “probable” (less than 70% likely) or (ii) the amount cannot be measured with reasonable accuracy (with it is ultra-conservative with expensing and unconservative here) 6. which makes it vulnerable to games designed to artificially create an event that would trigger recognition 3. this can make GAAP almost irrelevant to businesses whose principle resources are not traditional assets (businesses that are built on reputation. like in law. Whether it make sense for the law to use GAAP numbers in legal contexts. CONCLUSION: NUMBERS COUNT—SOMETIMES 1 . but accounting gives an artificial significance to a single moment in time. when should lawyers rely on GAAP in drafting legislation. A CRITIQUE: KNOWLEDGE IS POWER – – – – D. Answers wrong question: Accounting tells us how much the legal entity has recognized in the past years when it should tell us hoe much unneeded cash flow will the existing business throw off in perpetuity The law and lawyers need a way to think and talk about business Every lawyer should understand the time value of money and how risk affects value (if only to understand the economics of home loans and car leases) Most lawyers need to understand businesses. when they are recognized. Recognition: Under GAAP. 4. Intangibles: The cost of purchasing an asset is not treated as an immediate expense but as a deferred expense. Formal distinctions: In accounting. and contracts Finance is the rigorous science that values things in money. revenues and expenses are recognized over time. know-how. Conservatism: Accounting conservatism is admirable but it justifies bad rules (expensing all research and development) and facilitates abusive earnings management 5.1. 2.

CALCULATOR PROGRAMS – – – – The calculator programs below were created on a Texas Instruments model TI-83. however other similar models will have the capabilities to perform the same functions The following is code that the user must input into their own calculator which will be helpful when calculating perpetuity and yield for the discussion questions and during testing Underscores denote spaces Bold denotes calculator functions. PERPETUITY C. YIELD 1 .APPENDIX . everything else must be typed in A. INTRODUCTION PROGRAMS PRPTUITY: PROGRAM:PRPTUITY :ClrHome :Disp “_ _WHAT_IS_THE_ _” :Disp “ANNUAL_PAYMENT?” :Prompt P :ClrHome :Disp “_ _ WHAT_IS_THE_ _” :Disp “_INTEREST_RATE?_” :Prompt R :ClrHome :Disp “THE_VALUE_OF_THE” :Disp “_PERPETUITY_IS_” :Disp P / ( R / 100 ) PROGRAMS YIELD: PROGRAM:YIELD :ClrHome :Disp “_WHAT_WOULD_YOU_” :Disp “_LIKE_TO_CONVERT?” :Disp “ ” :Disp “_1:_NOM_TO_EFF_” :Disp “_2:_EFF_TO_NOM_” :Disp “ ” :Prompt X :If X = 1 :Then :ClrHome :Disp “_ _WHAT_IS_THE_ _” :Disp “NOMINAL_INTEREST” :Disp “_ _ _ _ _RATE?_ _ _ _ _” :Disp “ ” :Prompt I% :ClrHome :Disp “_HOW_MANY_TIMES_” :Disp “_PER_YEAR_WILL_” :Disp “_ _ _ _ THIS_BE_ _ _ _ _” :Disp “_ _COMPOUNDED?_ _” :Disp “ ” :Prompt C/Y B.

C/Y ) 3 .:ClrHome :Disp ►Eff( I% . C/Y ) :Disp “ ” :Else :If X = 2 :Then :Disp “_ _WHAT_IS_THE_ _” :Disp “_ _ _EFFECTIVE_ _ _” :Disp “_ INTEREST_RATE?_” :Disp “ ” :Prompt I% :ClrHome :Disp “_HOW_MANY_TIMES_” :Disp “_PER_YEAR_WILL_” :Disp “_ _ _ _ THIS_BE_ _ _ _ _” :Disp “_ _COMPOUNDED?_ _” :Disp “ ” :Prompt C/Y :ClrHome :Disp ►Nom( I% .

etc. more closely resembles the accounting on the GAAO income statement than that on the cash flows statement (basically GAAP that ignores receivables and payables) 1. Books revenue only when cash is received: Receivables (for revenue) are viewed as unrealized and not booked 2. determined by physically counting the number of goods on hand Company’s Market Value: Determined by multiplying the number of shares outstanding at the end of its most Compounding: Interest that is reinvested and earns interest (compounding period in the example above is one year) 5 .. but the practice is hard to police) Closing Inventory: Goods left over at the end of a period. a building. it is a pure bet Cash: Amount of cash in the bank Cash Flows: Cash (or the equivalent) received by the business less cash (or the equivalent) paid out (a checking Cash Method or Cash Basis: A type of income accounting most used in preparing income tax returns.4% means that each month 1/12 of that percentage is owed (1.45% per month) so the effective rate on 17. obsolescence. CAP RATE = PMT / VALUE) Channel Surfing: A manufacturer or wholesaler stuffs its distribution channel by delivering more goods to its customers than it knows that the customers can sell in order to book the revenue (the extra goods probably will be returned so the revenue is not really earned. purposely making a bad year look worse in order to make future years look better Book Value: Historical cost with some adjustments for things like wear and tear. or depreciation C Call: Option to buy (increases profit as value goes up) Call: Option to buy something at a later date at a set price (you are betting that the stock will go up) no capital is invested in the property. Books expenses only when paid: Payables (for expenses) do not appear on cash method financial statements Cash Receipts: Cash received Capitalizing: A stream of future payments reduced to the discounted present value Capitalization Rate or “Cap Rate”: The interest rate used in capitalizing future payments (VALUE = PMT / CAP RATE. therefore. management has decided must be disclosed under SFAF 5.86% (APR is an effective rate displayed in its nominal form)market conditions Asset Account: Record in respect to an asset (with student loans.4% is 18. as you take money out the asset goes up as you pay them back the asset goes down) Audit Letter: List of all material asserted claims and unasserted claims (with descriptions and evaluations).GLOSSARY A. because more bad news till not hurt the stock price much). DEFINITIONS A Account: Running record of transactions affecting one item (a bank account. an APR of 17.) Accounting: The process of analyzing and justifying one’s actions to another Accounts: Basic books and records a business keeps itself Accrual: Book the transaction before cash changes hands Accruing: Booking a revenue or expense for the sale of goods before cash changes hands Adjudication: Act like judiciary and decide the laws meaning Adjustable-rate or Variable-rate loans: Loans that provide for interest rate adjustments that reflect the current Amortization: The rate at which you pay down a loan Amortization Schedule: The terms of a loan that control when principle is to be repaid Annual Percentage Rate (APR): Computed by multiplying each compounding periodic rate by the number of compounding periods in a year. just to be able to charge future costs to the reserve (the bath year is usually a year in which the market is already expecting bad news. presented to the auditor during an audit (the auditor assumes management has consulted with its attorneys in connection with the list) B Balance: Amount in an account at a given time Balance Sheet: A useful way of summarizing all the accounts at an instant in time Big Bath Accounting: A company sets up a large reserve in an initial year (the big bath).

natural disasters in areas they are expected to occur (hurricanes in the Gulf of Mexico. and keep the extra 700. which plays an important role in GAAP (uncertainties as to when revenue is earned cause considerable accounting indeterminacy) Corporate Finance: Examines private businesses and is what is covered in this text Corporate Finance: Studies how businesses acquire and use money 1. is an approach to uncertainty. which means that the statements err on the side of caution by understating assets and overstating liabilities Contingencies: Uncertainties arising out of events that have occurred already. real estate. i. Buying property 5. buildings. improvements.e.000. at which time the lender may impose the sanctions specified in the lending contract period) Defease: Release the original borrower from the debt. which when resolved in the future may result in either (i) legal liability or (ii) damage to or loss of an asset Conservatism. Borrowing goods or services 3. stock usually drops on this day.000) you can sell the house.) Derivatives: Financial instrument whose value derives from something outside the bargain Dividends: Money that the company does not need is paid out to its investors in the form of a dividend Double-Entry Bookkeeping: Assures that the balance sheet balances by providing a limited check on arithmetic and transcription errors but says nothing about whether the entries are correct E Economic Depreciation: Exact actual decline in assets’ value (usually faster than GAAP straight-line depreciation) Economic Value: The estimated value of the use of the machine Effective Interest Rate or Yield: The interest rate after the nominal interest rate has been compounded Equity: What is left over for the shareholders when the creditors are all paid off Equity: Residual money owed to shareholders Equity Loan: Buy a house (500. pay off the loan.000 Ex-Dividend Day: Day on which holders of stock are locked in to receive a dividend regardless of if they sell it before the day the dividend is actually paid. equipment. Buying services Cost Accounting: A business’s internal accounting that measures profit on a product or service line Credit: An adjustment in a pair of entries that increases liabilities or equity or decreases assets Credit: Increase in a liability (bad thing) D Debit: An adjustment in a pair of entries that increases assets or decreases liabilities or equity Debit: Decrease in a liability (good thing) Debt Instrument: Proves the holder case payments at one or more specifies future times Default: The failure of a borrower to fulfill an obligation. while retained earnings build up stock value until paid out Expenditure: Any amount incurred. if the house goes up to (1.000) and borrow (300. some are deferred and not currently charged against revenues.000) down payment.Conservatism: Requires accountants to prepare conservative financial statements.000) with a (200. machinery. Selling goods or services 4. a key financial accounting principle. usually done when interest rates go up Deferral: Book the transaction after cash changes hands Deferral: Cash changes hands prior to the time when revenue or expense is recognized Deferring: Booking a revenue or expense for the sale of goods after cash changes hands Depreciation: The collection of accounting rules that provide how the costs of assets consumed in business are matched with revenues (not all assets are depreciated but most must be. at the closing the bank gets a mortgage on your house so that if you sell the house they get paid before you do and if you default on your loans they can force you to sell your house if you default. etc. tornadoes in the mid-west) are not sufficiently infrequent and unusual F 3 . expenditures not deferred are “expenses” Expense: A cost of earning revenue Extraordinary Items: Items that are booked in a special area of the income statement that are infrequent and unusual in occurrence (a car dealership falling into a sinkhole). Issuing stock 2.

first. pushing Inventory: A business’s stock of goods held for sale to customers Inventory Costs: The applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location JKL Left-Hand Entry: A debit. which focuses on current market values at the end of each period rather than waiting for a transaction to book the value 1. A 10% annual yield (1 / .” originally known as the Committee on Accounting Procedure (CAP) Forward Contract: One party unconditionally agrees to sell to the other party (and the other to buy) a fixed quantity of some asset at a fixed price at some point in the future (i.e. a 5% annual yield (1 / .5) has a multiple of 20 N Negative Amortization: Low payments with a high interest rate which gets added to principle and increases compounding Net Income. headquartered in London. at the end of the year assets are treated. as having been repurchased at these new values (liabilities are adjusted to reflect any change in their economic burden. Securities traders’ (or a bank that sells securities on the side) business is managing stocks and bonds. airlines agreeing to purchase X amount of fuel at Y price over Z years) G Generally Accepted Accounting Principles (GAAP): Rules that control basic financial statements Goodwill: A bookkeeping entry that is required so that the debits equal the credits H Hedge Fund: Investors buy shares of the fund.10) has a multiple of 10. Income: Other ways of referring to profit 3 . and second.Financial Accounting: Way in which capital users (business managers) report on hoe they are managing investors’ money Financial Accounting: How managers of for-profit businesses report to shareholders and others about the management of the business (by preparing and distributing financial statements Financial Accounting: Way in which capital users (business managers) report on hoe they are managing investors’ money Financial Accounting Standards Board (FASB): Responsible for setting out what accounting rules are “generally acceptable. so named because asset accounts appear on the left-hand side of the balance sheet Leverage: Borrowing to buy an asset Leverage: By borrowing to buy you increase the risk of gains and loses. the lender gets interest and commission Liabilities: Money owed to creditors Line Costs: the costs of carrying a voice call or data transmission from its starting point to its ending point M Mark-to-Market: Solution to the Savings and Loan problem was mark-to-market accounting. so their business is mark-to-market account statement is a simple cash flows statement) Mark-to-Market Accounting: An alternative to GAAP’s historical cost (recognition-based) accounting. resulting in gain or loss) Market Value: The wholesale cost to replace the inventory Multiple: Ratio of the capitalized value to the annual future payments 1. as having been sold for their fair market values. Net Revenue. MULTIPLE = 1 / CAP RATE 2. Critics say that this method is only reflective of how well the market is doing since a company can fluctuate with the current value of their assets 2. which invests in primarily dividends I Inflation: It takes more money this year than last year to buy the same basket of goods (a dollar this year has a different value than a dollar this year) Installment Sale: A seller financing. since the price is to be paid in installments over time Interest: Paid by the borrower to the lender to compensate the lender for borrower’s use of the lender’s funds International Accounting Standards Board (IASB): The international version of FASB.

GOODS SOLD = GOODS AVAILABLE – GOODS ON HAND AT END 2. COST OF GOODS SOLD = OPENING INVENTORY + PERIOD PURCHASES – CLOSING INVENTORY 5. (ii) keep a running total of all inventory purchases during the period. and (iii) take a closing inventory Perpetual Inventory: Keep track of each cost of item (airplane. 3. GOODS ACQUIRED = GOODS ON HAND + GOODS SOLD 2. and decreased for payments Pro-forma: Non-GAAP financial statements released in addition to GAAP statements that do not include certain expense items that do not qualify as extraordinary under GAAP (limited in that management must explain: (1) the difference between their pro-forma and GAAP. COST OF GOODS SOLD = OPENING INV. however the holder is not required to exercise their right while the writer must comply P Payables or Accounts Payable: Amount a business owes for products and services received but not yet paid for Periodic Inventory: Take inventory at the end of the period rather than keeping track of every item. Certified statements are not what the auditors would have prepared had they done the management’s job. there are a variety of acceptable ways to account for items Opinion Letter: Certification that the independent auditors have ensured the facts’ legitimacy subject to two conditions: 1. you group them all together 1. and (2) why the pro-forma version is preferable) Profit: Measure of how much better off the owners of a business are as a result of that business’s operations over a period of time (usually a year) Public Capitalism: Individuals investing directly in stocks and bonds (developed in the American capital markets in the early 20th Century) for an international convergence of accounting principles Public Finance: Examines governments 3 . just that they are not materially different from GAAP numbers 2. whose inventory only includes a few items at any given time Positive Amortization: Pay some of the principle plus the interest to avoid compounding Prepaid Interest: To an economist it is just reducing compounding. there are a variety of acceptable ways to account for items Option Contract: The “holder” has the right to buy from or sell to the “writer” certain property at a set price at some point in the future. yacht) and then when you sell them book the gain or loss Perpetual Inventory: Keep track of the actual costs of specific goods and expense these actual costs when the associated goods are sold and revenue is recognized. like yacht dealers. taxes. maintenance. All that is necessary to determine the cost of goods sold is to (i) remember last period’s closing inventory. When this formula is adjusted to account for multiple accounting periods the result is: GOODS SOLD IN PERIOD = GOODS AVAILABLE TO SELL IN PERIOD – GOODS ON HAND AT END OF PERIOD (“goods available to sell in period” includes goods left over from prior periods and goods acquired during the period) 4. increased to reflect subsequent additional lendings. Not tested by one standard set of rules. just that they are not materially different from GAAP numbers 2. Not tested by one standard set of rules. you can pay the interest before it is due Principal: The amount originally lent. Problem is that it is difficult to keep track of each individual item 2. etc.Net Lease: Requires that the lessee provide repairs. Used primarily by businesses. requiring the business to keep track of the cost of each inventory item in perpetuity 1. + PURCHASES – CLOSING INV. therefore at any given time a previously acquired item is either still on hand (not delivered) or has been sold (delivered) 1. GOODS SOLD = GOODS ACQUIRED – GOODS ON HAND 3. You only have to keep track of two things: (i) the inventory taken at the end of the year and (ii) the cost of your inventory Periodic Inventory: Takes advantage of the two facts that (i) the cost of goods sold only needs to be determined once per period and (ii) since sales revenue is booked when goods are delivered to customers only costs related to goods delivered during the period are relevant. in regards to the leased property Nominal Interest Rate or APR: The annual interest rate before compounding Nominal or Named Rate: Stated rate dependant upon compounding O Opening Inventory: Goods left over from prior periods Opinion Letter: Certification that the independent auditors have ensured the facts’ legitimacy subject to two conditions 1. Certified statements are not what the auditors would have prepared had they done the management’s job.

then at a later point the investor must return the same amount of stock as was originally borrowed (if the stock goes down or their investment goes up the investor will make money. it has nothing to do with management) Simple Annuity: Pays a fixed amount per year (or other time period) of r affixed number of years (or other time Short Sale: An investor borrows stock from his broker and sells it. so investors could not tell that the banks were in trouble (as interest rates rise the value of a bank goes down and as interest rates go down the value goes up. machines.. land. so if it goes down you make money but if it goes up you lose money (usually you cannot go out more than a year) Stock Options: An employer awards an employee an option to buy stock of the employer at some price above that at which the stock was trading on the grant date. etc. companies would money from paychecks under the Federal income tax withholding and send it on your behalf to the federal fund the business. after 3 years your yield would be 33. X months from now you must return the same amount of shares.1%) 3 . but this is not perpetuity like. a way of matching use) Time Value of Money: You would rather have a dollar today than have a dollar tomorrow because either (i) you can enjoy it today. when buying a put you are betting that something will go down. and were charged with felonies). interest rates went up so the value of their loans went down and accounting statements did not reflect this. they would use the money instead to that when they get their refund they get more money XYZ Yield: The percentage that you are actually owed (in a 10% nominal interest rate compounded yearly. if the stock goes up or the investment goes down they will lose money) Short Sales: Borrowing stock from your broker and selling it. now many people purposefully withhold extra money so government (small businesses got in trouble for not sending the money. so named because the liabilities and equities appear on the right-hand side of the balance sheet S Salvage Value: Value left over at the end of the machine’s life Savings and Loans: Banks were borrowing at 12% but their loans were at 5%.Pure Perpetuity: Promise to pay a periodic sum certain in perpetuity (forever) Put: Option to sell (increases profit as value goes down) Put: Option to sell something at a fixed price at a future date (if the underlying stock goes down then the value of the put goes up). assets that are valuable to a business by being used. avoid the need to draft complicated provisions to measure an employee’s effectiveness T Tangible Assets: Assets such as buildings. or (ii) put it in the bank and earn interest Trust Accounting: How a trustee explains their actions to the beneficiaries UVW Withholding: During WWII the US decided the best way to pay for the war was to tax wages. not by being sold (depreciation is needed to account for their use. known as a short position QR Receivables or Accounts Receivable: Amount a business is owed for products and services delivered but not yet paid for Regulations: Filing in the gaps in the statute Reserve or Sinking Fund View: Depreciation is the amount set aside (held in reserve) to replace deteriorating assets (technically a “sinking fund” is a separate cash account that is funded over time in order to assure that a business will have enough money to retire long-term debt that requires a large payment of principle maturity) Residual Value: The value of leased property at the end of the lease period Revenue: A gross amount earned from the sale of a good or service Right-Hand Entry: A credit.

24 Accrual (Revenue) Book: Test: Outline: 22 Annuity Book: Test: Outline: 8 Bonds Book: 26 Test: 21. 49 Outlines:38 Intangibles Book: Test: 20 Outline: Interest Book: Test: Outline: 4 Inventory Book: 89 Test: 9 Outline: 26 Lease Book: Test: 94 Outline: 9. 32 Outline: 8 By-pass Income Statement Book: 131 Test: 27. 51 Outline: Stock Book: Test: 22 Outline: Write Down Book: 229 Test: 50 Outline: 59 . 22 Outline: 32 Disclosure Book: 227 (fn. 12 Lawsuits 1 Book: Test: 27 Outline: Management Book: Test: 53 Outline: Passage-of-Title Book: Test: 52 Outline: Perpetuity Book: Test: Outline: 10 Present and Future Value Book: Test: Outline: 5 Profit Sharing Book: Test: 52 Outline: Repairs and Improvements Book: 109 Test: Outline: Salaries Book: Test: 22.Accrual Book: Test: Outline: 21. 54 Outline: 28 Deferral (Revenue) Book: Test: 19 Outline: 22 Deferred Revenue For Tech Support Book: Test: Outline: 53 Depreciation Book: 114 Test: 8. 24 Accrual (Expenses) Book: Test: 18 Outline: 23. 49 Outline: Contra Accounts (Negative Asset Accounts) Book: 116 Test: 51 Outline: 34 Deferral (What You Can Defer / Capitalize) Book: 95 Test: 8. 3 & 4) Test: 50 Outline: 58 Dividends Book: Test: 52 Outline: Employee Wages (See Salaries) Extraordinary Items Book: 131 Test: 20.

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